Discussion:C CORP CONVERSION TO S CORP

the question I have to ask is as follows.

should we convert to "S" just because we want to avoid double taxation? What are the other issues that I have to be concerned, if I do convert? what about the appreciated value on the real estate? how should I plan for changing the year end to december 31st? I will appreciate your help.

1.Built-in gains tax on that appreciated real estate will haunt you for 10 years. Get an appraisal. If client sells the r/e before the 10 year period, you will need to know how much of the gain existed on the date of the conversion. Built-in gains tax will apply on other assets as well if sold prior to 10 year waiting period. If business is sold, goodwill may be one of the assets that will be sold, so you may wish to have an appraisal of the business that will nail down the goodwill and other asset values at the conversion date.

2.Existing accumulated earnings and profits. Consider paying them out prior to 2009. Good possibility the 15% tax rate on dividends will go away after Bush leaves office. If you make the S election, you can elect each year to pay out AE&P prior to AAA in order to liquidate the C corp retained earnings.

3.You'll likely kiss the fiscal year goodbye with the S election.

4.If you stay a C corp, you could retain $50-$75k of taxable income in the C corp each year to gain the advantage of the low corporate tax rates. As an S corp, all of the K-1 income will be piled onto the owner's other income and be taxed at the highest marginal rate. (As long as the 15% rate is available on dividends, leaving $50k in a C corporation to be taxed, followed by taking a taxable dividend will yield an effective tax rate of only 27.75%) With the appreciating r/e in the C corporation, this is not a strategy I would recommend, as the tax on the back end will be nasty.

5.Not too much to worry about the change to 12/31 year end. The 5/31 return will be an 1120, the 7 month period ending 12/31 will be an 1120S, so there will be no doubling up of K-1 earnings in the year of conversion.

Hope this helps.

Regarding the undistributed profits, one plan my clients like for small businesses is to accumulate enough profits as a C corp to finance working capital needs (i.e. to fund inventory, accounts receivable etc.), paying taxes at the lower C corporation rates. Then make the S election and draw all future profits out of the company - after all, getting profits out to the owners for their personal use is usually the ultimate plan, and is almost always cheaper in terms of taxes with an S corporation.

If the client doensn't want to convert to being an S corporation, at the risk of sounding like a broken record, you may want to address the issue each year, to avoid surprises later. After a few years, you will "own" the problem of the appreciated real estate.

Are we having fun yet?

Good luck!

It seems the primary reason to convert most C's to S's is for the back end - when you eventually sell the assets of the business you don't want to get hit with the huge double taxation that can result. When C's look at the tax results of being a C vs. an S at the back end (hopefully with a realistic 10-year horizon if they choose to convert) most C's will be in favor of converting, even if they have to suffer some extra taxation along the way.

1. What happens to Retained Earnings of C-corp in conversion? Does it become basis in S-Corp? Is it taxed as dividned if distributed within 10 years?

2. If C-corp is part of a controlled group, does that have any affect on converting to S-Corp?

Thank-you!

2. I don't think so...but all controlled group rules still apply as to fringe and pension plans.

you are saying no matter if you change from C to S corp, the R/E are going to be taxed at the dividend rate. Usually an S's distributions are not taxed but I am guessing since this prior R/E from the C-corp was never double taxed it is going to have to be even though it is in the S-corps R/E balance from the conversion.

Can be devastating if large receivables, such as may exist in a medical corporation.

One of the greatest long term problems is the fact that you have that real estate in the corporation which, most would agree, should never have been done.

I wonder if you'd be better off keeping the C-Corp for the business and spinning-off the real estate into a more favorable tax entity?

If liquidation is the ultimate goal and the real estate is the largest chunk of the company's assets, would your client be better off selling the C-Corp with the real estate still inside? If there are other parts of the business that your client wants to keep, those could be spun-back to the client as part of the stock sale.

As others have correctly noted, this is not an easy decision. The client needs to have a clear goal in mind before he opens this large can of worms.

FlaGators, membership in a controlled group will certainly have an effect on whether or not S status can be elected. First of all, an S corp cannot have a C corporation as an eligible shareholder. So if the corporation is the subsidiary, it cannot elect S status. However, if the parent wants to elect S status, the subsidiaries may be treated a "qualified S corporation subsidiaries" (QSUB). In that case, the subsidiary retains its separate legal identity but becomes a disregarded entity for tax purposes and files what is the equivalent of a consolidated return at the parent level.

On the issue of taxation of C corp dividends paid out after the S election is made, another point to remember is that Democrats have just taken over Congress and will likely take the presidency in 2008. Therefore there may only be a short window remaining for those C corp retained earnings to be paid out as dividends taxed at 15%. So any S corps with existing C corp retained earnings may want to consider making the election FTF refers to electing to have distributions from R/E to be taxed from AE&P (C corp R/E) first rather than from AAA (S corp R/E), so that the C corp R/E gets drained before the tax rates are increased.

If a c-corp has a gain and then converts to an s-corp, the BIG lurks in the background for ten years before it evaporates. If you convert back to a c-corp before the ten years are up, the BIG slaps you around.

to S status. Even intangibles.

