While each of us is feeling the impacts of an economic slowdown in different ways, for shareholders of a C corporation, this could be a great time to participate in tax planning for the future. In general, many assets that may be held by C corporations, such as real property and stocks, have significantly declined in value, providing an important opportunity to lock in future gains without a double layer of tax. The tax planning is done by converting a C corporation into an S corporation for income tax purposes. In addition, a conversion filed before March 15, 2009, can relate back to January 1, 2009, for calendar year corporations. Although the conversion is a rather straightforward process of filing a two-page election with the Internal Revenue Service, deciding whether to make the election and the tax consequences associated therewith are more complicated.
In general, S corporations do not pay a corporate level income tax. Instead, an S corporation’s shareholders pay one level of tax on the corporation’s income as it is earned. In contrast, C corporation income is taxed twice—once at the corporate level when the income is earned (and in Florida this corporate level tax has both a state and a federal component) and a second time at the shareholder level, in the form of a dividend tax, when the remaining income is distributed.
Because S corporation shareholders generally only pay one level of income tax and are eligible for lower capital gains tax rates, the effective tax rate on capital gains from asset sales by S corporations is much lower than sales by C corporations. The difference in the effective tax rates can be as much as 30 to 35 percent. This means that the shareholders of an S corporation that is selling property for a $1 million long-term capital gain may net between $300,000 and $350,000 more after taxes than the shareholders of a C corporation selling exactly the same property for exactly the same gain.
Unfortunately, there are two reasons converting a C corporation into an S corporation is not always a perfect solution. First, the full benefits of the conversion cannot be realized for 10 years. S corporations that convert from C corporation status must still pay corporate level income tax on the sale or transfer of appreciated assets that they held as of the date of the corporation’s conversion unless the sale occurs after the tenth anniversary of the conversion. Within the ten-year period, however, appreciation in the asset that occurs after the conversion is not subject to double taxation. The second reason is that these corporations generally must pay taxable dividends near the time of the conversion in an amount equal to their retained “book” earnings. The deemed dividends which are paid at the time of conversion will be taxed at 15%; however, this rate may be changed in the near future and could go back to ordinary income tax rates of up to 35%. The combination of an up-front tax cost and a distant tax benefit has deterred some taxpayers from making the conversion even though the net present value of converting is significant.
As mentioned above, the interaction of these variables can be complicated, but the decision-making process can be simplified with the proper tools. We can model the tax costs and benefits of converting a C corporation into an S corporation. Additionally, we can manipulate the model to consider different scenarios and also can provide net present value calculations to simplify decision-making. In most cases, it is not necessary to restructure the corporation itself to convert a C corporation into an S corporation. In all situations, the client’s individual circumstances should be evaluated to determine whether a conversion is worthwhile. For some clients, converting a C corporation into an S corporation could save thousands, or even millions, of dollars.