Forbes, Switching From S To C Corporation? How You Do It Could Save (Or Cost) You Millions:
You're the sole shareholder of an S corporation. You've operated as a flow-through business since formation in 2016, and you've been perfectly content to do so. What's not to like about a single-level of taxation? Payroll tax savings? The refreshing simplicity of the rules governing subchapter S?
But after passage of the Tax Cuts and Jobs Act in December 2017, the advice began emanating from all corners. "Switch to a C corporation," they said. "The 21% rate is too good to pass up, and dealing with the 20% pass-through deduction will speed up your already disconcerting rate of hair loss."
While these arguments were certainly compelling, they weren't enough to convince you to change things up.
But then someone whispered four little numbers into your ear that changed everything. "1202" they urged, "check it out." "You can exclude all gain from the sale of stock held for more than five years, but only stock held in a C corporation." Well damn...your exit strategy had always been to sell your business after 5-10 years anyway, and the mere possibility of paying no tax upon disposition meant that, just like that, the siren song of subchapter C became too strong to ignore. Now you're ready to take the plunge and convert to a C corporation effective January 1, 2020.
But before you do, perhaps you should dig a bit deeper into the aforementioned Section 1202, because while it is indeed a provision that promises a huge tax break upon the sale of qualifying stock, it appears there is an inconsistency within the statutory language that will make the manner in which you convert hugely impactful on the eventual payoff.
Let's take a look...
Section 1202, in its simplest form, allows for a shareholder who acquires "qualified small business stock" (QSBS) after September 2010 and holds it for five years to sell that stock and exclude from income the greater of:
- $10 million, or
- 10 times the shareholder's basis in the stock.
This simplest form of Section 1202, however, is not its truest form. There are a host of requirements that must be met in order for stock to be meet the definition of QSBS; requirements that often confuse even the most seasoned of tax advisors. If you want a full — and I mean FULL — discussion of those requirements, I'd encourage you to read this article, written by a bright and virile young man.
[I]f you're ready to switch to a C corporation, and reaping the benefits of Section 1202 is one of your primary motivations in doing so, make sure you consider the manner of your conversion. A mistake could cost you millions.