What Is the Process to Convert From C Corporation to S Corporation?
Shareholders can choose to change a regular corporation to an S corporation to enjoy special tax benefits. An S corporation is formed by making a subchapter S election under the Internal Revenue Code. The election form is filed with the Internal Revenue Service (IRS) soon after the corporation files its articles of incorporation with a state. Once the IRS accepts the election, the corporation has the right to treat its profits and losses in accordance with the tax regulations in effect for corporations with an S designation.
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Definition
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An S corporation is a regular corporation with a special tax status granted by subchapter S of the Internal Revenue Code. This tax status enables the corporation to avoid paying taxes itself and, instead, pass the profits and losses to its shareholders to be reflected on their personal income tax returns. In this way, the shareholders avoid double taxation: being taxed once at the corporate level on corporate income and then again at the personal level when dividends (profits) are distributed. Only small corporations can use an S election, as the Internal Revenue Code restricts the election to corporations with fewer than 100 shareholders.
Federal Election
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To make a subchapter S election, a business must first incorporate as a regular corporation under the laws of a state. Once the articles of incorporation are filed and the corporation comes into existence, the shareholders can decide to make a subchapter S election at any time thereafter. To do so, download IRS Form 2553: "Election by a Small Business Corporation." It is a one-page PDF form with instructions. Fill it out and send it in. It usually takes the IRS six to eight weeks to process the election and to return to you proof of the corporation's new tax status.
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Requirements
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The Subchapter S election is only available to small corporations, and is most often used by closely held or family corporations. An S corporation cannot have more than 100 shareholders, all of whom must be U.S. citizens or permanent residents, and it cannot own any subsidiaries. Any regular corporation that plans to go public or to raise money by issuing shares of stock to a large group of people is not eligible to make a Subchapter S election.
State Election
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Corporations pay federal and state taxes on income. To enjoy the full benefit of S corporation status, a corporation would seek state recognition of the S election as soon as it is approved by the IRS. However, each state treats S corporations differently. Some states recognize the election and provide the corporation with the exact same benefits regarding state taxes as the corporation enjoys for federal taxes. Some states, like Massachusetts, will allow special tax treatment of income but only up to a certain amount; any income after is taxed at the C corporation level. Some states, like New York and New Jersey, tax both the S corporation's profits and the shareholder's proportional share. Some states don't recognize the S election at all. It is very important to contact the state taxing authority to determine how the state treats S corporations and to file whatever form is needed for the election to be recognized by the state.
Special Considerations
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A corporation must make the subchapter S election within a certain time period in order for the election to be effective for the current tax year. Form 2553 must be filed with the IRS within two months and 15 days after the beginning of the tax year, or any time before the tax year starts, for the status to be in effect for the current tax year. If you miss the window, you can still make the election, but it won't go into effect until the next tax year.
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