S Corporations vs. C Corporations: Tax Planning and Conversion Rules

Entity choice determines how profits reach owners, how second-layer taxes arise, and how built-in gains and losses surface when a company switches regimes or welcomes new investors.

C Corporations pay entity-level tax; shareholders pay again on dividends.

The corporation computes taxable income at the 21-percent federal rate, then distributes after-tax profits as dividends taxed to individuals at preferential or ordinary rates depending on holding period and income level.

Qualified dividends flow through Form 1099-DIV and never reduce corporate E&P; stock redemptions follow § 302 tests to avoid dividend treatment. Retained earnings finance growth but build exposure to future dividend or liquidating-gain tax.

S Corporations pass profits and most losses directly to shareholders.

An election under § 1362 causes the entity to file Form 1120-S and issue Schedule K-1s; shareholders include income whether or not cash is distributed, but avoid corporate-level tax.

Limitations apply: only one class of stock, no more than 100 shareholders, and only eligible U.S. individuals, certain trusts, or estates may hold shares. Debt basis and at-risk rules govern loss deductions; built-in gains tax lurks on appreciated assets for five years after conversion from C status.

Election mechanics and termination traps.

All shareholders sign Form 2553 within two months fifteen days of the intended effective date, or file late with reasonable-cause relief. Adding an ineligible shareholder, issuing preferred-style rights, or missing calendar-year requirements automatically terminates S status.

Voluntary revocation requires greater-than-50-percent shareholder consent and specifies the year of reversion to C status—often timed to absorb NOLs before the 80-percent limitation cap applies.

Built-in gains tax and LIFO recapture deter whipsaw conversions.

When a C corporation converts to S, corporate-level tax equals 21 percent of net recognized built-in gain realized or deemed realized within five years. Unrealized receivables, appreciated inventory, and intangibles trigger the tax upon collection or sale.

LIFO inventories recapture the difference between LIFO and FIFO at conversion, taxed over four years, yet shareholders receive basis adjustments to prevent double taxation.

Compensation and fringe-benefit disparities influence payroll strategy.

S-corporation owners working in the business draw reasonable salary subject to FICA; additional profit escapes self-employment tax. C-corporation owner-employees incur payroll tax on salary, yet qualify for tax-favored fringe benefits—health premiums, group-term life insurance—that S shareholders holding more than 2 percent must include in income.

Conversion from S to C reopens E&P ledgers and timing decisions.

Distributions from accumulated adjustments account (AAA) remain tax-free to the extent of basis; once exhausted, distributions from accumulated C-corporation E&P become dividends. Post-conversion planning often pays out AAA before the first C-year closes to avoid later dividend treatment.

State conformity complicates modelling.

Many states tax S corporations at reduced entity-level rates or impose elective pass-through-entity (PTE) taxes that shift state tax to the entity and generate federal deductions under Notice 2020-75. C-corporation state rates remain deductible but subject to the § 164 SALT cap for individuals on dividends.

Financial-statement impacts under ASC 740 and ASC 740-10-25.

S-status eliminates deferred-tax liabilities on temporary differences; conversion back to C requires re-establishing DTAs and DTLs, with the offset flowing through the income-tax line in the period of change. Valuation-allowance assessments update once again if projected taxable income shifts under the new regime.

Exit strategies shape entity-choice calculus.

Venture-capital preference for one-class common stock and IPO readiness leans toward C status, while closely held service firms prefer S status for single-layer taxation. Hybrid structures—holding-company C with S subsidiaries disregarded for tax—can blend investment scalability with pass-through flexibility.

Continuous monitoring of shareholder eligibility, earnings-and-profits levels, and built-in gain exposure guides whether to maintain, revoke, or adopt an S-corporation election in pursuit of optimal after-tax cash flow for owners and investors.

____________

FOLLOW US FOR MORE.

DATA STUDIOS

datastudios.org