Switch from C Corp to S Corp? Part 2

You should be aware that if your corporation has any “earnings and profits,” then, even if it elects S corporation status, it may be subject to a corporate‐level tax on its passive investment income.

This tax would apply in any year the S corporation’s passive investment income exceeds 25% of its gross receipts. If that happens, the net passive income (after applicable deductions) that exceeds 25% of gross receipts is taxed at the highest corporate tax rate (currently 35%). Thus, a corporation that has (for the sake of simplicity) $100,000 of passive investment income and no other income or deductions would pay a tax of $26,250, i.e., 35% of $75,000 (the excess of $100,000 gross receipts over 25% of $100,000).

The tax reduces the amount of income passed through by the S corporation to the shareholders. Thus, in the above example, the S corporation would pass through income of only $73,750 ($100,000 minus the $26,250 of tax) rather than $100,000. However, there would still be double taxation since a tax was imposed at the corporate level. In addition, if the tax applies for three consecutive years, the corporation’s S election will terminate.

Since even the smallest amount of accumulated earnings and profits from C corporation years will subject an S corporation to a potential passive investment income tax, it is important to know (1) whether the corporation has any accumulated earnings and profits and, if so, (2) exactly how much the corporation has because the corporation can eliminate its tax risk completely by distributing all the earnings and profits. We can help you determine this.

Passive investment income generally includes non‐business related items such as dividends, interest, rents, and royalties. Passive investment income does not include dividends received from an 80%‐or‐more owned C corporation subsidiary when those dividends are generated by the C corporation’s active conduct of a trade or business. Gross receipts generally includes all amounts realized by the corporation, without reduction for cost of goods sold, returns, allowances, or other deductions.

You can avoid the tax by either (1) eliminating the accumulated earnings and profits from C corporation years, or (2) limiting the corporation’s passive investment income to 25% or less of its gross receipts.

For example, you can avoid any risk of the tax by having the corporation make an actual or deemed distribution of its accumulated earnings and profits from C corporation years before the end of the first S corporation tax year. The distribution will be treated as qualified dividend, taxable at a maximum rate of 20%. However, depending on the recipient’s adjusted gross income, the dividend also may be subject to the 3.8% net investment income tax.

If a distribution would mean too much tax to the shareholders, you can still elect S corporation status and avoid the passive investment income tax, as long as the passive income does not exceed 25% of the corporation’s gross receipts. If you decide to elect S status, but not to distribute the corporation’s accumulated earnings and profits from C corporation years, you would have to carefully watch the corporation’s future income to be sure that it does not exceed the 25%‐of‐gross‐receipts threshold. We can work with you to develop strategies to reduce the passive investment income and/or increase the corporation’s nonpassive income.

Switch from an C Corp to S Corp? Part 1

Considering converting your C corporation to an S corporation? It is important for you to understand the effects of a built‐in gains tax that may apply when appreciated assets held by the corporation at the time of the conversion are subsequently disposed of and what we can do to minimize its impact.

Although an S corporation is normally not subject to tax, when a C corporation converts to S corporation status, the tax law imposes a tax at the highest corporate rate (currently 35%) on the net built‐in gains of the corporation. The idea is to prevent the use of an S election to escape tax at the corporate level on the appreciation that occurred while the corporation was a C corporation. This tax is imposed when the built‐in gains are recognized (i.e., the appreciated assets are sold or otherwise disposed of) during the five‐year period after the S election takes effect (referred to as the “recognition period”).

Assets that have not appreciated, accounts payable, unpaid bonuses, and some other liabilities may carry built‐in losses that can be used to offset built‐in gains. From a planning perspective, it is important to establish these amounts before the S election becomes effective so that all potential offsets to built‐in gains can be utilized.

The tax may apply even if the S corporation does not make any unusual asset dispositions. For instance, a cash method corporation that collects an account receivable that accrued during the C corporation period, or an accrual method corporation that disposes of inventory that was acquired during the C corporation period, may be subject to the built‐in gains tax.

The recognized built‐in gain is passed through to the shareholders as income, in addition to being taxed at the highest corporate level. This unfortunate result is mitigated somewhat by treating the tax as a corporate loss that passes through to the shareholders.

You can see how important it is to plan for the impact of the built‐in gains tax since, at a minimum, it is necessary to establish the amount of built‐in gains (and losses) at the time of the conversion to an S corporation. After the conversion, we can plan by timing the sale of assets, matching gains and losses, and so on. Right now, the important thing is to value the corporation’s assets and have appraisals, where feasible, of the assets including inventory as of the date the S corporation election will take effect in order to ensure that the appreciation which takes place after that date will not be subject to the built‐in gains tax.

We can assist you in getting the necessary appraisals, as well as in identifying any built‐in losses that could reduce the effect of the built‐in gain tax.