The headline reflects the most common corporate conversion, C to S. At the same time, the prevailing tax consequences may also apply to C conversions to LLCs and S corporations buying assets from a C company in a tax-free transaction.
While the actual conversion of a C corporation to an S is relatively simple, the actual tax ramifications are not. If the C has a net unrealized built-in gain (or BIG) in its assets on the effective date of the conversion, it must track dispositions of these assets for the next five years. The BIG tax is based on the difference or extent that fair market value exceeds net asset basis for each asset disposed. And the BIG tax is at the maximum corporate rate.
The C corporate form has somewhat returned to vogue based on some provisions of the Tax Act of 2017. However, if the company will never “go public,” a conversion to an S prior to a sale eliminates the two levels of taxation of a C. The first is the corporate tax on the delta of sale price less adjusted basis of the stock; the second level of tax occurs as distributions are received at the shareholder level.
To remove the stigma of two levels of taxation, the S corporation must not be sold in the ensuring five years from conversion. Also, with nominal asset dispositions in the five-year BIG recognition period, the BIG tax is minimized. Conversely, a disposition may result in a BIG loss, depending upon the value assigned to that asset.
We have performed numerous business valuations at the time of C to S conversion. Technically, the market value for the business must be allocated to all fixed assets on the balance sheet, as well as intangible assets (IP) and goodwill (GW). Thus, the conversion allows for a restated balance sheet, similar to an allocation of purchase price based on a company purchase (sale). The importance of this new S asset allocation is at least two-fold:
- When the S is sold, some IP value has been displayed to the buyer.
- At the five-year mark, any basis attributed to IP and GW will reduce the BIG carry forward attributable to fixed assets.