3 Steps to Change Your C Corp to an S Corp

When choosing the right business type, it’s essential to ensure it fits your management style, entity needs, and tax purposes. While C Corporations offer the most tax-related options for business owners, those with S Corp status gain pass-through taxation. 

If you’re considering switching types, keep reading to discover how to convert a C Corp to an S Corp.

Key Takeaways

• An S Corporation is a tax classification that eligible LLCs and C Corporations can elect by filing Form 2553 with the IRS.

• Business owners must form an C Corporation or LLC before electing S Corp status.

• S Corp status offers liability protection and pass-through taxation, among other advantages.

What Is an S Corporation?

An S Corporation is not a business type or a way of structuring a business entity. Rather, it’s a tax classification that the Internal Revenue Service (IRS) recognizes on a federal level. Business owners must form and choose a business type, like an LLC or C Corporation, before electing S Corporation status.

When it comes time to file taxes for business income, the IRS sees S Corps as pass-through entities. Owners can have their Corporate earnings and losses go through to their individual shareholders’ tax rates instead of filing a Corporate tax return separately.[1] Depending on the type and size of the business entity, this can result in significant federal tax savings.

However, not just any small business Corporation can elect S Corp status. Electing this tax status means that S Corporations shareholder’s are responsible for taking on their entity’s taxes at the state and federal levels. For this reason, the entity must operate in the United States, among other rules.

To qualify for S Corp status, your entity must be a domestic Corporation, have no more than 100 allowable shareholders, only one class of stock, and not be an ineligible Corporation.[1] Check the qualifications before applying for S Corp status. Otherwise, your application may be rejected. 

S Corp vs. C Corp

A C Corporation is the commonly used structure that most people think of when they hear “Corporation.” This entity type is a good option for large companies as it offers business owners the most tax-related options and provides the greatest level of separation between the owners and the company. A C Corp can also raise capital by issuing publicly traded stock.

On the other hand, C Corporations have more formal requirements than other entity types, such as an LLC, making it a less attractive option for small businesses. 

The most notable difference between an S Corp and a C Corp is that an S Corp is a pass-through entity. With an S Corp, business owners report Corporate income and losses through their individual tax returns. Owners can use their personal tax rates rather than filing a separate tax return for business-related income. In addition to tax savings, this helps owners avoid filing taxes twice, also known as Corporate "double taxation."

Check out the table below for a few high-level differences between a C Corp and an S Corp.

How to Convert a C Corp to S Corp

Now that you know why you might want to change your C Corp to an S Corp, we’ll take you through a breakdown of each step with the information you need to know. Deciding to change the tax classification of your entity is important, so make sure you’re all caught up on IRS requirements, due dates, timelines, required forms, and costs.

1. Determine Your S Corp Eligibility

To elect S Corp status, businessess must first be inCorporated as a C Corporation or LLC. Remember that this isn’t a business type or way to structure your entity, but rather, an elected tax classification federally recognized by the IRS. 

According to the IRS, a C Corp or any other eligible entity can elect S Corp status under the following requirements:

• Is a domestic entity

• Has no more than 100 shareholders

  • An individual and their spouse or estates count as one shareholder.

  • All members of a family and their estates count as one shareholder.

• Has only consenting individuals, estates, exempt organizations or certain trusts as shareholders

  • Nonresident aliens cannot be shareholders.

• Has one class of stock

• Is not an ineligible Corporation, such as a bank or thrift institution, an insurance company subject to certain taxes, or a current or former domestic international sales Corporation (DISC)

• Has or will adopt to one of the following tax years:

  • A tax year ending December 31

  • A natural business year

  • An ownership tax year

  • A tax year elected under section 444

  • A 52-53-week tax year ending with reference  to a year listed above

  • Any other tax year that the entity can establish a business purpose for[2]

For more guidance and support, see the IRS’ instructions for filing Form 2553.

2. Review S Corp Tax Election Due Dates

Owners must complete and file IRS Form 2553 no more than two months and 15 days after the beginning of the tax year you want the election to take effect. For example, if you want your S Corp status to begin January 1 and have a tax year end of December 31, you would file by March 15.[2]

Alternatively, you can file any time before the tax year you want your S Corp status to take effect. 

If you fail to file Form 2553 on time, the IRS offers relief for late elections if you can show reasonable cause. There are certain rules for late elections, so read the IRS’ detailed instructions carefully.

3. File IRS Form 2553

The most crucial step is to file Form 2553 with the IRS to formally elect S Corp status. Filing the form is free, although owners may need to pay a fee if they file late. You should expect to hear back within 60 days of filing the form.[3]

S Corp Tax Implications

You'll likely run into certain tax implications when converting a C Corp to an S Corp. As a pass-through entity, S Corps do not pay federal Corporate tax. However, because S Corps are responsible for tax on certain passive income and built-in gains at the entity level, there are some conversion issues to be aware of.[1]

While S Corps have extra tax benefits, they’re still responsible for taxes on specific built-in gains and passive income.[4] Any S Corp that was previously a C Corp or acquired an asset while it was a C Corp needs to pay a built-in gains tax, which can be filed using IRS Form 1120-S. This form also includes a line to declare passive income.[5]

FAQs

What happens to retained earnings when converting from C Corp to S Corp?

Retained earnings, also known as passive income, are taxed. Business owners can declare these earnings on Form 1120-S.

What are the tax consequences of changing from C Corp to S Corp?

There are several tax implications on built-in gains, passive income, and more. Be sure to read the IRS’ guidance carefully before converting.

What are the benefits of changing from C Corp to S Corp?

While S Corps offer the same liability protection, ownership, and management benefits as C Corps, S Corps have significant tax benefits for small companies. Corporate gains and losses are taxed at each shareholder’s individual rate, saving them from double taxation or having to file twice.

Is there built-in gain tax on conversion from C Corp to S Corp?

Yes, any S Corp that was previously a C Corp must pay a built-in gains tax using Form 1120-S.

What happens to net operating losses in a C Corp when it converts to an S Corp?

Generally, S Corps cannot use net operating losses (NOLs). Instead, they can use their separate shares of the S Corp’s business income and other business deductions to figure out their own individual NOLs.[6]

How much does it cost to convert to S Corp?

Filing Form 2553 is free. However, owners may need to pay a fee if they file late. 

What is the tax on dividends paid out?

Because S Corps are pass-through entities and do not pay Corporate tax, they are not subject to tax on dividends paid out. Corporate profits go directly to the owners, which is why S Corps are a good option for small business owners.[7]

What is the difference between a C Corp and an S Corp?

S Corporations are pass-through entities that offer many tax benefits, most importantly helping business owners avoid double taxation.

What is the tax rate for an S Corp?

Since Corporate profits and losses pass through to S Corp shareholders, tax rates are determined based on each shareholder’s individual rate.

Bibliography

1. Internal Revenue Service. “S Corporations.” Accessed December 22, 2023.

2. Internal Revenue Service. “Instructions for Form 2553. (Rev. December 2020).” Accessed December 23, 2023.

3. Internal Revenue Service. “About Form 2553, Election by a Small Business Corporation.” Accessed December 23, 2023.

4. Investopedia. “What Is an S Corp? Definition, Taxes, and How to File.” Accessed December 23, 2023.

5. Internal Revenue Service. “Instructions for Schedule D (Form 1120-S).” Accessed December 23, 2023.

6. Internal Revenue Service. “Publication 536 (2022), Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.” Accessed December 23, 2023.

7. Investopedia. “Can a Corporation Deduct Dividend Payments Before Its Taxes Are Calculated?” Accessed December 23, 2023.