Converting an S Corporation to a C Corporation: A Scholarly Analysis

Introduction

The conversion of an S Corporation to a C Corporation raises numerous tax, accounting, and strategic considerations. This article examines the mechanisms for conversion, treatment of accumulated adjustments accounts (AAA), post-termination transition period (PTTP), the creation of a new parent company, debt-equity issues, treatment of suspended losses, and other pertinent topics.

1. Pulling AAA Out Before Conversion

Mechanism

Under IRC §1368(e)(1)(A), an S Corporation may distribute amounts from its AAA to shareholders tax-free to the extent of their stock basis. Before converting to a C Corporation, many taxpayers consider distributing the AAA to avoid the loss of tax-preferred distributions post-conversion. A tax-free distribution followed by loaning the funds back to the corporation presents complexities under the debt-equity rules (Treas. Reg. §1.385).

Debt-Equity Considerations

If shareholders loan funds back to the corporation after receiving an AAA distribution, the IRS may recharacterize the loan as equity under Treas. Reg. §1.385-3. Key factors include:

• Substance over form: A bona fide loan must have repayment terms, an interest rate, and evidence of intent to repay.
• Proportionality: Loans mirroring ownership percentages may appear as disguised equity.
• Risk of recharacterization: Recharacterized debt would subject the AAA funds to corporate taxation upon future distributions.

2. Post-Termination Transition Period (PTTP)

The PTTP allows former S Corporations to distribute previously taxed AAA balances tax-free for a limited time post-conversion. Per IRC §1377(b)(1) and Treas. Reg. §1.1377-1, this period lasts until the later of:

1. One year after termination of S status, or
2. The due date (with extensions) of the last S Corporation tax return.

Cash Distributions Post-Termination

During the PTTP, distributions may be treated as coming first from AAA, then from accumulated earnings and profits (E&P) generated as a C Corporation. After the PTTP, remaining AAA is effectively absorbed into E&P and loses its tax-preferred character.

Unused AAA Post-Conversion

Unused AAA does not retain its separate character post-conversion and is reclassified as part of E&P (Treas. Reg. §1.1368-2). This can lead to double taxation on future distributions—first at the corporate level and again at the shareholder level.

3. Creating a New Parent Company

The creation of a new parent company before converting to a C Corporation provides strategic benefits, including tax-free transfers of appreciated assets and mitigation of future tax liabilities.

Mechanism

1. Form a new C Corporation as the parent and contribute S Corporation stock to the new parent.
2. The S Corporation becomes a Qualified Subchapter S Subsidiary (QSub) under IRC §1361(b)(3)(B).
3. The QSub transfers appreciated assets (e.g., land) to the parent corporation tax-free, leveraging the disregarded entity status under IRC §337(d) and Treas. Reg. §1.337(d)-3.
4. Terminate the S election and convert the QSub to a C Corporation.

Advantages

• Avoiding Double Taxation: By moving appreciated assets to the parent, these are no longer subject to corporate-level taxation when sold by the C Corporation.
• Earnings Isolation: The parent can shield assets and earnings from risks associated with the converted C Corporation.

Risks and Challenges

• Step Transaction Doctrine: The IRS could recharacterize the steps as a single transaction with tax avoidance as the primary purpose, negating the intended tax benefits.
• Gain Recognition under IRC §311(b): If the transfer is deemed a distribution rather than an intercompany reallocation, gain may be recognized.
• Loss of S Corporation Basis: Shareholders’ basis in the parent may differ, affecting future tax implications.
• Asset Protection Risks: Transferred assets may be exposed to liabilities of the parent or converted entity.

Relevant Authorities

• IRC §§1361(b)(3)(B), 337(d), and 311(b)
• Treas. Reg. §1.337(d)-3
• Rev. Rul. 2003-56 (step transaction doctrine)

Best Practices

• Document the business purposes of restructuring, such as improving operational efficiency or isolating high-value assets.
• Space out the steps to avoid appearance of a pre-planned sequence aimed solely at avoiding tax.

4. Treatment of Suspended Losses

Suspended losses under IRC §1366(d)(1) cannot offset income in a C Corporation. Shareholders lose these losses unless they can be utilized during the PTTP or upon liquidation of the corporation.

Mechanism for Utilization

• Losses can offset income during the PTTP under IRC §1371(b).
• Upon liquidation, shareholders may claim losses against proceeds if the stock basis exceeds distributions.

5. Cash Distributions After Termination

After S Corporation status is terminated, distributions are treated as follows:

1. First from AAA (during PTTP).
2. Next from accumulated E&P (subject to dividend treatment under IRC §301(c)).
3. Finally, from the shareholder’s basis (return of capital under IRC §1001).

Distributions beyond these limits are capital gains.

6. Terminating S Status

Mechanisms

• Voluntary revocation: Filing IRS Form 8832 or a letter of revocation signed by shareholders holding more than 50% of shares (IRC §1362(d)(1)).
• Involuntary termination: Failing S Corporation eligibility requirements (e.g., exceeding 100 shareholders or having an ineligible shareholder) under IRC §1362(d)(2).

Impact on Accounting Method

S Corporations often use the cash method under IRC §448(b). Conversion to a C Corporation may require switching to the accrual method, triggering §481(a) adjustments to account for timing differences.

7. Regulatory and Ruling Considerations

Debt-Equity Risks

• Treas. Reg. §1.385-1 et seq.: Framework for distinguishing debt from equity.
• Rev. Rul. 85-119: Reinforces the IRS’s stance on recharacterizing loans as disguised equity.

Case Law and Rulings

• Estate of Strangi v. Commissioner, T.C. Memo 2003-145: Reinforces scrutiny of intra-family loans.
• Rev. Rul. 94-43: Discusses PTTP distributions and AAA reclassification.

Conclusion

Converting an S Corporation to a C Corporation involves intricate tax planning and strategic decision-making. Leveraging the creation of a parent company to transfer appreciated assets offers significant tax advantages while mitigating risks associated with double taxation. However, the step transaction doctrine and other regulatory hurdles require careful planning, robust documentation, and sound business purposes for each step. By adhering to IRS regulations and rulings, practitioners can minimize risks and maximize benefits.

References

1. IRC §§1361, 1362, 1368, 1377, 1371, 337.
2. Treas. Reg. §§1.1368-2, 1.1377-1, 1.337(d)-3, 1.385-1.
3. Rev. Rul. 94-43, 85-119, 2003-56.
4. Estate of Strangi v. Commissioner, T.C. Memo 2003-145.

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