C Corporation converting to an S Corporation

Tax implications of a C Corporation converting to an S Corporation

There are basically two tax options for a corporation. A regular corporation (or C corporation) pays tax on its earnings at the corporate level. Then, a second tax is paid when those same earnings are distributed as dividends to the shareholders. This system of double taxation is precisely the reason why many people choose S corporation status, as S Corporations pay no tax on their own at the corporate level. Rather, the S corporation income flows through to the shareholders, and they pay the tax personally at the individual level, on the shareholders individual income tax return.

So if you are a C Corporation, what happens when you convert to an S corporation? Let’s consider the following example: ABC, an S corporation, has approximately $200,000 of  C corporation accumulated earnings from years preceding its election to be taxed as an S corporation. These earnings are referred to as C corporation earnings and profits, or E&P for short. When a corporation has undistributed E&P, this is viewed, for tax purposes, as the potential for paying taxable dividends in the future. When such a corporation elects to be taxed as an S corporation, as ABC did, that dividend-paying potential carries over to the S corporation. This is by far the most important ramification of having C corporation earnings and profits.

The E&P concept is imperative to the double taxation system imposed on C corporations. When a C corporation makes a non-liquidating distribution of money or property to its stockholders, the question is what does the distribution really represent? A distribution of corporate earnings (dividends), a return of the shareholder’s stock investment, or a distribution in excess of their investment? Each category of distribution is taxed differently.

The first and most important question is whether a distribution is really a dividend, and E&P is the measuring stick used in this scenario. Theoretically, E&P represents the corporation’s ability to pay dividends. A distribution is treated as a dividend (and taxed to the shareholders as ordinary income) to the extent the corporation has accumulated E&P. Distributions in excess of accumulated E&P are treated as a nontaxable return of capital to the extent of the shareholder’s stock basis. Distributions beyond that are treated as a sale of the shareholder’s stock, generally taxed as a long-term capital gain, depending on the holding period.

S corporation shareholders are taxed on income whether or not the earnings are distributed. When distributions are actually made from an S corporation, they are assumed to come first from income that has already been taxed, but has remained undistributed as retained earnings. Thus, when you make distributions up to the amount of undistributed previously taxed income, they distributions are not taxed any further. This rule applies whether or not the S corporation has E&P from C corporation tax years.

The difference between S corporations with C Corporation E&P (and S corporations without C Corporation E&P), is reflected when there are distributions in excess of undistributed previously taxed income. An S corporation with C Corporation E&P is required to maintain an account called the accumulated adjustments account (AAA). This account is a tally of the S corporation’s previously taxed, but undistributed income. If an S corporation with C corporation E&P makes a distribution in excess of AAA, the excess is treated as a taxable dividend to the extent of C corporation E&P.

The following example illustrates how distributions are treated depending on whether the corporation has C Corporation E&P.

Assume an S corporation is owned by a single shareholder. The shareholder’s stock basis is $50,000 consisting of an initial capital investment of $10,000 plus $40,000 of undistributed S corporation income (AAA) on which the shareholder has paid already paid tax. Assume the corporation makes a distribution of $70,000.

If the corporation has no C corporation E&P, the first $50,000 of the distribution is tax-free. The corporation is simply distributing previously taxed earnings of $40,000 and then returning the shareholder’s initial investment of $10,000. The remaining $20,000 is treated as sale of the shareholder’s stock as a capital gain to the shareholder.

Consider the same example; however the corporation also has $10,000 of C Corporation E&P. The first $40,000 of the distribution represents distributing previously taxed earnings of $40,000, same as above. The next $10,000 of the distribution would be considered a taxable dividend to the shareholder (this is the amount of C Corporation E&P). The remaining $20,000 is treated as first a tax-free return of the shareholder’s initial stock investment of $10,000, and the remaining $10,000 represents payment for the sale of the shareholder’s stock, normally treated as capital gain.

To summarize, the existence of C Corporation E&P simply means that distributions from the corporation in excess of undistributed previously taxed income (AAA) will be considered an ordinary dividend to the extent of C Corporation E&P. C Corporation E&P must be distributed as a taxable dividend before the shareholder can receive a tax-free return of their capital stock investment.

Please note that in the case of liquidating distributions, there is no distinction between S corporations with E&P and those without. All liquidating distributions are treated the same, typically capital gain to the shareholder, to the extent such distributions exceed stock basis.

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