Subchapter C to S Conversion

Many estate, tax, and business advisors encourage business owners to consider converting their company tax status from a C corporation to a subchapter S corporation. For reasons we discuss below, it is important for converting companies to obtain a qualified business valuation of the Company’s total invested capital on the day after the conversion date. The valuation provides a snapshot benchmark that is helpful if the business is eventually sold or major assets are transferred within statutory holding periods. This valuation is an “Insurance Policy” worth its weight in gold if changes occur down the road. VAVA Inc. has more than 25 years of experience handling valuations for C to S conversions.

There are several reasons shareholders would make this C to S election, but many advisors agree that the main incentive is to avoid the second layer of double taxation on dividend distributions received from a C corporation. If the S corporation is sold or sells any of its assets within a certain period of time after the conversion from a C corporation, the current tax code requires that a potential built-in gain (“BIG”) tax is levied on the sale. This BIG tax is based on the unrecognized appreciation in asset value from the period of time when the entity was a C corporation. Accordingly, the fair market value of the entity and its assets as of the effective date of the S corporation election is needed. To compute and document the potential future BIG tax, IRC Section 1374 provides the entity must obtain a valuation on the conversion date. It is essential that a qualified appraiser perform this valuation.

This Built-In Gains (“BIG”) tax is assessed at existing marginal tax rates on the appreciated property but is only realized if the BIG property is sold within 10 years (starting from the first day of the first tax year of conversion to S-Corp status.) The Small Business Jobs Act of 2010 reduced the recognition period to 5 years. The Protecting Americans From Tax Hikes Act of 2015 permanently extended the BIG tax recognition period to 5 years.

There are limitations to S corporations in regard to the number of permitted shareholders. As an S corporation, 100 shareholders is the maximum. The only eligible individuals who can participate as shareholders in an S corporation are U.S. citizens or residents. Certain trusts, estates, and tax-exempt organizations can be shareholders in an S corporation. (UpCounsel, Inc., 2019)

Only corporations with one class of stock are eligible to convert to S corporation status. One class stock may become problematic and limited if there are special allocations involving certain shareholders regarding corporate earnings. Another potential problem involves financing arrangements that consider equity-based payments or options to buy shares. (UpCounsel, Inc., 2019)

If you, your clients, or your advisors are contemplating a C to S conversion, please contact VAVA Inc. and we will be happy to have a collaborative consultation. A valuation performed correctly today can save headaches and major dollars down the road.