C Corp to S Corp Problems

By Jason Watson, CPA
Posted Sunday, October 29, 2023

There are several potential problems when electing a C corporation to be taxed as an S corporation. First is called the built-in gains tax, or BIG tax for short. If the C corporation has net unrealized gains on appreciated assets, you must track these assets for a certain period of time. This also means your assets need to be appraised as of the conversion date.

For example, if an S Corp that was recently converted from a C Corp sells some real estate that increased in value when owned by the C Corp, the S Corp will probably pay taxes on the appreciation even though the corporation is now an S Corp. The BIG tax is for any asset sold within 5 years of S Corp election (it was a 10-year look back period, then whittled down to 7 due to the American Recovery and Reinvestment Act of 2009 and then 5 thanks to the Small Business Jobs Act of 2010). Here is an example-

MyCorp was a C corporation for several years until it recently made an S Corp election following some good advice. The only asset had a value of $100,000 at the time of election and its basis was $20,000. Two years later the asset was sold for $140,000 without consulting with MyCorp’s accountant.

Because there was a net built-in gain at the time of the S Corp, it will be subject to corporate income tax on $80,000 of its gain. The remaining $40,000 of its gain is not subject to corporate tax.

However, the entire $120,000 gain ($140,000 less the basis of $20,000) is taxed to the shareholders of the S corporation (but it is reduced by the amount of tax that MyCorp had to pay on the gain).

See Sections 1366(f)(2) and 1374 of the Internal Revenue Code (IRC) if you find yourself in the unique position of not having enough information on the BIG tax.

More bad news- Normally, Net Operating Losses (NOLs) can be carried forward and used in future years for C Corps. On the other hand, unused NOLs will be lost forever with an S corporation election unless the C Corp can use it for previous years through amended tax returns. Otherwise the NOL cannot be used by the S Corp nor its shareholders.

Other issues arise from accounts receivable, inventory, and rents, royalties and investment income. More discussion is always required when dreaming of converting your C Corp to an S Corp. And don’t worry, we won’t judge you on the reasons you were a C corporation from the beginning (there aren’t many legitimate reasons short of funding the startup or seed money with a self-directed 401k or paring down debt with excess cash).