A C corporation is a business structure that makes sense for some small businesses.
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But many other small businesses were formed as C corporations for the wrong reasons and later regret their decision. Instead of providing their company with critical advantages, C corporation status is now an albatross these companies would rather leave behind.
The decision to stop being a C corporation is especially attractive for companies that are approaching a corporate sale. Since special tax treatment for long-term capital gains is not available to C corporations, corporate sales often result in tax burdens for both corporations and their shareholders.
One of the common strategies for avoiding exorbitant tax rates is to transition a C corp to an S corp prior to sale. Fortunately, the process of transitioning to an S corporation is relatively straightforward and does not require a total reorganization. Although we always advise you to consult a legal professional, here's what the process looks like.
- Prequalify for S corp status. There is no formal prequalification process for the transition from a C corp to an S corp. Even so, restrictions on S corporations vary from state to state and you'll want to do your research to make sure you qualify before you invest too much time in the process.
- Formalize your decision. Transitioning to an S corporation is a decision that has to be approved by the Board of Directors. Your Board of Directors will need to vote to convert the company to an S corporation and formally document their approval in the minutes of the meeting.
- File Form 2553. Form 2553 is the official IRS document for transitioning from a C corporation to an S Corporation. In this form, you will be required to provide information about your company and your shareholders, including ownership shares. The IRS requires you to file this form no more than two months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year preceding the tax year it is to take effect.
- Follow-up issues. You should expect to receive approval for the transition from the IRS. Once that has been received, you'll have to file the last tax return for the C corporation and prepare to file your first return as an S corporation. There may also be other forms or filings (e.g. K-1 schedules) that require completion.