What to Expect From a C-corporation Conversion

By Kevin F. Powers, CPA, and Patrick J. Smith, CPA
| 9/23/2019
Recent developments are leading more S-corporation banks (or their parent holding companies) to consider converting to C-corporation status. Before making such a decision, it is important to understand the tax implications, as well as the conversion process itself.

Some S-corporation banks are mulling the switch in the wake of the Tax Cuts and Jobs Act of 2017 (TCJA), which slashed the federal corporate tax rate from 35% to 21%. Others seek the greater flexibility a C-corporation structure offers, particularly in terms of the number of shareholders allowed and the flexibility to raise multiple forms of capital.

Tax implications for the corporation

The maximum effective federal tax rate for individual shareholders of an S-corporation bank under the TCJA is 29.6% (assuming all income of the S-corporation bank is eligible for the 20% pass-through entity deduction), which is substantially more than the corporate tax rate. However, the tax effects of a C-corporation conversion go beyond a lower tax rate.

Upon converting to a C corporation, a bank needs to reestablish deferred income taxes on its balance sheet, with a corresponding tax expense (benefit) running through the income statement. The conversion also might necessitate changes in accounting method. For example, an organization with more than $25 million average gross receipts for the prior three-year period no longer is eligible to use the cash method of accounting once it becomes a C corporation, which will result in the recapture of any deferred income for an S-corporation bank that had been using the overall cash method of accounting.

The income tax return filing requirements, as well as the estimated tax payment procedures, also will change for both the bank and the shareholders, as the S-corporation income no longer will pass through to the shareholders.  

Tax implications for shareholders

After a conversion, shareholders no longer receive Schedules K-1, “Partner’s Share of Income, Deductions, Credits, Etc.,” although they might continue to receive dividend distributions from the corporation. Any dividends that C-corporation shareholders receive generally will be taxable as qualified dividend income subject to the lower individual capital gains tax rate, rather than ordinary income tax rates.

Conversion also means shareholders generally will not adjust their tax basis in the C-corporation stock for their allocable share of the S-corporation profits (losses), less any distributions received, as they did as S-corporation shareholders. They will not, however, forfeit any of the adjustments reflected in their stock basis through the date they convert back to a C corporation.

Conversion could ease state tax filing obligations in some cases, too. For example, some states have mandatory income tax withholding rules for nonresident S-corporation shareholders, which could require the shareholders to file in multiple states. This requirement is eliminated upon conversion to a C corporation, and shareholders generally will file only state tax returns for their state of residency as well as other states in which they might have income-producing activities. However, their state filing requirements no longer will be dependent on the bank’s state footprint.

Note, though, that a C corporation generally can make tax-free distributions to shareholders during the one-year period following conversion (unless it elects otherwise), limited to the amount of the S-corporation accumulated adjustments account (AAA). If, for example, the AAA balance is $1 million, the corporation can distribute up to $1 million on a tax-free basis, and the distributions will be subject to normal S-corporation treatment. After one year – and during the year for any distributions that exceed AAA – the distributions generally are taxable as qualified dividend income. This special one-year distribution rule applies to cash distributions only and not to distributions of any other property.

Conversion methods

C-corporation conversion usually is accomplished by seeking approval for voluntary termination of the S-corporation election from the majority of the shareholders of outstanding stock. C-corporation status will be effective as of the beginning of the tax year as long as the company files a statement of revocation with the IRS by the 15th day of the third month of that tax year (for example, March 15 of a calendar tax year). 

A company also could file a prospective voluntary termination for a date other than the beginning of the calendar year. So, if the S corporation is on a Dec. 31 tax year-end, it could request a revocation effective Feb. 14, with the statement postmarked to the IRS on or before Feb. 14. Because the corporation then would need to file two tax returns (for both entity types) for that tax year, this alternative generally is not preferable. As such, it might be warranted in certain circumstances, such as when the company has an urgent need to raise capital midyear.

Although generally not advisable, an S-corporation election may also be terminated by breaking the S-corporation eligibility rules. For example, an S corporation could issue a second class of stock (for example, preferred stock), exceed the limit on the number of eligible shareholders, or issue stock to a nonqualifying shareholder such as another corporation. However, it is generally not advisable to terminate an S-corporation election in this manner because most S corporations have shareholder agreements in place that prohibit the company and other shareholders from taking actions that automatically would terminate S-corporation status. 

Communicating the implications to shareholders

No one-size-fits-all model exists for discussing the implications of conversion with shareholders. Some S corporations have a concentrated ownership that lies with a small group of shareholders or family members, while others have more widely distributed shares. The specific facts and circumstances will dictate the appropriate communication method, but it generally will prove wise to provide financial and tax projections that illustrate the benefits to both the company and the individual shareholders.

Implications for financial reporting

C-corporation conversion not only will affect taxation but also the company’s financial statements. A converted company will need to reestablish deferred income taxes on its balance sheet, including on unrealized gains and losses on securities held for sale. It also will be required to start recording federal and applicable state tax expense on its income statement going forward.

Act now

Although the deadline to file a revocation statement to convert for the 2020 calendar year might seem far off, S corporations that wish to convert to C-corporation status would be wise to start the ball rolling as soon possible. The requisite planning, communication, and voting can take more time than expected.
 

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