Tax rules and rates can change quickly, depending on how the winds of Congress blow.
Thus, good tax planning requires reevaluation from time to time so that you can maximize your
business’s cash benefits according to the most recent tax rates and breaks.
Under the current trend, individual tax rates are going up, and corporate tax rates are (perhaps) going
down—more on this below.
Article written by our friends at the Bradford Tax Institute
Depending on how corporate tax reform plays out in the coming months, the C corporation could become
an attractive form of business.
If you operate your business as an S corporation and you decide it is time to change to a C corporation or
a proprietorship, this article is for you. In this article, we explain what you need to do to eliminate the S
corporation and operate your business as either a C corporation or a sole proprietorship.
The Winds of Tax Reform
surprise that many people would like this to change.
The president is among those calling for reform, and he has proposed reducing the top corporate rate to
28 percent (25 percent for manufacturers).2 That would mean a 7 percent drop (10 percent for
manufacturers) from the current top rate of 35 percent.
At the same time, individual tax rates are creeping upward. For the first time since 2002, the top tax rate
for individuals (39.6 percent) is higher than the top tax rate for C corporations.3 And if you are in the 39.6
percent tax bracket, it’s likely you’re also paying the 3.8 percent Medicare tax, making your rate 43.4
percent.
If you run your business as an S corporation, you should pay close attention to this change. High
individual rates and low corporate rates might make the C corporate form a better choice for your
business, depending on what type of business you have and how you operate.
How will the winds of tax reform ultimately blow? That’s a tough question to answer. The only thing
certain is that we at the Tax Reduction Letter will keep you up to date with the latest news and strategies.
So stay tuned.
How to Change from an S Corporation
For now, we can stick with the law as it is currently written. The following describes how you can
change
your S corporation to the entity of your choice.
You have two main choices for a new business form. You can do one of two things:
- Convert to a sole proprietorship or partnership (“liquidate”).
- Convert to a C corporation (“terminate” the S election).
1. Liquidation
You can liquidate an S corporation just as you can any corporation. The rules and considerations for this
are generally the same as for C corporations.
2. Termination of the S Election
If you terminate your S election, you will convert your business into a C corporation.
You can terminate the S corporation by either
- Sending the IRS a statement of “revocation,” or
- Altering your business so that it no longer qualifies as an S corporation.
If you go the termination route, plan for the long term. Once you terminate, you cannot reelect S status for
five years (unless you get the consent of the IRS)
Revocation
The procedure for revocation involves two steps:
- Send the IRS a statement revoking your S corporation election. The IRS does not provide an official form for revocation.
- Get written consent from more than half your shareholders (explained below). Here, again, the IRS gives you the rules for consent.
Consent Nitty-Gritties
There are some important points to keep in mind with regard to consents:
- If you live in a community property state, community law makes your spouse a shareholder of your corporation in the absence of specific steps to avoid that. Therefore, it’s most likely that your community property spouse must give consent to the revocation.
- If you own the stock as a tenant in common, a joint tenant, or a tenant by the entirety, you need the consent of the other tenant.
- Voting stock and nonvoting stock count equally for the purpose of determining a majority of shareholders’ consent.
Violate the Rules - the Alternate Termination
Choice 1 for terminating your S corporation election is revocation. Why? You can easily do what’s needed
for revocation. It’s crystal clear that you’ve revoked your election. And you can specify the date your S
corporation election terminates.
In some rare cases, though, you may not be able to meet the requirements of revocation. For example,
you may not be able to get the written consent of all the necessary shareholders by the time you want to
terminate the election.
If this happens, intentionally violate one of the requirements for S corporation status. With the violation,
you instantly say good-bye to your S corporation. What happens is this: on the date of the disqualifying
event, the law terminates your S corporation election and your corporation becomes a C corporation.
Two easy violations are (1) creating a second class of stock and (2) transferring stock to an ineligible shareholder.
Effective Date
If you revoke your S election in the first two and half months of your tax year, the IRS considers your
business a C corporation for the entire year. The deadline for this is the 15th day of the third month. For
a calendar-year taxpayer, this means March 15.
When the termination is outside the two-and-a-half-month window, you divide the tax year into two
periods: an S short year and a C short year. You pay taxes as an S corporation for the first period and as
a C corporation for the second.
Example. Suppose you are on the calendar year and terminate your S election on April 1. You pay taxes
as you normally would for an S corporation from January 1 to March 31, the day before the effective date
of termination. From April 1 to December 31, you pay taxes as a C corporation.
How to Split Income between the Short Years
If you have both an S and a C period, you have to divide the tax year’s income, deductions, credits, and
losses between the two. (We’ll refer to income, deductions, credits, and losses below as a group and call
them “income” for short.)
Here, again, you have a choice. You can choose from two options:
- Divide your income evenly over the year, so you have an equal amount for each day of the year
- "Close the books” and treat the periods as entirely separate, individual tax years.
Default rule. Unless you elect otherwise, you must divide the income evenly throughout the year.
Example. If you revoke your S corporation on April 1, you will have an S corporation for 90 days of the
year (31 plus 28 plus 31 equals 90). Thus, you multiply your income for the entire year by 90/365 to
determine the income for the S portion. Likewise, you multiply the amounts by 275/365 to determine the
income for the C portion.
Close the Books. Alternatively, you could close the books and treat each period independently. On the
income and expenses you have in the S part of the year, you pay taxes using the S corporation rules. For
income in the C period, you pay taxes using the C corporation rules.
Closing the books may give you tax planning opportunities. For example, you may want to incur your
expenses during the S corporation period, so that you can pass them through to your individual return.
To elect the close-the-books method, you must get the consent of all the shareholders.
Questions? Please don't hesitate to call us. We're here to help!
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