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By now, you are familiar with the Tax Cuts and Jobs Act (TCJA) passed a few years ago and likely recall that it lowered regular corporate taxes to 21%. In response to the lower corporate tax rate, there was a provision to lower overall taxes on the individual level using the Qualified Business Income. This allowed S-corporations (flow-through entities) to benefit from lower business taxes without converting to a C-corporation.
However, there might be other considerations to converting your S-Corporation to a C-Corporation. You can voluntarily convert your S-Corporation to a C-Corporation almost any time, but once you do, there is a five-year hold where you cannot convert back.
There are a few scenarios in which it would make sense to convert from an S-Corporation to a C-Corporation:
Once most shareholders who own the business agree to conversion and sign the Statement of Consent, the process with the IRS is quite simple. Any CPA can prepare the proper forms for the IRS so that the Company can convert to a C-Corporation. However, you must note that the process must be done by March 15th of the year you want to convert. Otherwise, the conversion will occur during the tax year, which will cause you to have to prepare and file two short-period tax returns. You can elect to convert to a C-Corporation beginning January 1st of the following year, which would allow you to submit the application any time during the year before conversion.
The biggest downside of a C-Corporation is double taxation. The corporation pays the federal income tax on its profit, usually at 21%. Any qualified dividends paid to investors are taxed again at the individual level at rates between 15% – 23.8%. For S-Corporations, the flow-through income is taxed once at the individual owner’s level, ranging anywhere from 10% – 37%. Assuming there is sufficient undistributed corporate income, the S-corporation distribution to owners would not be taxed again.
The other point to consider is that once you apply to convert to a C Corporation, you have a limited time to distribute the undistributed S-corporation earnings to the shareholders (which is tax-free) before it’s considered a dividend (and taxed between 15% – 23.8% on the shareholders’ personal return).
Converting from an S-Corp to a C-Corp has its benefits, but there are also long-term implications that you need to be aware of. Therefore, before you start the process of changing your tax status, speak with a CPA to review any pitfalls that might occur based on your unique situation.
If you have questions about the conversion and if it’s a good fit for your business, please call Cray Kaiser at 630-953-4900.