S Corp and C Corp Conversions
March 6, 2017
What Business Leaders Need to Know About Valuations for S Corp and C Corp Conversions
Individual circumstances and preferences alone dictate the decision of which corporate structure to adopt. Each structure has its own benefits and restrictions which affect a business in various ways. An extensive discussion on the most beneficial structure for different circumstances will not be had here. Instead, we will focus on one of the most frequent conversions, that of a C corporation (C corp) to an S corporation (S corp) and the purposes of a valuation in such a conversion. The same principles and purposes listed for a valuation in a C corp to S corp conversion can be applied to other types of conversions.
S Corp to C Corp
S corps have become increasing popular as an alternative to the traditional C corp structure. Although there are more restrictions imposed on S corps, a primary motivation for this shift is the tax benefit of S Corps when compared to C Corps, typically referred to as “pass-through” taxation.
With C corps, the corporation is required to pay taxes on profits, with some or all of the remainder passed on to the owners as earnings. The owners are also taxed on their personal earnings, so the same profits from the company that are passed on to owners as earnings are taxed twice, resulting in “double taxation.”
With an S corp, the corporation itself is not required to pay taxes on its profits. All profits are passed through the corporation to the owners as earnings, who are then responsible for paying taxes on those earnings. This is known as “pass through” taxation.
What Are the Requirements to Convert from C Corp to S Corp?
S corps present an attractive alternative to small business owners; however, not all C corps qualify for the conversion. Requirements for conversion include the following:
- Incorporated in the United States
- No more than 100 shareholders
- Shareholders must be U.S. citizens, resident aliens, estates, other S corporations, or certain qualified trusts
- One class of stock (class can have voting and nonvoting shares)
- Written consent from all shareholders
Why Do I Need a Valuation for My Corporate Structure Conversion?
According to IRC Section 1374, any assets sold by an S corp within 10 years after the date of its conversion to from a C corp – known as the “recognition period” – could still be taxed to the company as if the structure conversion had not happened. Gains attributable to intangible assets and goodwill could also be taxed in the same manner. Assets sold after this 10-year period, however, are subject to S corp tax rates.
A valuation of the individual assets at the time of conversion provides a base level against which to measure any future gain to calculate the appropriate tax liability. A valuation of these assets at the conclusion of the recognition period would also be valuable, to ensure that any gain beyond that point in time is correctly taxed at S corp rates.
How do I choose a valuation firm?
With thousands of valuation firms in the country, how should a company go about selecting an advisor? According to the IRS, a firm should have significant experience, which is defined as at least five years of relevant experience in business valuations. The American Institute of Certified Public Accountants (AICPA) Practice AID suggests companies choose a valuation specialist with professional certifications (e.g. CPA/ABV, ASA, CFA, or CVA). The valuation firm’s reputation should also be taken into account.