Selecting the appropriate business entity carries significant consequences, including the impact on your tax liability. The most prevalent business structures are sole proprietorships, partnerships, limited liability companies, C corporations, and S corporations.
Occasionally, a business might choose to transition from one entity type to another for tax purposes, business goals, or even investment opportunities. Below are some common reasons as to why a business would need to change its business structure.
Tax Benefits: Different business entities are subject to different tax treatments. For example, converting to an S Corporation might reduce self-employment taxes or avoid double taxation on corporate profits.
Liability Protection: Certain business structures, like limited liability companies (LLCs) and corporations, provide personal liability protection to owners, which can be a key factor in choosing to switch from a sole proprietorship or partnership.
Attracting Investment: Corporations, particularly C Corporations, are often more attractive to investors due to their ability to issue shares and have a more structured management system.
Management and Operational Flexibility: LLCs, for example, offer flexible management structures compared to corporations, which might better suit the business's needs.
Regulatory Requirements: Compliance with state and federal regulations can vary significantly between entity types. A business might change its structure to simplify compliance or benefit from favorable regulatory environments.
Business Growth: As a business expands, its needs and goals may evolve. Transitioning to a different entity type can better align with the company's growth strategy and operational scale.
Succession Planning: For businesses considering future transitions in ownership, certain structures like S Corporations or LLCs might offer more straightforward processes for transferring ownership.
Profit Distribution: Different entities have varying rules on profit distribution. An S Corporation, for instance, allows profits (and losses) to be passed through directly to shareholders, which can be advantageous for tax purposes.
Each reason involves weighing the benefits against drawbacks, including any tax costs associated with the transition. While S corporations can offer considerable tax advantages compared to C corporations, in certain situations, you may run into costly tax issues during the transition.
Consider these four scenarios when converting your C Corporation into a S Corporation.
LIFO Inventory System - C Corporations that use last-in, first-out (LIFO) inventories must pay tax on the benefits they derived from using LIFO which could spread over four years. The tax cost should be weighed against the potential tax gains from converting to S status.
Built-in Gains Tax - Even though S corporations usually aren't taxed, former C corporations must pay taxes on any gains (like appreciated property) they had when they converted, if these gains are recognized within five years. This can be a drawback, but sometimes converting to an S corporation still offers better tax benefits despite this tax on built-in gains.
Passive Income - Former C corporations that become S corporations are subject to a special tax if their passive investment income (such as dividends, interest, rents, royalties, and stock sale gains) exceeds 25% of their gross receipts and if they have retained earnings from their C corporation years. If this tax is owed for three consecutive years, the corporation’s S election is terminated. To avoid this tax, you can either distribute the accumulated earnings and profits to shareholders, making it taxable to them, or reduce the amount of passive income.
Unused Losses - If your C corporation has unused net operating losses, they can't be used by the S corporation or passed to shareholders. If these losses can't be applied to previous C corporation years, you need to consider the cost of losing these losses against the potential tax savings of becoming an S corporation.
These are just a few factors to consider when switching a business from C to S status. For example, shareholder-employees of S corporations lose some tax-free fringe benefits, and shareholders with outstanding loans from qualified plans may face issues. It's important to understand these implications before converting.
If you’re thinking about an entity conversion, contact us. We can explain your options, the tax impact, and strategies to minimize taxes.