When Is the Best Time to Switch from an S Corp to a C Corp?

Conventional wisdom states that it’s nearly always better to operate your business as a pass-through entity, such as an S corporation, rather than as a regular C corporation. Many small business owners elect S corporation status after forming their corporation with the state.  And, the reason given is nearly always to avoid the specter of double taxation.  Yet, there are times when it is necessary or desirable to be a contrarian and change from an S corp to a C corp.  This article highlights when to consider undoing an S corporation election.

When Do You Have to Revoke an S Corp Election?

In order to make have a valid S corporation, the corporation cannot have:

• More than 100 shareholders
• Any ineligible shareholders
• More than one class of stock (although it can have both voting and non-voting stock).

You must revoke an S corp election when the requirements to operate as an S corporation are no longer met. In fact, if the IRS discovers the corporation does not qualify as an S corporation, it will automatically terminate the election, with unpleasant tax consequences. 

This means, for example, that if a corporation decides to raise capital by bringing in many more shareholders or by issuing a new class of preferred stock, it may have to revoke its S corporation election.

By planning ahead, the shareholders and the corporation can implement tax planning strategies to minimize the tax consequences. 

CT Tip: A company can also risk its S corp status if for three consecutive years it has accumulated earnings and profits (AE&P) and has passive investment income that exceeds 25 percent of its gross receipts.  Because an S corporation cannot accumulate earnings and profits, only corporations that had accumulated earnings before making the S election or which acquire a corporation that has AE&P are at-risk.  In these cases, professional tax guidance is needed.

The IRS has procedures that permit a corporation to apply to continue the S corporation status if the failure to meet the requirements were inadvertent.

When Might You Want to Revoke an S Corp Election?

Even if the corporation still qualifies for S corporation status, there may be advantages to revoking the election.  Two of these circumstances are

• when the passive activity rules and the at-risk rules severely limit the shareholder’s ability to deduct corporate losses
• when the corporation wants to accumulate income to be used in the future

In addition to restrictions on shareholders and types of shares, an S corporation is subject to the at-risk rules and the passive activities rules and these rules can greatly limit the amount of losses that can be deducted by its shareholders.  In this event, operating as a C corporation may enable the shareholder to fully deduct the money that has been lost. However, both the at-risk and passive activity loss rules are complicated, and working with a tax professional is the best way to ensure that the best decisions are made.

One of the most common reasons for revoking an S corporation is the desire to accumulate earnings within the corporation. While operating as a C corporation could mean that income is taxed twice—once at the corporate level and once at the shareholder level, shareholders in an S corporation may find themselves in the unpleasant situation of paying taxes on money that they never actually received.  How does this occur? Because an S corp is a “pass-through” entity, the shareholders are taxed on their share of the net profits—even if the money is actually kept in the corporate bank account to be spent in the future. In contrast, a C corporation can choose to accumulate income and its shareholders are only taxed on the dividends that are actually distributed to them.

How to Revoke an S Corporation Election

There is no “official” IRS form that must be filed in order to revoke an S corporation election.  Instead, the corporate files a written statement with the appropriate IRS service center. The statement must clearly state that the corporation is revoking its election to be an S corporation. There must be consent from shareholders who hold more than 50% of the number of issued and outstanding shares of stock (including non-voting stock).

Unless the revocation specifies an effective date (which cannot be a date prior to the filing of the revocation statement), then the effective date depends on when in the corporation’s tax year the revocation was filed. If it was made on or before the 15^th day of the third month of the current tax year, it is effective as of the start of the current tax year.  If the statement is filed later than that date, it is effective starting with the first day of the next tax year.