An S corporation may face corporate-level income taxes in specific scenarios. These situations typically arise when a C corporation transitions to S corporation status or when an S corporation acquires a C corporation. Here’s a closer look at these circumstances:
Built-In Gains: An S corporation must pay tax on the gain from disposing of assets that appreciated in value during the five years prior to its conversion from a C corporation. This rule also applies to assets acquired from a C corporation during a merger. The built-in gain is taxed at the highest corporate tax rate. However, any remaining C corporation net operating losses and capital loss carryforwards can be used to reduce this built-in gain amount.
Example: Apex Design Corporation transitions to an S corporation and, as of the conversion date, owns an office building with a basis of $2.5 million and a fair market value of $3 million. Three years later, the building is sold for $5 million. The S Corp will be taxed on the $500,000 gain that existed at the date the Corp converted to S Corp. Apex Design will pay $105,000 in taxes and pass through an after-tax gain of $395,000 to its shareholders, plus an additional $2 million gain accrued after the conversion. The additional $2 million gain from the sale that accrued after the conversion from a C corporation to an S corporation will be taxed to the shareholders at their individual income tax rates.
Had Apex Design waited an additional year, the gain could have been avoided since the holding period would exceed the five-year recognition period.
Tip: To minimize built-in gains tax, get an appraisal when converting from a C corporation to an S corporation. This helps identify built-in gains at the time of conversion and excludes any post-conversion gains.
Passive Investment Income: Passive investment income includes royalties, rents, dividends, interest, annuities, and gains from the sale of securities.
If an S corporation that previously was a C corporation (or acquired one) has leftover profits from the time, it was a C Corp, it must pay an excess net passive income tax if the current passive investment income exceeds 25% of its current gross receipts. To avoid this, distribute all earnings from the predecessor C corporation.
Example: Apex Design, initially a C corporation, converts to an S corporation with $1,000 in earnings on its books. Five years later, it earns $100,000 in rental income from a leasing personal property, while still producing only $1,000 of regular income. Since passive income exceeds 25% of its gross receipts, Apex Design must pay tax on its passive investment income. Distributing the $1,000 in earnings would have prevented this penalty.
Tip: Keep passive income low by avoiding dividend-issuing securities. Note that if an S corporation has accumulated earnings for three consecutive years with over 25% passive investment income each year, its S corporation election will be terminated at the end of the third year.
Rental activities can avoid being classified as passive income if significant services are provided. For instance, operating a bed-and-breakfast is not considered passive income due to the services involved, whereas renting out an entire facility under a long-term lease could be.
LIFO Inventory Recapture: When a C corporation that uses the last-in, first-out (LIFO) method for inventory valuation converts to an S corporation, it must recapture the excess of inventory value under LIFO compared to first-in, first-out (FIFO) valuation. This recapture tax is paid in four equal installments, starting with the due date of the final corporate tax return for the C corporation, and the remaining three installments are due over the next three years.
Example: Apex Design, a C corporation, uses LIFO for its inventory, which is valued at $100,000. After converting to an S corporation, the FIFO valuation is $200,000, resulting in an $100,000 of LIFO recapture on which taxes must be paid.
In conclusion, transitioning from a C corporation to an S corporation requires careful tax planning. To avoid taxes on built-in gains, passive income, and LIFO inventory recapture, distribute C corporation earnings, get asset appraisals, and manage passive income. Proper tax planning will help you with a smooth transition and you will also maximize tax liabilities.