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Is there a way to switch from a C Corporation to an S corporation or LLC?
By: Jason White
Is there a way to switch from a C Corporation to an S corporation or LLC?
Answer:
C corp to S corp conversion: An S corp is a tax status election only, so converting from a C corp to an S corp is a fairly simple process. An S corp is created by forming a subchapter C, or regular, corporation with the state and then electing subchapter S corporation tax status for the corporation by filing Federal Form 2553 with the IRS. A business can also operate for a period of time as a C corp before it elects for S corp tax status.
In terms of filing Form 2553, an electing corporation must file Form 2553 no more than 2 months and 15 days after the beginning of the corporation’s tax year in which the election is to take effect or at any time during the tax year preceding the tax year in which the election is to take effect. For example, assuming your corporation was formed in 2012 or a prior tax year and the corporation uses the calendar year for its tax year, you would need to have filed Form 2553 by March 15th, 2013 in order for your S corp election to take effect on January 1st, 2013. If you file Form 2553 now, your S corp election will not take effect until the start of the next tax year – January 1st, 2014. Late S corp elections are possible with new corporations in certain circumstances; however, if your corporation was operating in 2012 and/or prior tax years and has already filed tax returns for those years, you will not be able to file Form 2553 now and have the election retroactively apply to the start of your 2013 tax year. You can review information on the S corp qualifications and election process at the following websites:
Form 2553 and instructions:
While S corps can offer certain pass-through income and employment tax advantages, electing S corp tax status for an existing C corp that has been in business for a period of time can have significant tax implications (i.e. Built-in gains tax, inventories, passive income, unused losses) that should be thoroughly reviewed with a local tax advisor or CPA before making the election. To evaluate whether an S corp is an effective tax structure for your business, you should consult your tax advisor or CPA. The following are brief discussions of some of the tax considerations when converting from a C to an S corp after operating for a period of time:
- Converting from C Corporation to S Corporation
- The S Corporation Built-in Gains Tax: aicpa.org
- S Corporation Built-in Gains Tax: nixonpeabody.com (see “2. Temporary reduction in recognition period for S Corporation built-in gains tax under Structuring Investments in Companies”)
- Taking the Sting Out of S Corporations’ Earnings and Profits: journalofaccountancy.com
Converting C corp to an LLC: We do not know your reasons for wanting to convert your C corp to an LLC or whether doing so would provide you or your business with any legal or tax benefits, but basically you have two options. The first option is a statutory (juridical or formless) conversion from a domestic corporation to a domestic LLC in accordance with your state’s inter-entity conversion statutes. The second option is a non-statutory conversion, or a conversion outside of the statutory conversion process (i.e., a merger or dissolution and reformation transaction). This last option involves forming an entirely new LLC to house the business and merging the corporation with and into the newly formed LLC or liquidating and dissolving the corporation and transferring the corporation’s assets held by its shareholders to the newly formed LLC. A dissolution and reformation transaction typically requires the corporation’s liabilities be paid off. The following are related discussions for your review:
From a tax standpoint, converting a C corp to an LLC taxed as a sole proprietorship or partnership can have significant tax ramifications. The IRS treats such conversions as a liquidation of the corporation regardless of whether the conversion takes the form of a statutory or non-statutory conversion for legal purposes. We do not know all the details of your C corp, but if the corporation’s assets and/or stock have appreciated in value, liquidating the corporation could create significant negative tax consequences. Conversely, if the corporation’s assets and/or stock have depreciated rather than appreciated, liquidating the corporation may result in little or no tax cost. Each situation is unique and must be reviewed by a competent tax professional to determine the precise tax consequences.
Liquidation of a corporation is generally a taxable event for both the corporation and its shareholders. I.R.C. §336(a) states that a liquidating corporation recognizes gain on the distribution of appreciated property, recognizes depreciation recapture as if the corporation had sold each of its assets at its fair market value, and generally recognizes loss on the distribution of depreciated property. I.R.C. §331(a) provides that the corporation’s shareholder (s) also recognize gain or loss on the distribution equal to the fair market value of the distribution received minus the basis in the shareholder’s stock.”
Professional assistance: While we have provided you with some of conversion considerations in your situation, to thoroughly understand the legal and tax implications of each option, we recommend that you review your conversion options with a local lawyer and tax advisor or CPA. When reorganizing an existing business, business owners generally use local professionals (CPA, lawyer, and business insurance agent) for help in reviewing their business plans and evaluating business entities, tax, licensing, legal, and risk management issues.
Published: June 6, 2013
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