C vs. S Corp. Tread Carefully When Changing Entity Status

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Many businesses make the switch from C to S corporation status in order to save taxes. Doing so can help companies avoid the double taxation that happens when C corporation earnings are taxed at the corporate level and again when they’re passed through to shareholders as individuals.

S corporations are pass-through entities, so their earnings bypass corporate taxes and are taxed at the individual level only. Thus, businesses organized as C corporations can often cut their taxes considerably by becoming S corporations.

But wait: This doesn’t necessarily mean that making the switch is always the right thing to do. You might sacrifice some C corporation benefits by changing your entity structure to an S corporation.

Mapping the pros and cons

Ownership flexibility is one of these C corporation benefits. S corporations can have only 100 individual shareholders, while C corporations can have an unlimited number of owners. Note, too, that an S corporation may not have a nonresident alien as a shareholder. In addition, S corporations can issue only one class of stock — common or preferred — while C corporations can issue both common and preferred stock.

Note that issuing different types of common stock shares also can violate this rule. For example, if one set of common stock shares is awarded a higher percentage of the company’s profits, this would result in a second class of shares, which wouldn’t be allowed for an S corporation. However, S corporations can allow different voting rights for different shares of stock without creating a new class of stock.

Factoring in the ACA

The Affordable Care Act (ACA) has added a new variable to the C vs. S corporation decision-making process. If you are an active participant in an S corporation, your earnings aren’t subject to the net investment income tax (NIIT). (This is a 3.8% surtax on certain kinds of investment income that you must pay if your adjusted gross income exceeds a certain level.) But C corporation dividends are subject to the NIIT, if otherwise applicable, regardless of the owner’s participation level in the corporation.

Plus, if you sell S corporation stock, these proceeds won’t be subject to the NIIT if the owner is an active participant in the S corporation. But proceeds from the sale of C corporation stock are subject to this surtax.

A multifaceted decision

Many factors go into the C vs. S corporation decision, including a number of nontax considerations that aren’t covered above. Take the time to carefully study the benefits and drawbacks of each option before choosing the right structure for your company.

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