As a company grows, the business environment changes and other factors impact how the company operates, there may come a time when the business structure is no longer conducive to the company’s goals. Over time, a form of legal organization that once suited the business and was conducive to its goals may come to work against these interests. It is important to note that in most cases where practical tax and business considerations allow, it is possible to convert your company’s form of organization to better suit the organization’s current and emerging goals. The business tax lawyers, CPAs, and financial professionals at the Tax Law Offices of David W. Klasing can provide strategic guidance to align your business structure with your organizational goals.
Can You Convert a California Corporation to Other Entity Forms?
As a threshold question, one must first determine whether the laws of the state of California permit the conversion of a domestic (California) stock corporation to other forms of entity organization recognized in the state. As a general rule, A domestic stock corporation can convert into another recognized California business entity. Likewise, a California limited liability company (LLC), limited partnership (LP) or general partnership (GP) can convert into a California or foreign other business entity. Similarly, provided that the laws of the foreign jurisdiction allow for it, a foreign corporation can convert to a California corporation. However, the exception is that a California corporation cannot convert to a foreign entity.
What Steps Are Required to Convert a C Corp to an S Corporation?
For federal tax purposes, the only requirement that is set forth to convert a C corporation to an S corporation is completing and filing Form 2553 with the IRS to change the tax election. Requirements regarding the completion and filing of IRS Form 2553 include that:
- It must be signed by all the shareholders
- The signed form must be submitted to the IRS no later than two months and 15 days past the beginning of the tax year for which the S corporation election is being made.
Form 1120S should be filed for the tax year in which the S corporation election is made.
What Tax, Financial and Legal Considerations Are Associated with Conversion of a C Corp?
When converting a California C Corporation to a California S Corporation, the biggest difference individuals will need to understand is a tax election. Technically all California corporations are initially formed as C corporations. It is only after the articles of incorporation have been filed, the bylaws enacted, shares issued, and the initial shareholders hold the first shareholder meeting that a newly formed California C corporation can elect to be treated as an S corporation by filing IRS Form 2553. If an S election is not made and filed within approximately 45 days of incorporating, the corporation will remain a C corporation until Form 2553 is filed. There does not appear to be additional filing requirements with the California Secretary of State.
Additional tax compliance and other considerations that should accompany any decision to convert a C Corp should include:
- Pass-through tax considerations – Converting a C Corp to an S Corp will result in disparate tax handling as the entity moves from an independent tax entity to a pass-through entity.
- Built-in gains (BIG) tax considerations — If the S corporation sells assets derived from the C corporation at a profit or retained earnings from the C corporation is distributed within five (5) years of conversion the IRS imposes a 35% tax on the gains. In some cases, the BIG tax will apply even if assets are not sold but are such things as receivable accounts accrued under C status but collected under S.
- Passive investment income taxes – A converted S corporations can be subject to taxes on passive investment income (e.g., interest, retained earnings, rents or royalties, or stock sale gains) inherited from a C corporation (PFIC tax). If this income exceeds 25 percent of the S corporation’s gross income and the S corporation has accumulated earnings and profits carried over from its C corporation years, then the S corporation will be subject to a special tax. If the PFIC tax applies for three consecutive years, the S conversion is terminated. Distributing any passive income to S shareholders will avoid the PFIC tax.
- FICA and Self-employment tax minimization considerations — S corporation shareholders can minimize both self-employment and FICA taxes by creating a balance between a reasonable salary and dividends. Dividends/distributions are not subject to either self-employment tax or FICA.
The above represents only some of the considerations that should be addressed prior to converting a C Corp in California. Speak to an experienced tax attorney or CPA prior to engaging in any substantive actions regarding your business and its form of legal organization.
Tax Attorneys and CPAs Provide Business Entity Advice and Guidance
At the Tax Law Offices of David W. Klasing our attorneys, CPAs, and financial professionals can help your business address difficulties incurred due to an array of tax or financial concerns. If your company has undergone changes and its form of organization is a drag on your goals, we can assess whether organizations such as a C Corp, S Corp, LLC, or another form is more likely to be conducive to your goals. To schedule a confidential reduced rate consultation, call the Tax Law Offices of David W. Klasing at 800-681-1295 today.
