Convert C Corp to S Corp

IRC Section 1374 built-in gains tax

When a C corp elects S corp status, every asset is "marked" at fair market value on the conversion date. The unrealized gain (FMV minus tax basis) is the "built-in gain" or BIG. If any asset is sold during the recognition period (currently 5 years), the BIG portion of the sale is taxed at 21 percent at the entity level, then the after-tax distribution is taxed again to shareholders. Effective double-tax rate may exceed 40 percent.

The recognition period was originally 10 years, reduced to 7, then 5, with the 5-year period made permanent by the PATH Act of 2015. Verify with Treasury that the 5-year period remains current.

Practical implication: get an independent appraisal of all assets (real estate, equipment, goodwill, IP) at the conversion date. This locks the BIG amount. Without an appraisal, the IRS may impute higher values later. The appraisal cost ($5,000 to $25,000 depending on complexity) is far cheaper than disputing valuation on audit.

Source: 26 U.S.C. Section 1374

LIFO recapture (Section 1363(d))

If the C corp used LIFO inventory accounting, conversion triggers immediate LIFO recapture. The difference between LIFO inventory value and FIFO inventory value is added to gross income on the last C corp return and taxed at 21 percent.

The recapture tax may be paid in four annual installments under Section 1363(d)(2), interest-free if timely. For a C corp with $1M LIFO reserve, the recapture is $210,000 federal tax, payable $52,500 per year for four years.

Source: 26 U.S.C. Section 1363(d)

Accumulated earnings and profits (AE&P)

C corp accumulated earnings and profits carry forward to the S corp. Distributions from an S corp with AE&P follow a specific ordering rule under IRC Section 1368:

1. First, tax-free return of Accumulated Adjustments Account (AAA) up to its balance (representing post-S election earnings already taxed to shareholders)
2. Next, taxable dividends out of AE&P at qualified dividend rates
3. Then, tax-free return of remaining basis
4. Finally, capital gain

Shareholders may want to "purge" AE&P by deemed dividend election under Section 1368(e)(3), accelerating the dividend tax to convert the AE&P account to AAA. This may make sense if shareholders are in low brackets or if AE&P is small.

Passive investment income trap (Section 1375)

An S corp with C corp AE&P that has passive investment income (interest, dividends, royalties, rents, gains) exceeding 25 percent of gross receipts for three consecutive years automatically loses S corp status under IRC Section 1362(d)(3).

Section 1375 also imposes a tax on excess passive investment income while the S election remains valid. For a converted S corp that has shifted from operating to passive (selling the operating business and holding the proceeds), this may force re-conversion to C corp or distribution of passive assets.

Source: 26 U.S.C. Section 1375; 26 U.S.C. Section 1362(d)(3)

When C-to-S conversion makes sense

• Operating business with minimal appreciated assets (no large BIG exposure)
• No LIFO inventory or LIFO recapture acceptably small
• No plans to sell appreciated assets in next 5 years
• Shareholders all qualify as US persons (no NRA-blocking issues)
• Shareholders desire pass-through to use QBI deduction and avoid dividend tax
• AE&P is small or shareholders accept the deemed dividend purge
• Business cash flow consistently distributable (no passive-income drift)