An entity often makes the decision to convert from a C corporation to an S corporation for the tax advantages associated with this election. However, converting from a C corporation to an S corporation presents a number of tax and valuation issues. In this issue of the Tax Insight, we provide an overview of C corporation to S corporation conversions, along with the key valuation considerations.
Why does an entity choose to convert from a C corporation to an S corporation? The primary benefit of choosing the election is that shareholders (likely) will not have to pay the second layer of taxes on distributions. The following table illustrates the key ownership differences between a C corporation and an S corporation.
In a C corporation, a shareholder can be anyone or any entity. Conversely, in an S corporation, shareholders can be any one of the following:
- U.S. individuals
- Certain trusts
- Certain tax-exempt organizations
- Resident aliens (green card holder or has presence in U.S. for at least 183 days during the current year)
However, shareholders cannot be non-resident aliens, partnerships, LLCs, IRA, C corporations, certain trusts, and tax-exempt organizations. In addition, under IRC Section 1361 S corporation requirements, the company must be a domestic corporation with no more than 100 shareholders. Also, the company can only have one class of stock. In a C corporation to S corporation conversion, all shareholders must unanimously agree to the election. Contemporaneous documentation is required at the time of the election.
Under IRC Section 1374, a corporation making an S corporation election must obtain a valuation to determine the built-in gain – the appreciation in asset value from the period of time when the entity was a C corporation – as of the date of the S corporation election.
If the S corporation subsequently sells any of these assets within the 10-year time period1 after its conversion from a C corporation (the recognition period), a built-in gain may be realized and the company will be liable to pay the highest corporate level tax rate on the gain as if it were a C corporation. Further, built-in gains attributable to intangible assets and goodwill may be subjected to tax, unless an S corporation can establish that such intangible assets are separable from goodwill and were acquired post S corporation election.
Minimize Your Exposure
To minimize your exposure, thorough valuation of all tangible and intangible assets is critical before converting from a C corporation to an S corporation. Fair market value (FMV) should be determined on an asset by asset basis at the time of the conversion. If the FMV is allocated in the aggregate across all assets at the time of conversion, the IRS gains leverage in retroactively assessing the FMV on an asset by asset basis.
It is also important to clearly document any change in value that may occur after the S corporation election date. Tax courts consider taxpayer intentions when analyzing tax penalties. A company should document its efforts to obtain an accurate valuation of the appreciating assets to demonstrate that it acted responsibly.
S-Corporation Filing Requirements
Any entity wishing to make an S corporation election must file Form 2553, Election by a Small Business Corporation. The form must be filed two-and-a-half months after the beginning of the tax year the election is to take effect, or the year preceding the year the election is to take effect. Late election relief is available under certain circumstances.
For more information about valuations for C corporation to S corporation conversions, contact your VRC representative.
*Some states impose taxes
**Double taxation potentially exists if S corporation was previously a C corporation and income was derived from disposition of an asset.