I have a client who is currently a C-Corp and wants to convert to an S-Corp mainly to avoid double taxation.

The corporation is several years old and has high taxable profit and over 350,000 undistributed profit.

Should we convert to an S-Corp if the only/main reason is to avoid double taxation?

Are there any other issues we should be concerned about if we convert to an S-Corp?

asked 09 Oct '09, 18:43

TaxQueries's gravatar image

TaxQueries ♦♦
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With these high profits you are going to have built in gains taxes but also, all the undistributed profits will show up on the shareholders k-1(s) at the end of the year and would be highly taxed at that amount of income.

I would not even think about it until you at least start paying out these profits in the form of dividends or eat up some of these profits while still a c corporation.

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answered 09 Oct '09, 19:56

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SandySea
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BIG tax planning is complex and different for every client, so there is no easy answer. I have a ten year excel template that I use, which allows me to calculate the impact of different strategies and scenarios for a client. Here are some things you have to think about:

  • Are they cash basis? If so do they have A/R? For a cash basis corporation, the FMV of the A/R at the time of conversion can be a large built-in gain. If they are accrual basis, A/R will not have much impact and often it is much easier to convert.

  • How large are the shareholders wages? If the shareholders were paying a large amount in wages to avoid C Corp income, the a big consideration is how fast do you adjust the wages down to after conversion. The main advantage of the S-Corp is the FICA game of paying the lowest reasonable wage possible; however, in my opinion a sudden drop in shareholder wages after conversion could be a red flag to the IRS in audit. For example, if you have doctors making $400k in a C Corp, and you drop them down to $120k in the first year of the S-Corp, then I think you increase your risk of the reasonableness of the S-Corp shareholder wage being challenged.

  • Remember, that the BIG tax is only due if the net recognized built-in gains is actually realized. Plus, it is limited by net income tax as if taxed as a C Corporation. This means that if you never have net income (as if a C Corp) over the 10 year period, there will not be any BIG tax due. This means you could bonus wages in the ten year period to avoid BIG tax, but the price you pay is that you are not getting the benefit of playing the FICA game and paying a lower "reasonable wage". Also, most assets (except A/R or inventory, etc) have to be sold to trigger BIG tax, so you can do some asset planning to avoid the tax.

  • Watch you E&P going into conversion. With proper planning you can get most of the E&P paid out at the low 15% rate, but there is limited time on this.

  • Analyze the changes to employee benefits for shareholders. The rules for S-Corporation are very different and often shareholders with disability and other benefits are actually negatively impacted by a conversion even though the entity saves money overall.

  • Lastly, look into state tax considerations as many states have entity tax increases starting soon. For example, here in Oregon, we are doing a lot of BIG tax/S-Corp conversion planning for clients because Oregon is starting a new gross receipts minimum tax on C Corps that will costs up to $15k per year for many of our clients.

http://pdxcpa.wordpress.com

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answered 16 Oct '09, 08:28

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PDXCPA
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Good analysis! I also have extensive experience analyzing C-corp to S-corp conversions, and especially have liked the "old & cold" C-corps with poor E&P records. Like you, I also have templates, but they always need a little tweeking since no two transactions are identical. Whether or not to convert to an S-corp many times comes down to what the ultimate exit strategy is and when it most likely will occur.

(25 Oct '09, 17:41) Brent Berkman

Look at the rules under Section 1374 which describes the tax on built in gains which Sandysea is referring to.

Not only could you have a large tax currently, but you have to be able to value your assets at the date of conversion to determine any future built in gains. I would always recommend that my client get a valuation of your assets from a qualified appraiser at the date of the conversion. It will help reduce countless migraine and cluster headaches when you are audited in 10 years because you sold some asset that was on the books at the date of the conversion from C corp to S corp.

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answered 13 Oct '09, 00:30

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jim
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There are basically two considerations in addition to what the corporate exit strategy/ business succession plan is.

1) Earnings & Profits of the C-corporation will be subject to tax at the shareholder level when distributed, but they are currently subject to a 15% tax rate since they were taxed at the corporate level.

2) Corproate income tax on built-in gains at the time of conversion to an S-corporation for the difference between the fair market value of all the assets, including goodwill, and their respective tax bases.

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answered 15 Oct '09, 04:11

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Brent Berkman
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Asked: 09 Oct '09, 18:43

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Last updated: 16 Oct '09, 08:28