Switching a C corporation to S status: what it costs

If I filed Form 1120 and never filed Form 2553, am I a C corporation?

An incorporated business that has filed Form 1120 and has no valid S election has generally been taxed as a C corporation. Filing Form 1120 does not make S status start automatically; the corporation must submit Form 2553 and receive an IRS acknowledgment showing whether the election was accepted and when it takes effect (IRS filing-status steps).

Check the election notice and prior returns before choosing a switch date. If the corporation intended S status for an earlier year but missed Form 2553, see late S corporation election relief; a new prospective election does not resolve those earlier years.

Can my existing C corporation elect S status, and when does it start?

An existing C corporation can elect S status without forming a new company if it qualifies and files Form 2553 on time. The IRS requires a domestic corporation, allowable shareholders, no more than 100 shareholders, one class of stock, shareholder consent, and an allowable tax year; certain banks, insurance companies, and other excluded corporations cannot elect. A partnership, corporation, or nonresident alien individual cannot directly own S corporation stock. A noncitizen who is a US tax resident is not excluded solely for lacking citizenship; certain qualifying trusts have separate rules (IRS eligibility rules; Form 2553 instructions).

If an earlier S election was revoked or terminated, the corporation generally needs IRS consent to reelect before its fifth tax year beginning after the first affected year (Form 2553 instructions).

Voting and nonvoting shares can coexist, but outstanding shares generally must have identical distribution and liquidation rights. Check stock documents for preferred payout rights. If spouses have a community interest in the stock or its income, both must consent to Form 2553 (Form 2553 instructions).

An authorized officer signs Form 2553; each required shareholder or former shareholder signs the consent on page 2 (Form 2553).

For an existing calendar-year corporation, an ordinary election starts January 1, not when Form 2553 is sent. The normal deadline is March 15 of that year, or the next business day if it falls on a weekend or legal holiday. An election filed after January 1 for that year works only if the corporation was eligible every earlier day of the year and every shareholder since January 1 consents, including former shareholders; otherwise it starts the following year (Internal Revenue Code section 1362; Form 2553 instructions). Once the deadline passes, the next ordinary start is January 1 of the following year; Form 2553 can be filed during the current C year. A fiscal-year corporation must use a permitted S tax year; changing years can create a short year. Form 2553 item E sets the S start, Part II covers a requested fiscal year, and Form 1128 is needed if S status starts after the short year (Form 2553 instructions). See late S corporation election relief for an intended earlier start. State tax treatment and election requirements need a separate check.

Does the S election itself tax cash, property, or retained earnings?

The S election generally does not treat the corporation as selling its assets or paying out its cash and old earnings on the switch date. Tax can arise later when the S corporation recognizes gain already built into C-era assets or distributes old C corporation earnings and profits (Schedule D instructions; Form 1120-S distribution instructions).

One immediate exception needs a check: if the C corporation used LIFO inventory accounting, the LIFO recapture amount increases income in its last C year. The additional tax is paid in four equal installments: the first by the unextended due date of the last Form 1120, the rest by the unextended due dates of the next three Forms 1120-S (Form 1120-S instructions, line 23a). A corporation with LIFO inventory should calculate that amount before filing Form 2553.

What is built-in gain, and which assets need a switch-date value?

Built-in gain is appreciation that existed when the first S year began: an asset's fair market value on that date minus its adjusted tax basis. The IRS also measures the corporation's aggregate asset value against aggregate adjusted basis to determine its net unrealized built-in gain (Form 1120-S instructions, Schedule B item 8).

List every asset the corporation held on the switch date and document tax basis and fair market value, especially real estate, equipment, inventory, investments, and intangible value such as goodwill. Also identify receivables and other income earned before the switch but recognized afterward; built-in gain rules can reach those items even without an asset sale (Schedule D instructions, Part III). A book balance sheet alone does not establish tax basis or fair market value.

When does built-in gains tax apply, and how is the five-year period counted?

An S corporation that was previously a C corporation may owe built-in gains tax when it recognizes C-era gain during the five-year period beginning on the first day of its first S tax year. Sales and distributions of appreciated property can trigger recognition; qualifying built-in losses, taxable-income limits, and eligible C-year carryovers affect the calculation. Within the recognition period, gain held back by the taxable-income limit carries to the next tax year (Schedule D instructions, Part III).

The period is measured from that first S day, not from the date Form 2553 was mailed or accepted. A gain recognized after the period is generally outside this federal corporate-level tax, though it may still pass through to shareholders. But gain reported on the installment method from a C-era asset sold before or during the period can remain subject to built-in gains tax afterward (Treasury regulation section 1.1374-4(h)). A transferred-basis asset later acquired from a C corporation can have its own five-year period (Schedule D instructions). The federal built-in gains tax uses the corporate rate, currently 21%, on the amount determined under the tax calculation (Publication 542; Schedule D instructions). A sale during the period can also pass gain to shareholders; the corporation treats the built-in gains tax as a loss or deduction when reporting it. Model both tax levels (Schedule D instructions, line 23).

Is book retained earnings the same as accumulated earnings and profits?

No. Retained earnings is a book balance; accumulated earnings and profits, or AE&P, is a tax account for C corporation earnings. The IRS reports retained earnings on the book balance sheet and AE&P separately on Form 1120-S Schedule M-2, with AE&P figured under tax rules (Form 1120-S instructions, Schedules L and M-2).

