Should You Switch from a C-Corporation to a S-Corporation?

Changing from a C corporation to a S corporation can be beneficial, but there are numerous factors to consider. With the March 15, 2011 deadline for making this election effective January 1,  2011 fast approaching, you should seek guidance for your situation.

Basic benefits of a switch: If a C Corporation owner elects S corp status, the corporation’s income and deduction items are passed through to the owner, reported on his or her 1040 and taxed at personal rates. Significantly, switching to S status would avoid any threat of double taxation on: (1) future corporate operating profits and (2) future appreciation in corporate assets that occurs after the switch.

As you may know, double taxation occurs when a C corporation pays corporate-level tax on its income and gains. Then the owner pays tax again at the shareholder level when those income and gains are distributed as taxable dividends.

In contrast, a business owner is only taxed once under the S corp form of doing business, while retaining other benefits such as corporate protection from personal liability. 

Basic drawbacks to a switch: The decision to switch isn’t always a slam-dunk. If the owner has substantial income from other sources or if the company is quite profitable, he or she may be forced to pay the 35% maximum rate on most or all of the incremental income passed through. Rule of thumb: With the current tax brackets in effect, the owner often fares better if the company generates annual profits of less than $100,000.

In addition, beware of the onerous "built-in gains" (BIG) tax. It comes into play if the corporation owns appreciated assets when it switches from C to S status. When this corporate-level tax applies, the rate is 35%.

Tax law can change daily, please talk to your tax adviser before making decisions that will affect your taxes.

C-Corporation vs. S-Corporation

When considering a C-Corporation vs. a S-Corporation there are many legal items to consider which are NOT discussed in this article, please see an attorney regarding these matters.

Aside from legalities here are some things to consider:

• If you plan to take out significant amounts of profits (cash) above what you would consider a "reasonable salary" for the work that you are doing for the corporation (as officer), an S-Corporation may be more beneficial because once a reasonable wage is paid, excess profits can be taken out of the corporation as a distribution free from self-employment taxes.  If you did this in a C-Corporation the money taken out would be considered a dividend and be doubled taxed.


• C-Corporations often pay high wages rendering the corporation to have no profits and thus pay no taxes. This is perfectly fine as long as the wages paid are considered "reasonable".  The IRS can challenge the wages if they believe they are in excess of a reasonable salary and reclassify them as dividends.  Having said this, the IRS can also challenge a S-Corporation's officer's salary if they believe the wage was too low and then they will want to reclassify the distributions taken as salary.


• Many retirement plan maximum contributions are based upon your salary.  This usually negates the negative of paying payroll taxes on more wages.


• If you plan to retain profits in the corporation remember that in an S-Corporation you still have to pay taxes on that money - some shareholders may need a distribution in order to pay these taxes.


• There are many restrictions placed on S-Corporations that have not been discussed such as who is allowed to be a shareholder of a S-Corporation, how many shareholders, only one class of stock is allowed, etc.

Tax law can change daily, please talk to your tax adviser before making decisions that will affect your taxes.

Advantages of S-Corporations

Note:  All references to corporations in this blog post are referring to S-Corporations.

Corporations are formed under state law so you will need to refer to your state for specific, but in general the following are some of the advantages of establishing a S-Corporation:

• A S- corporation is a separate legal entity, which generally means that the shareholders are not liable for the corporation's debts; however many banks have the owners of S-Corporation's personally guarantee the loans of the corporation.  When you do this then you become personally liable for the corporation's debts.


• A shareholder can generally take losses up to their tax basis in the corporation.


• All profits and losses are passed through the corporation to the shareholders and taxed on the shareholder's individual return thus avoiding the potential of double taxation (please note shareholders are taxed on any profit whether or not the profits are distributed)


• Distributions from S-Corporations are not subject to self-employment taxes.  {Officers are required to take a reasonable salary and pay self-employment taxes on that salary.}

Tax law can change daily, please talk to your tax adviser before making decisions that will affect your taxes.