Here is a quick PHC read from the New York State Society of CPAs Journal... http://www.nysscpa.org/cpajournal/old/14469571.htm

If you are currently a C corporation and your only assets are the patent and prototype, your best tax bet is to sell the stock of your company instead of just the assets. That would allow you to cash the check at capital gains rates. If there are losses in your company, the buyer might prefer to keep the C status in order to leverage the losses. Are you the only shareholder?

Really, though, your options are highly dependant on the value of your assets. If there is just $5,000 in play, you have no viable options other than paying what you owe. On the other hand, if $5,000,000 is in play, there is much more room to be creative. What is a 'bunch of $$' in your world?

What is your basis? Let's say your basis is $2m for this hypothetical example and you get $8m in an asset sale. The C corporation would owe about $2.4m in taxes, meaning there would be $5.6m left to distribute. For the shareholders, a $5.6m stock sale has the same economic benefit of an $8m asset sale. (State taxes could also play a role, but I'm just roughing this with the Federal tax in mind.)

So, if $5.6m is a break-even stock price for the shareholders, what is the market generally willing to pay for your stock if you have a $2.4m tax liability? Without knowing anything specific, I'd say you should have no problem getting $6m and $6.5m is well within industry norms.

The additional advantage of the stock sale is that any unknown liabilities are passed along to the stock buyers and there is no cost to the sellers in shuttering the company.

Try to steer your purchasers in the direction of a stock sale. If the end-user/investor refuses to buy your stock (the most common outcome since buyers hate stock), sell your assets then focus your efforts on selling your stock in a separate, unrelated transaction. Just keep in mind that you have to do the stock sale in the same fiscal year as the asset sale in order to make the transaction viable to the purchaser.

If you need additional information or want to get discuss specifics in a less public venue, please send me email and I'll help point you in the right direction.

If you convert to an S corporation now, before you realize the benefits of the asset sale, that may be your best option. Do you have losses on the books now? Ideally, you'd want your company's value to be zero when you convert to an S. That way, you'll have used all your losses to offset your existing gains and no gains to traped in the C. If you had a zero balance or mild loss, converted to an S then sold your assets, that would put you in the best tax position.

For the type of money you're talking, please sit down with a sharp CPA or tax advisor. On an $8,000,000 sale, good tax advice could easily save you more than a million dollars. Expect to spend somewhere between a few hundred and a couple thousand dollars for the advice.

(And, next time you start a business, make sure to have a good CPA going into the project.)

also, the C-corp has inventory and A/R, is there a BIG concern here? (AR is worth 50K and Inventory about 80K)

thank in advance.

Kbryan1014 - There are no balance sheet changes to these accounts.

John Huddleston Seattle Bellevue Tax Accountant

John Huddleston Seattle Bellevue Tax Accountant

Hasn't your CPA been calculating your potential exposure each year to Section 531 and advising accordingly?

The BIG tax applies to the sale of any assets in existance at the date of conversion for 10 years after conversion to S. So the widget-maker machine that you purchase in Dec 2007 and take a $100k Section 179 deduction on will have a FMV of close to $100k but a tax basis of $0. It therefore has a BIG of $100k. If sold within 10 years, the BIG will apply. Goodwill is not recorded on your books but certainly exists and has a $0 tax basis; thus if you sell all the assets of the corp within 10 years the goodwill that is sold will be subject to BIG. Unfortunately, if the corp continues to grow, so does the GW. When you sell, the IRS will consider all the GW to have existed on the date of conversion unless you can refute that assumption, therefore a business valuation to include the unrecorded GW should be obtained in order to refute that assumption.

Accumulated earnings tax is a penalty tax applicable to C corps. It is a tax assessed by the IRS, not one voluntarily paid. To avoid AE tax you need to pay out dividends to bring RE down to a level which can be reasonably argued as necessary to fund the working capital needs of the corp. It may well be that with $76mil in sales that you already have sufficient justification for that much in RE, but have not properly documented those reasons. (Unless you're sitting on $6mil of spare cash which is not required for operations, it should be easy to justify your RE - e.g., needed to fund growth in sales, needed to fund the widget-maker you intend to purchase next year, needed to ...)

Tax on excess passive income will not come into play if the corporation continues to generate nonpassive income (i.e. sales) rather than passive income (i.e. dividends, rents, interest). You haven't told us what the business of the corp is, but I presume it is not generating $76mil of passive income.

Yes, different s/h's can sell stock in different proportions to derive the 50% being sold to the new buyer.

Good luck.

Client had losses of $250k in 2006 and will have losses of $50k in 2007. Client knows losses will not transfer but is exploring converting from C to S corp.

Is there a way to make use of the losses without dissolution?

Although it involves eventual dissolution of the C corp, can a "oldco" "newco" be used wherein oldco sells assets to newco giving newco a step up in basis and a chance for oldco to use losses against gain from sale of assets. After sale of assets oldco would cease and newco would obtain oldco's name as an assumed name.

Is there another/better way to make use of the losses.