Have you out grown your S Corporation?

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Here’s a cold hard fact for you business owners: the US has the highest statutory corporate tax rate in the world.[1] Of course, this is a thorn in the side of many business owners, considering the competitive disadvantage it gives in the global economy. As you’re no doubt aware, however, tax laws can change quickly. Given the current climate, it’s possible that S corporation owners may soon be considering the switch to either a C corporation or sole proprietorship.

It turns out that even the president has called for a change in the tax laws governing corporations. He has suggested that the maximum federal tax rate be 28 percent, and even lower than that for manufacturers.[2] The current federal rate is maximum 35 percent, so this would be a significant change. However, at the same time that the reduction of corporate rates is being discussed, individual tax rates are rising. In fact, the highest individual tax rate (39.6 percent) is now higher than the maximum corporate tax rate![3]

But, what does all this mean for business owners? It means that if you currently own an S corporation, you may be better off converting your business to a C corporation if individual taxes continue to rise and corporate taxes fall. So, you’ll want to keep a close eye on the changes in tax law in the coming years. Please note: Every business is different, and this advice may not be applicable to you, depending upon the industry you’re in. Always run the numbers before making a change in entity structure.

If the time comes when you are, indeed, ready to change your entity structure to something other than an S corporation, here’s what you need to know.

Moving Away from the S Corporation

Regardless of the reason you are converting your S corporation to another entity structure, the ways to do so remain the same. You have two options:

  1. Liquidate your business and convert to a sole proprietorship or partnership. Liquidating an S corporation is fairly similar to liquidating a C corporation.[4] You’ll basically need to sell your assets and convert them to personal assets. Using this option allows you the flexibility to reincorporate your business in the future if you choose to do so.
  2. Terminate the S election on your tax documents and convert to a C corporation. You have two options for doing this. You can send the IRS a revocation of your S election with two simple steps: 1) prepare a form stating your revocation, and 2) acquire the written consent of more than half your shareholders.[5] Note that the IRS does not provide these forms. Alternately, you can change certain aspects of your business so that it no longer qualifies for S corporation status. If you choose either one of these termination methods rather than liquidating, you will not be able to elect S corporation status again for your business for five years (unless you request special consent from the IRS).[6]

When you decide to convert to a C corporation using the revocation method, you’ll want to make sure you follow all the correct procedures regarding the consents:

  • Community Property States—If you live in one of these states, your spouse is automatically a shareholder in your corporation unless you took specific steps to prevent this. That means your spouse will also have to provide consent if you are the sole shareholder.[7]
  • Nonvoting StockWhen determining whether you have majority shareholder consent, know that nonvoting stock counts equal to voting stock.[8]
  • Tenant RulesYou must have the other tenant’s consent for stock you own as a joint tenant, tenant by the entirety, or tenant in common.

We’ve laid out the details for two separate ways to convert your S corporation to a C corporation, but if at all possible, you should use the revocation method. Why? Because it gives you clear documentation showing that you have ceased your S corporation. Trying to disqualify your business for S corporation election does not provide you with a specific date that your business ceased to be an S corporation.

However, if it’s not possible to meet the revocation requirements on time, all you have to do is violate one of the requirements for S corporation status intentionally.[9] The date of the violation is the date your S corporation ceases to exist and becomes a C corporation.[10] A couple of easy ways to invoke a disqualifying event is to create a second class of stock or give stock to a shareholder who is ineligible for S corporation stock.

Timing It Right

If a change in tax law does make it advantageous for you to ditch the S-corporation entity structure, then you’ll want to make sure you complete the change on time in order to get the full benefits. Completing the revocation in the first two and a half months of the tax year means the IRS considers your business a C corporation for the whole year.[11]

If you miss this deadline, you can still get some of the benefits intended from the change. You’ll simply have an S short year and a C short year, dividing your tax year into two periods. Whatever day you finalize the termination of your S corporation is the date your C corporation tax period begins.[12]

Having a split tax year means you have to divide all your income, credits, losses, and deductions between the two periods. You have two options for doing this: 1) you can divide the amounts evenly over the course of the year, or 2) you can treat the two as entirely separate tax years, that is, you close the books.[13] The first option is the default method, so you’ll have to specifically elect the second option if you so choose.

To figure the amounts by dividing them evenly throughout the year, you simply determine how many days your company was an S and how many it was a C. For example, if you close the S corporation on April 1, your business spent 90 days as an S (January 1-March 31). The entire year’s income, credits, losses, and deductions would be multiplied by 90/365 to get the S year portion.

Alternately, if you close the books and treat the periods as two separate tax years, you may be able to plan your expenses in order to maximize the deductions under a specific entity structure. You could, for instance, incur larger expense under the S corporation and pass them through to your individual return.[14] In order close the books, you’ll need consent from all shareholders.[15]

The choice of entity structure for your business is an important one. However, it doesn’t have to be permanent. Occasionally, it is to your advantage to keep an eye on changes in tax laws that affect the entity structure of your company. As always, check your strategies with your tax advisor to make sure you follow all procedures and obtain the proper documentation.

  1. See this Tax Foundation article.
  2. See the Washington Post article on this.
  3. 2014 tax brackets
  4. See IRC Section 1371(a)
  5. IRC Section 1362(d)(1)(B).
  6. IRC Section 1362(g).
  7. Reg. Section 1.1362-6(b)(2)(i).
  8. Reg. Section 1.1362-6(a)(3)(i).
  9. T.J. Henry Assocs., Inc., 80 TC 886 (1983)
  10. IRC Section 1362(d)(2)(B); Reg. Section 1.1362-2(b)(2).
  11. IRC Section 1362(d)(1)(C)(i); Reg. Section 1.1362-2(a)(2).
  12. IRC Section 1362(e)(1)(A); Reg. Section 1.1362-3(a).
  13. IRC Section 1362(e)(3).
  14. IRC Section 1366(a).
  15. Reg. Section 1.1362-6(a)(5).