Choosing a type of business structure for your company is an important decision, one that should not be made lightly. Entrepreneurs who have created and formed their businesses as C-Corporations may wonder if they should consider changing the business structure. If you are considering turning your C-Corporation into either a partnership or an S-Corporation, it is important to understand the potential benefits and drawbacks, including possible tax benefits for your small business.
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How are C-Corporations taxed?
C-Corporations are treated as separate legal entities for tax purposes. This means the company is responsible for filing periodic tax returns and for paying taxes at corporate tax rates, after offsetting income with applicable credits, deductions, and losses.
Shareholders are paid dividends on their proportionate shares of the earnings. Those dividends are then taxed again at each shareholder’s individual income tax rate. This structure is commonly referred to as “double taxation” because income is taxed both at the corporate and individual levels.
How are Partnerships and S-Corporations taxed?
Unlike C-Corporations, Partnerships and S-Corporations are not subject to double taxation. Instead, these types of structures are pass-through entities. Income is not taxed at the company level.
Both S-Corporations and Partnerships must file informational tax returns with the IRS and, if applicable, state and local tax authorities. But, the company itself is not responsible for paying taxes on earnings. Individual shareholders (for S-Corporations) or partners (for Partnerships) are taxed on their proportional or allocated share of the earnings, as laid out in their shareholder or partnership agreements.
Notably, the owners of both Partnerships and S-Corporations are taxed on their share of the income the company made – whether or not that income was actually distributed to the owners.
What are some possible tax benefits of converting from a C-Corp to an S-Corp or a Partnership?
The most obvious change when converting a C-Corporation to an S-Corporation or to a Partnership is that the company’s owners can avoid double taxation of earnings. Depending on the corporation’s earnings and its shareholders’ tax brackets, this can result in significant savings.
S-Corporations may also realize tax savings by distributing earnings to shareholders as dividends, which are not subject to payroll taxes. However, under current tax laws, each shareholder employee must be paid a salary subject to payroll taxes and the salary may not be unreasonably low in the eyes of the tax authorities. If the IRS deems it too low, they may recharacterize dividend income as salary and assess payroll taxes to the company. Partnerships do not pay payroll taxes, although their partners are considered self-employed and therefore must pay self-employment taxes on income.
What are the potential drawbacks of converting a C-Corporation to an S-Corporation or Partnership?
When converting to an S-Corporation, the company may be subject to taxation on “built-in gains,” which can result if the S-Corporation sells real estate or other assets originally held by the C-Corporation, and makes a profit in the process. To avoid this tax, assets must be held by the S-Corporation for at least five years after conversion before being sold or distributed.
Another potential drawback is that the S-Corporation cannot pass through the C-Corporation’s operating losses to its shareholders, and inventory “inherited” by the S-Corporation may also be taxed, depending on the accounting method the company chooses.
After converting a C-Corporation, the new entity may have to pay taxes on passive investment income like retained earnings, rents or royalties, and interest. If passive investment income is more than 25% of the gross income for the S-Corporation, a separate tax is assessed. After three years in a row of failing the 25% test, the company will lose its S-Corporation election.
Consider also the self-employment tax. Partners in a general Partnership are subject to this requirement on the company’s income, whether distributed or not, whereas corporate shareholders are generally not.
Talk to a tax lawyer if you are considering conversion
Converting your business structure from a C-Corporation to another type of entity is a decision best made after evaluating the options and weighing the pros and cons. Conversion can be costly, but converting during an economic downturn, when gains and earnings are depressed, may defray some of the expense. For some business owners, it may be more advantageous to leave their existing business C-Corporation structure in place.If you are considering making a change to your company’s legal entity, ask a lawyer for advice on the potential pros and cons specific to your situation.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.