21 Nov Business Diversification: S Status Conversion
Business diversification will always need to include some accounting for tax. Truly diversified companies will always consider the tax implications of their M&A activity and overall business strategy. C-corporations seeking a way to shelter more from the government, avoid taxes and further diversify should take a hard look at an S Status Conversion. In short, an S Status Conversion will allow the company to distribute earnings to small business owners free of the double-tax imposed on C Corporations.
There are two major downsides to converting to S Corp status:
1. The company will lose the low tax rates imposed on income accumulations of up to $75K annually for C corporations.
2. The newly converted S Corp will also lose the ability to offer tax-preferred employee benefits to company employees and shareholders.
In many instances, however, these downsides are not large enough for the profitable C Corp who may need to properly diversify. There are a few offsets to the downsides.
1. There is a 5% corporate tax “bubble” which occurs once businesses hit the $100K mark. In effect, this creates a standard 34% flat tax on all corporate earnings up to $10 million.
2. Silent “golfer” owners will find little upside to tax-preferred employee benefits. At least, the benefits will generally not be enough to offset the diversification benefits of converting to an S Corp.
While there are a number of nuances and a few more considerations to take into effect when converting to an S Corp (like having <100 shareholders, one class of voting stock, etc.). However, there are a number of other conversion traps which need to be considered when swapping out your C Corp for an S Corp. Here are a few to consider.
Post-conversion S Corp distributions in excess of S Corp earnings triggers a shareholder dividend tax to the extent of the C earnings and profits. This could put a threshold cap on distributions to ensure they do not exceed S Corp earnings. In the event of profitable C Corps which convert, this could prove problematic, especially if the C Corp had a great deal of cash or retained earnings on hand at the time of conversion.
Accumulated C Corp earnings can also trigger a section 1375 tax trap wherein investment income on an S Corp is taxed at the highest corporate rate (35% as of today) in the event that net passive income (interest, dividends, rents, royalties, etc.) exceeds 25% of gross receipts. In this event, it is wise to monitor passive income from the S Corp to ensure it does not exceed the 25% threshold of gross receipts.
Finally, an S Corp can be subject to the built-in-gain (“BIG”) tax trap (or section 1374). This tax kicks in when the newly converted S Corp attempts to sell assets owned by the C Corp at the time of the conversion within 10 years of the conversion date. The BIG tax is in addition to any tax triggered at the S-level on any gain from the asset sale and is imposed at the maximum corporate rate (35% as of today) on the lesser of:
a. Built-in-gain at the time of converstion or
b. The gain recognized on the sale of said assets
In any event, careful consideration should be given to divesting assets after converting from a C Corp to an S Corp. In fact, conversion itself should be considered carefully as a strategy congruent with the business’s short and long term goals and vision, including any potential future merger activity.