A negative retained-earnings balance does not prove AE&P is zero. Reconstruct AE&P from C-year returns, distributions, and tax adjustments before deciding how later payouts will be taxed. The IRS permits estimates based on retained earnings for Schedule M-2 reporting, but that reporting shortcut does not make the two accounts identical (Form 1120-S instructions, Schedule M-2).

How are distributions taxed after the switch if old C earnings remain?

Old C corporation earnings do not make every S corporation payout a dividend. When an S corporation has AE&P, the usual order uses its accumulated adjustments account, or AAA, first; then AE&P; then remaining amounts under the shareholder stock-basis rules (Internal Revenue Code section 1368; Form 1120-S instructions).

The corporation reports dividends paid from AE&P on Form 1099-DIV, not Schedule K-1 (Form 1120-S Schedule K, line 17c; instructions).

The corporation can elect, with the affected shareholders' consent, to distribute AE&P before AAA for a tax year. That election is irrevocable for that year, so it should be modeled before distributions are made (Form 1120-S instructions, Schedule M-2). Shareholder basis is separate from the corporation's cash balance; see how S corporations are taxed for the ongoing basis rules.

A separate deemed-dividend election can treat AE&P as paid to shareholders and immediately contributed back, even when no cash moves. It needs the affected shareholders' consent and can create dividend income without a cash payout. For either election, attach a statement naming it and recording each affected shareholder's consent to a timely filed original or amended Form 1120-S for that tax year (Form 1120-S instructions, Schedule M-2).

What happens to C corporation losses and unused tax attributes?

C-year net operating losses do not become shareholder losses and generally cannot offset ordinary S-year income. The Code bars carrying C-year tax attributes into an S year except where another rule permits it. S years still use up time-limited carryover periods, so C-year capital losses or credits can expire unused (Internal Revenue Code section 1371).

Some C-year net operating losses and capital losses can reduce the built-in gains tax calculation, and certain old business credits can reduce that tax. Their use is limited and depends on the asset group and the type of gain or credit (Schedule D instructions, lines 19 and 22). Keep the carryover schedules, year-by-year use, and any ownership-change records; do not assume an unused C-year amount will benefit the S shareholders.

Can old earnings plus passive income end S status?

Yes. If an S corporation has AE&P at each year-end and passive investment income exceeds 25% of gross receipts in each of three consecutive S tax years, its election terminates on the first day of the following tax year. The corporation may also owe an entity-level tax on excess net passive income for an affected year (Form 1120-S instructions; Internal Revenue Code section 1362).

For this rule, passive investment income generally includes interest, dividends, royalties, annuities, and rents. Stock and securities gains are excluded from passive investment income but count in total gross receipts to the extent of the gain (Internal Revenue Code section 1362(d)(3)). Rent from an active rental business may be excluded when the corporation provides significant services or incurs substantial costs (Treasury regulation section 1.1362-2). Compare passive receipts with total gross receipts and check whether AE&P remains at year-end; a shareholder's passive-loss label is not the test. Review both before the election if the business holds investments or earns substantial interest or rent.

When might keeping profits in the C corporation make a switch less attractive?

Keeping C status may be more attractive when the corporation plans to retain and reinvest profits, has significant appreciated assets it may sell soon, or has C-year tax attributes that would be restricted after an S election. S status generally passes current income to shareholders even when the corporation keeps the cash; C status taxes current profit at the corporation and generally taxes shareholders when a dividend is paid. A C corporation that accumulates earnings beyond reasonable business needs may face accumulated earnings tax (IRS S corporations; Publication 542). If shareholders hold stock that may qualify for the section 1202 sale exclusion, an S election can affect that benefit; see LLC or C corporation? for the eligibility rules (Internal Revenue Code section 1202).

Before choosing a date, gather prior Forms 1120, any IRS election notice, stock and shareholder records, asset tax bases and switch-date values, AE&P workpapers, loss and credit schedules, and planned distributions or sales. For the broader prospective election and owner-pay comparison, see should you elect S corporation status?.

Example

Illustrative US dollars; no state tax is calculated. A C corporation begins its first S year with land worth $300,000 and an adjusted tax basis of $100,000. Its built-in gain in that land is $200,000. If it sells the land for $320,000 during the recognition period, $200,000 of the $220,000 total gain reflects pre-switch appreciation and may enter the built-in gains tax calculation. The $20,000 increase after the switch is outside that pre-switch amount. The actual corporate tax depends on the corporation's overall built-in gains, losses, taxable income, and permitted carryovers.

Separately, suppose the corporation has $60,000 of old AE&P, earns $40,000 of S-year income that increases AAA, and distributes $70,000 in cash to a shareholder with enough stock basis. Under the usual ordering, $40,000 comes from AAA and $30,000 is a dividend from AE&P; $30,000 of AE&P remains. The shareholder may owe tax on the S-year income even if part of the cash stays in the company. An AE&P-first election would change the distribution result.

Different for you?

• Form 2553 was missed for a past year: the election date may be recoverable under late S corporation election relief.
• You are comparing future C and S taxes, including owner pay: see should you elect S corporation status? and S corporation owner salary.
• You need the ongoing rules for S income, basis, and K-1s: see how S corporations are taxed.
• You want to move assets into another company or change the legal entity: see changing your business structure.
• You have appreciated assets, AE&P, unused losses or credits, substantial passive income, or planned payouts: the switch needs a company-specific calculation before Form 2553 is filed; see corporate tax.