Should an ESOP Company Convert from C Corporation to S Corporation?

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Are you one of the few remaining C Corporation ESOP companies that have been contemplating a switch?  No one likes the double taxation of a C Corporation.  However, there are likely other legal or tax reasons why you haven’t yet converted to an S Corporation, including the following: 

• Problems created by the IRC Section 1361(b)(1)(A) – S Corporation 100 Shareholder Limit.

• A C Corporation with LIFO (Last In, First Out) inventory must generally include the LIFO Recapture Under Section 1363(d) in the final tax year as a C Corporation.

• Assets sold within a period after the conversion from a C Corporation to an S Corporation may be subject to the IRC Section 1374 – Built-In Gains (BIG) Tax

• IRC Section 182 – Net Operating Losses incurred by the C Corporation prior to converting generally cannot be directly passed on to the shareholders.

The decision to remain a C Corporation has been made easier up to this point by the historically low tax rates.  Since tax rates are scheduled to increase at the end of the year, 2012 may be the ideal time to convert to an S Corporation.  Now Is the Time: Converting a C Corporation to an S Corporation or LLC  reviews the tax inefficiency of C Corporations and discusses converting a C Corporation to an S Corporation or LLC.

Double taxation of C corporation income from operations and from the sale of its business make C status tax inefficient. Changes in federal tax law scheduled to take effect in 2013 would worsen this tax inefficiency. The owners of a C corporation can avoid the tax inefficiency of the C corporation form by converting the corporation to S corporation status or converting it to an LLC.

While converting to an S corporation may be able to be accomplished without a current tax cost, converting a C corporation to an LLC can result in current tax at the corporate and shareholder level. Nevertheless, that current tax cost may be far less than the future tax cost of operating the business in a C corporation and incurring double taxation at what may be higher tax rates, or of incurring the higher tax cost (or reduced value) on a disposition of the business and the attendant double taxation of any appreciation in the value of the business. Since individual tax rates on qualifying dividends from C corporations and on capital gains are at historically low rates, this is may be the time to exit C status.

For ESOP companies, remember that the most powerful reason to be an S Corporation is that S Corporation ESOP Companies Increase Cash Flows by Eliminating Income Taxes!

Also, if you are currently a C Corporation considering Selling to an ESOP, remember that Selling a C Corporation to an ESOP Enables a Business Owner to Defer/Avoid Taxation on the Sale Proceeds.  Some business owners will opt to first Sell to an ESOP while a C Corporation and then converting to an S Corporation after the ESOP transaction.