Is There a Tax Advantage to Converting a C-Corp to a Partnership or S-Corp?

What you’ll discover:

C-Corporations are taxed differently from S-Corporations.
How are S-Corporations and Partnerships taxed?
What are some of the tax advantages of changing a C-Corp to an S-Corp or a Partnership?
What are the risks of changing a C-Corporation to an S-Corporation or Partnership?
If you are contemplating conversion, consult with a tax attorney.

Selecting a business structure for your firm is a critical choice that should not be taken lightly. Entrepreneurs who have started their firms as C-Corporations may ponder whether they should change the company structure. If you are thinking about converting your C-Corporation into a partnership or an S-Corporation, you should analyze the potential benefits and downsides, including any tax advantages for your small company.

C-Corporations are taxed differently from S-Corporations.

For tax reasons, C-Corporations are recognized as independent legal entities. This implies that the firm is responsible for submitting periodic tax returns and paying taxes at corporate tax rates after deducting income from credits, deductions, and losses.

Dividends are given to shareholders based on their proportional share of profits. Dividends are then taxed again at the individual income tax rate of each shareholder. This arrangement is known as “double taxation,” since income is taxed at both the corporate and individual levels.

How are S-Corporations and Partnerships taxed?

Partnerships and S-Corporations, unlike C-Corporations, are not liable to double taxation. These structures, on the other hand, are pass-through entities. At the corporate level, income is not taxed.

S-Corporations and Partnerships are both required to submit informational tax returns with the IRS and, if relevant, state and local tax authorities. Yet, the corporation is not accountable for paying profits taxes. Individual shareholders (in the case of S-Corporations) or partners (in the case of Partnerships) are taxed on their proportionate or allotted share of profits, as specified in their shareholder or partnership agreements.

Note, the owners of both Partnerships and S-Corporations are taxed on their portion of the company’s profits, whether or not it is delivered to the owners.

What are some of the tax advantages of changing a C-Corp to an S-Corp or a Partnership?

The most noticeable difference between changing a C-Corporation to an S-Corporation or a Partnership is that the company’s shareholders may avoid double taxes on profits. Depending on the corporation’s profits and the tax levels of its owners, this might result in considerable savings.

S-Corporations may also save money on taxes by distributing profits to shareholders in the form of dividends, which are not subject to payroll taxes. Yet, under existing tax legislation, each shareholder employee must be paid a wage subject to payroll taxes, and the payment cannot be considered unreasonably low by the tax authorities. If the IRS believes it is too low, it has the authority to recharacterize dividend income as salary and charge payroll taxes to the corporation. Partnerships do not pay payroll taxes, but its partners are self-employed and must pay self-employment taxes on their earnings.

What are the risks of changing a C-Corporation to an S-Corporation or Partnership?

By converting to an S-Corporation, the firm may be liable to taxes on “built-in profits,” which may happen if the S-Corporation sells real estate or other assets formerly owned by the C-Corporation, and earns a profit in the process. To avoid this tax, the S-Corporation must hold assets for at least five years after conversion before selling or distributing them.

Another possible disadvantage is that the S-Corporation cannot pass through the C-operational Corporation’s losses to its shareholders, and inventory “inherited” by the S-Corporation may be taxed as well, depending on the accounting technique used.

After a C-Corporation conversion, the new firm may be required to pay taxes on passive investment income such as retained profits, rents or royalties, and interest. A separate tax is levied if passive investment income exceeds 25% of the S-gross Corporation’s revenue. After failing the 25% test for three years in a row, the corporation will lose its S-Corporation election.

Consider the self-employment tax as well. General Partnership partners are liable to this obligation on the company’s income, whether dispersed or not, although corporation shareholders are exempt.

If you are contemplating conversion, consult with a tax attorney.

Changing your company structure from a C-Corporation to another form of corporation is a choice that should be taken after carefully analyzing the advantages and downsides. Converting may be expensive, but converting during an economic downturn, when profits and incomes are low, may help to offset some of the costs. Some company owners may find it more profitable to keep their present C-Corporation form.