It may be tempting to convert a closely-held C corporation into an S corporation. This may help lower the ultimate tax bill to shareholders by eliminating an entire layer of taxation. By converting a C corporation to an S corporation, you are eliminating a tax entity that pays up to 35 percent on income and routing those profits to shareholders' individual income tax returns, which are presumably taxed at lower rates. Before you make a move, though, check the rules that apply to these conversions and capital gains, our you may be in for an unpleasant tax surprise. In some cases, you may be better off waiting to do the conversion.
1. Determine the value of any capital property in the C corporation. Generally, you will use the fair market value of this property, which is the price you would be willing to sell it for and could reasonably expect given an informed buyer not related to you in an "arm's length" transaction.
2. Determine your tax basis in the capital property. This is the amount you have paid into each property for acquisition, renovation and improvement, not counting repairs. Subtract any deductions for depreciation the company has already taken on these properties.
3. Determine when you placed the property into service. This is important, because the Internal Revenue Service (IRS) assesses capital gains tax on any accumulated capital gains on assets held by companies that were formerly C corporations for less than five years. This means your S corporation will have to pay up to 35 percent in taxes on any accumulated gains from property first placed into service by the old C corporation, for up to five years.
4. File a Form 2553 with the IRS. This document is also referred to as a "subchapter S election," and serves notice to the IRS to start treating your corporation as a pass-through entity. This means the corporation generally won't pay income taxes. Instead, the profits will flow through to the individual income tax returns of the shareholders.
- Use caution when converting C corporations that attribute over 25 percent of their earnings to passive activities. Special penalties apply, and you could have your eligibility for subchapter S treatment revoked by the IRS.
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