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How to Convert a C Coproration to an S Corporation

written by: J. Edward Casteele•edited by: Jean Scheid•updated: 1/10/2011

C corporations and S corporations each have their advantages. If your small business is a C corporation, you may decide that you would see more tax advantages or have greater corporate control with an S corporation instead. Fortunately, it isn't difficult to convert C corporations to S corporations.

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    C Corporations Versus S Corporations

    Some businesses benefit more from being an S corporation than a C corporation. Though similar in function, there are a number of differences between C corporations and S corporations. The corporation types are taxed differently, with C corporations being subject to "double taxing" in which income is taxed at the corporate level and as well as the payroll level. Organization requirements differ for the two corporation types as well with C corporations requiring more in-depth record-keeping. C corporations do have the advantage of being able to sell shares of company stock to shareholders either privately or in a public stock exchange. If you're running a small business as a C corporation and have no plans to expand your business or provide shares of company stock, you may find your business will benefit more if you convert the C corporation to an S corporation.

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    Advantages of Converting

    One of the main advantages of choosing to convert a C corporation to an S corporation is that the conversion removes the "double taxation" of income your company receives. Instead of being taxed at the corporate level, money that comes into an S corporation flows through to the owners. Though the individual rate that you're taxed remains the same, the elimination of the extra 40% that is taxed at the corporate level for C corporations makes a major difference in your company's income.

    Another advantage is that the owners of an S corporation have more control over their company with fewer record-keeping requirements. S corporations aren't required to keep meetings of minutes and aren't subject to some of the restrictions placed on larger C corporations. Though you are still required to make sure that your company operates according to legal and ethical guidelines, running an S corporation is significantly less stressful than running a C corporation.

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    Converting Your Corporation

    To convert a C corporation to an S corporation you must first make sure that your company is eligible for the conversion. To be eligible for conversion to an S corporation a company must have no more than 35 shareholders (including employees that receive company shares as part of a benefits package.) In addition, the company cannot do business outside of the United States. If your C corporation has too many shareholders or does business internationally then you can't convert your C corporation to an S corporation.

    Once you're sure that you can convert, alert the IRS of the change in your filing status. This is done by filing IRS form 2553, making sure that it is signed by a corporate officer such as the company president, vice president, or chief accounting officer. Be aware that any realized gains that occur within 10 years of the conversion can still be taxed by the IRS as gains for a C corporation and that passive income greater than 25% of the corporation's gross income is also taxed as income for a C corporation for three years after the conversion. If your company keeps inventory and uses a last-in-first-out (LIFO) inventory system then corporate taxes are due on your inventory but may be paid spread out over a four-year period.

    Image Credit: Michael Connors