The right entity choice: Should you convert from a C to an S corporation?
As internal and external factors change with your business, you’ll want to reevaluate whether or not you should convert your entity choice. 415 Group partner Ray Maynard, CPA, explains some things you should consider when deciding to convert from a C to an S corporation and vice versa.
The biggest difference between a C corporation and an S corporation is when taxes are paid. Since a C corporation is not a passthrough entity, it typically has double taxation in order to get cash to the owner(s) of the business. The corporation pays tax on its income and, when a dividend is paid, the individuals receiving a dividend pay taxes on that income again. However, when an S corporation has earnings, the income passes through to the shareholder’s tax returns. The income is not typically taxed at the corporate level and is only taxed at the shareholder level.
There are other differences between the two—such as how many shareholders each are allowed—but the level at which taxes are paid will typically be the biggest factor in converting from a C to an S corporation or the other way around.
As a general rule, if you want to leave all the money in the company to pay down debt or make capital expenditures, choosing a C corporation can be the best way to go. This is due to the fact that the corporate tax rate can be lower. By leaving cash in the company, the income will only be taxed once. If the corporation then pays a dividend, the money will be taxed again at the shareholder level (double taxation). However, if you want to take substantially all the money out (because you have little debt and/or a lot of capital), an S corporation would often be the better decision. This income is only taxed once at the shareholder level (single taxation).
These examples are the two ends of the spectrum, with most businesses landing somewhere in the middle. Calculations can be tricky, so it’s best to work with an accounting firm who can help you decide.
The main issue to keep in mind is the future cashflow needs of your business. If you need the cash to pay down debt, you’ll typically want to be a C corporation. If not, you can choose an S corporation—you’ll pay tax at individual rates, but you’ll avoid the double taxation that a C corporation is subjected to.
Some businesses start as a C corporation, convert to an S corporation, and wind up converting back to a C corporation. The entity type should be reassessed as tax rates change and when the cashflow needs of the business or owner change. An accounting firm that works closely with their clients will typically keep these scenarios in mind.
It is important for a business to stay actively involved with their CPA. If you know you’re going to have a changing event, it’s better to ask your CPA about converting your entity type before an issue occurs. It can be handled after the fact, but its effectiveness could be delayed. You should not talk to your accountant only when it comes time for annual taxes. Instead, stay in open communication with them so you can consider the tax ramifications of converting your entity type before the event happens.
If you have questions about converting entity choices, contact us today.