The Big Switch: Weighing the Costs of Converting a C Corp to an S Corp

Operating as an S corporation can be a powerful tool, often helping small businesses reduce their federal employment tax burden, a major win for your bottom line. But before you make the leap from a C corporation (C Corp) to an S corporation (S Corp), there are hidden tax landmines that can make the transition costly if you’re not prepared.

Converting is not just a form filing; it’s a fundamental change with lasting tax consequences.

You can’t simply decide to be an S Corp; you must fit the blueprint established by the IRS. If your business fails any of these core requirements, the switch is a non-starter.

The main financial lure of the S Corp is how owners are paid. The IRS requires a shareholder who performs services to pay themselves a “reasonable salary.” This income is subject to Social Security and Medicare taxes.

However, the shareholder is then required to pay tax on their share (proportional to their ownership percentage) of the S Corp’s income. This income is generally not subject to those employment taxes. This split is one of the core advantages of S corporations. Converting from a C Corp is often a strategic move to turn a portion of your compensation from fully taxable wages into less-taxed income, a huge potential savings for you and your family.

Shareholders should also be aware of another potential tax complication. If a shareholder does not meet the IRS’s requirements for material participation in the S Corp’s business activities, their share of the S Corp’s income may be subject to the net investment income tax.

When you convert to an S Corp, the IRS is essentially watching the company assets you owned at the time of conversion. If your C Corp holds appreciated property (assets worth more than their book value, like real estate, equipment, or goodwill), the IRS considers that a “built-in gain.”

The Rule: If your new S Corp sells or disposes of these assets within five years of the conversion date, the corporation itself will be hit with a hefty tax on that gain.

Think of this tax as an “inventory tax.” The C Corp tagged these gains before the switch, and the S Corp must pay a toll if it unlocks them too soon. If you plan to sell major assets shortly after conversion, you may be better off waiting until the five-year clock runs out. There’s also the additional administrative burden of valuing the appreciated assets at the time of conversion, often requiring a formal appraisal for difficult to value assets.

S Corps that used to be C Corps often carry over a financial inheritance: accumulated earnings and profits (E&P). This E&P can trigger a special tax if your S Corp starts making too much passive income.

The Rule: Your S Corp will face a special tax if its passive investment income (such as interest, dividends, rents, royalties, or gains from stock sales) exceeds 25% of its gross receipts and the company has C Corp E&P on the books.

If this passive income tax is due for three consecutive years, the IRS will automatically terminate your S Corp election. This means you get forced back into C Corp status, potentially losing the very benefits you switched for.

You can avoid this trap by either distributing the E&P to shareholders or by simply limiting your passive income. This forces you to reflect on your business model: are you an active operating business or a holding company?

If your C Corp used the LIFO (Last-In, First-Out) method for inventory valuation, you must recognize a cost when converting.

The Rule: The C Corp must include the “LIFO recapture amount” (the benefits derived from using LIFO) into its income in the year before the S election takes effect.

The resulting tax bill can be paid in four equal annual installments. While this creates a tax liability upfront, the payment is spread out, allowing you to balance this cost against the long-term tax savings of S Corp status.

Sometimes, a C Corp that has been running at a loss and holds valuable Net Operating Losses (NOLs). While the business remains a C Corp, these losses may be used to offset future income, reducing future tax bills.

When you switch to S Corp status, those NOLs cannot be used to offset your new S Corp income, nor can they be passed through to shareholders.

If you can’t carry those losses back to offset income from previous C Corp years, you essentially give them up. You must carefully weigh the value of those lost NOLs against the future tax savings the S Corp status will generate for you and your family.

The costs aren’t purely tax-related. The conversion affects how you compensate yourself and your key employees, and it brings new compliance demands:

Fringe Benefits: As a majority shareholder-employee of an S Corp, you lose access to the full range of tax-free fringe benefits available in a C Corp (like tax-free health insurance premiums). Those costs suddenly become taxable to you, the shareholder.

Tracking Your Basis: As an S Corp, shareholders must track their stock basis and debt basis year-by-year. This basis is your personal investment “scorecard.” It determines the limit on losses you can claim and how your distributions are taxed. If you convert, you must start tracking this immediately, as the old C Corp rules no longer apply.

The path from a C Corp to an S Corp is dotted with specific, complex rules. Skipping due diligence here risks significant, unnecessary tax bills for you and the potential termination of your S Corp status down the road.

We are here to help you design a transition strategy that eliminates or minimizes these tax problems. A lot depends on your company’s particular circumstances, your asset mix, and your long-term business goals.

Choosing the right business structure is a significant move for your company’s future. To explore strategies for a seamless transition from a C Corp to an S Corp, please visit our tax services page and contact us today. We look forward to helping you ensure this decision creates long-term growth for your family and your team.