Many S corporations benefit from the numerous and significant tax advantages these entities are given. These tax benefits make converting from a C corporation to an S corporation an attractive option for many business owners. Unfortunately, there are numerous other tax issues that should be assessed before any conversion is made.

Even though S corporations are usually not subject to tax, a conversion from a C corporation to an S corporation makes any appreciated business property subject to built-in gains tax. For a period of 10 years after the conversion, any appreciated value can be subject to this substantial and unfavorable tax. Likewise, C corporations that used LIFO inventories will be required to pay tax on these benefits after converting to an S corporation as well.

Additional tax liabilities such as unused losses and passive income may also be introduced after a C corporation converts to an S corporation. If for example, a former C corporation had a passive investment income from dividends, rents, interest or royalties that exceeded 25% of their annual receipts, they may be subject to this additional tax.

When considering a conversion from a C corporation to an S corporation, it is important to understand the shareholders and employees of S corporations will no longer receive the full range of tax benefits that were once available when operating as a C corporation. Shareholders that have loans outstanding may also run into additional tax complications after conversion.

Although converting from a C corporation to an S corporation can produce significant tax liabilities, there are strategic methods for minimizing or eliminating some of these issues. Working with an attorney experienced with business formation and planning can help business owners understand the tax liabilities involved with a conversion, and may be able to offer valuable advice on how to reduce these losses.