We anticipate higher personal tax rates in 2011. For many of our clients, converting their existing S Corporation to a C Corporation may make sense. We do not anticipate an increase in Corporate rates for 2011. Consequently, this may be a viable strategy for 2011 and beyond.
Although in many cases current year taxes may be lower, C Corporations are subject to double taxation. This means that there is corporate tax paid and then an individual tax paid when profits are taken by the owners. However, there are many strategies to minimize or eliminate these taxes. Unfortunately, many S Corporations have loans to their shareholders. This is caused for many reasons, but creates a unique problem and opportunity in the conversion.
S-Corporation converts to a C-Corporation. S-Corporation balance sheet contains a loan from shareholder in which losses have been allowed reducing the “debt-basis” of the loan to zero.
A repayment of a “shareholder loan” in a C-Corporation would normally constitute a return of capital and have no tax consequences. It would simply reduce the debt basis in the corporation. However, in this case the debt basis has already been reduced. What is the treatment and/or tax consequences to the C-Corporation when the shareholder loan is paid off?
The C-Corporation will not receive a dividends paid deduction as defined under IRC §561 due to the fact that the expense has essentially already been taken when the losses were allowed when the entity was an S-Corporation.
The cash received by the shareholder would be considered a dividend as defined in IRC §316 and taxed at the tax rate on the individual return.
By leaving the loan on the books and accruing interest, the stockholder can remove the funds out of the corporation without it being double taxed. This interest income is taxed at ordinary income tax rates. Note that depending on the level of your income this may be subject to the new “surtax” in future years.
It may be more beneficial to distribute the loan prior to converting the S-Corporation to a C-Corporation. Assuming that there is not any stock basis since the debt basis was used, the distribution would be taxed as a capital gain. This would be the preferable scenario if the shareholder is in the 10% or 15% individual tax bracket because the LTCG tax rate is 0% for 2010. Otherwise the LTCG would be taxed at 15% for 2010. (For 2011, the LTCG rates are expected to raise to 10% for 15% individual tax rate and taxed at 20% for all others.) This would accomplish both the shareholder receiving distribution and allow the accrued interest deduction from the C-Corporation in future years.
If you need any assistance or have any questions regarding the potential viability of converting your S Corporation to a C Corporation, please do not hesitate to contact us.