The Protecting Americans from Tax Hikes (PATH) Act of 2015 accomplished more than just extending certain tax breaks. It also made some taxpayer-friendly provisions permanent — including the shortened recognition period for companies that convert from C corporation to S corporation status. This change is causing some manufacturers and distributors to re-evaluate their corporate status.
After weighing the pros and cons, some companies are electing Subchapter S status to gain enhanced flexibility in business decisions and to lower taxes. Here are some important issues to consider before you convert.
The income of C corporations is taxed twice. First, the C corporation is charged corporate-level income taxes. Shareholders then pay tax personally on C corporation distributions and dividends. But S corporations are flow-through entities for income tax purposes. This means that income, gains and losses flow through to the owners’ personal tax returns. S corporations generally aren’t taxed at the corporate level.
However, double taxation of C corporations may become a major issue when the owners decide to sell assets or transfer equity. Historically, if a C corporation elected S corporation status and sold assets or transferred equity any time within a 10-year “recognition period,” it was charged corporate-level tax on any built-in gains that occurred while the company was a C corporation. For these transactions any gains related to appreciation that occurred after making the S election passed through the owners’ personal tax returns.
Under the PATH Act, the recognition period has been permanently shortened to five years. If a business sells assets or stock within the recognition period, only the appreciation in value from the date of the S corporation election will be exempt from corporate-level tax.
So it’s important to establish the company’s fair market value at the conversion date and to allocate it to the company’s assets. This enables taxpayers to quantify which portion of the gain should be taxed as C corporation gain and which portion should be taxed as a flow-through gain to shareholders.
Subchapter S Qualifications
For businesses contemplating a Subchapter S election, there’s no time like the present to start the clock on the five-year recognition period. But not every business qualifies for this election. It’s available to only domestic corporations that use a calendar fiscal year and offer just one class of stock (though differences in voting rights are permitted). Qualifying businesses also must have no more than 100 shareholders — including individuals, certain trusts and estates but excluding partnerships, corporations, foreign individuals and entities, and ineligible corporations.
Beware, too, that Subchapter S status restricts how the company distributes cash and liquidates assets. All payouts must be made to shareholders on a pro rata basis. If these rules aren’t followed or if the company merges with another entity that doesn’t qualify, the company will be at risk of losing its Subchapter S status.
Although S corporations are required to make pro rata distributions to shareholders, they aren’t required to distribute income to shareholders. So shareholders who lack control over making distributions may find themselves required to pay personal-level taxes on S corporation income, regardless of whether the company distributed any cash to cover those tax liabilities.
The annual tax burden can be substantial for highly profitable S corporations — and even more substantial for high-income taxpayers. As a courtesy, most S corporations pay enough distributions to cover shareholders’ tax obligations. But there’s no guarantee of distributions for shareholders who lack control over the business.
A Tough Choice
Before electing to S status, your business must obtain the approval of all shareholders. Although there may be benefits to making the switch — especially now that the recognition period to avoid corporate-level capital gains tax has been permanently shortened — it’s not a prudent option for every business. Your legal and tax advisors can help determine the right choice for your circumstances.