As companies grow and change over the course of their lifetime, certain structures that were set up at the beginning of the venture may grow obsolete and need to be changed. Legal forms of organization that were once appropriate and helpful to the business may come to work against it. There’s an importance in noting that in most cases where tax and business considerations allow, it is possible to convert a company’s organization to better suit current and emerging goals.
Can You Convert a California Corporation to Other Entity Forms?
Generally, domestic stock corporations can convert into other official California business entities. California limited liability company (LLC), limited partnership (LP) or general partnership (GP) can convert into a California or foreign other business entity. Provided that the laws of the foreign jurisdiction allow for it, a foreign corporation can convert to a California corporation. The exception is that a California corporation cannot convert to a foreign entity.
What Steps Are Required to Convert a C Corp to an S Corporation?
With the help of a professional or CPA, for federal tax purposes, the simple requirement to convert a C corporation to an S corporation is filing Form 2553 with the IRS. Requirements of filing of IRS Form 2553 include:
Form being signed by all the shareholders
The form must be submitted within two months and 15 days past the beginning of the tax year within which the S corporation election is being made.
Additonally, form 1120S should be filed for the tax year in which the S corporation election is made.
What Tax, Financial and Legal Considerations Are Associated with Conversion of a C Corp?
When changing California C Corporations to California S Corporations, the biggest alteration to understand is a tax election. All California corporations are formed as C corps. It is only after the filing of articles of incorporation, enactment of the bylaws, issuance of shares, and first shareholder meeting is conducted that a newly formed California C corp can elect to become an S corporation, filing IRS Form 2553. In the case an S election is not conducted and filed within 45 days of incorporating, the corporation will remain a C corporation until the form is filed. These seem to be the only filing needs with the California Secretary of State.
Additional considerations to discuss with your CPA when deciding to convert an S Corp include:
– Pass-through tax considerations – Converting a C Corp to an S Corp results in disparate tax handling as the business moves from an independent tax entity to a pass-through entity.
– Built-in gains (BIG) tax considerations — Within five (5) years of conversion the IRS imposes a 35% tax on the gains derived from asset sales of the C corporation and distributed by the S corporation. The BIG tax may apply if assets are not sold but are similar to receivable accounts accrued under C status and collected under S.
– Passive investment income taxes – A converted S corporation can be subject to taxes on passive investment income inherited from its existence as a C corporation (PFIC tax). If this income exceeds 25 percent of the S corporation’s gross income it will be subject to a special tax. If the PFIC tax applies three years in a row, the S conversion is terminated. (https://ctlsites.uga.edu/) Distributing passive income to S shareholders avoids PFIC taxes.
– FICA and Self-employment tax minimization considerations — S corporation shareholders can minimize both self-employment and FICA taxes by creating a reasonable between dividends and salary.
The above represents only some of the considerations that should be addressed prior to converting a C Corp in California. Speak to an experienced CPA prior to engaging in any actions regarding your business’s form of legalization.