If your business is currently operating as a C corporation and you do not know the reason why (other than because it has always operated as a C corporation), this article is directed at you.
For federal tax purposes, corporations are classified as either subchapter C or subchapter S corporations. While there are many differences between the treatment of C corporations and other types of entities, perhaps the most notable is that C corporations are subject to two levels of taxation. The corporation is taxed on its income, and the corporation’s shareholders also pay taxes when distributions are made. Both an S corporation and a Limited Liability Company (LLC) do not pay tax at the corporate level (thereby eliminating the double tax), which could save your business and its shareholders federal income taxes presently and upon an eventual sale.
Now is a great time to consider converting your C corporation to an S corporation or an LLC. As most business owners are aware, asset values are currently deflated, which would decrease any taxable gain realized as a result of conversion. In addition, Congress continues to discuss increasing income tax rates on capital gains and dividends, which would increase the income tax implications of a conversion at a later date.
Conversion from a C corporation to an S corporation is as easy as making an election with the IRS to be treated as an S corporation (a so-called “S election”). However, only certain businesses may file an S election. An S corporation may have no more than 100 shareholders (though certain family members are considered to be a single shareholder for purposes of this requirement). Further, generally only individuals, non-profit entities and certain kinds of trusts can qualify as shareholders.
Historically, business owners of a C corporation often viewed the “built-in gains tax” as a reason not to make an S election. The built-in gains tax is a tax upon the sale of assets owned by an S corporation if those assets are sold within 10 years of the S election to the extent the assets were appreciated when the C corporation made its S election. Even if the built-in gains tax is a concern, with the current environment of deflated asset values, the potential built-in gains tax liability on a C to S conversion is likely to be relatively low.
If a conversion from a C corporation is of interest, and an S election is not a viable option, you may wish to consider converting to an LLC. Such a conversion is not as simple as electing S status. For federal tax purposes, upon conversion from a C corporation to an LLC, the corporation is taxed at the entity level as if it had sold all of its assets for fair market value and the shareholders are then treated as having received liquidating distributions of the proceeds. In other words, unlike converting a C corporation to an S, there are income tax consequences to converting a C corporation to an LLC. However, depressed asset values, unused net operating losses or capital loss carryovers (which can be used to offset gain) and historically low rates on distributions from the corporation to its shareholders may all help to minimize the income tax implications of converting from a C corporation to an LLC.
In addition to avoiding double taxation, a benefit of converting to an LLC is that the assets of the entity will receive an increase in basis to their current fair market value. This means that if the owners later sell the LLC, the gain realized upon the sale will be less.
If, after reading this article, you are wondering why your business is a C corporation and whether you can reduce income taxes through conversion to an S Corporation or LLC, you should ask your tax advisor if a conversion is right for you.