A surprising number of my clients continue to be organized as C corporations, and have not taken advantage of making an S Corp election. This can be a potentially costly oversight if the company’s owners are looking to sell at some point in the future, particularly since in many cases, there are no significant disadvantages to making the S Corp election.
The key reason to make an S Corp election is to avoid the double taxation that is inherent in the C Corp structure. When a C Corp makes money, it pays taxes, and then it distributes profits to its shareholders, who also pay taxes on the distributions.
With an S Corp election, the corporation elects to pass through its income and losses to its shareholders, without first paying taxes at the corporate level. So, the corporation’s profits are only taxed once.
During a sale, the tax difference between a C Corp and an S Corp can become even more magnified. Because buyers often would prefer to buy a corporation’s assets rather than the entire corporate entity, there can be a pressure to create a transaction that will cause a double taxation of the proceeds of the sale. An S Corp provides a much more flexible vehicle for a potential sale, as it provides potentially favorable tax treatment.
Unfortunately, this is an issue that you need to consider well in advance of a sale. The Internal Revenue Code includes a “Built In Gains” Tax which can act to neutralize a portion of the benefit of making an S Corp election for five or more years after the switch.
If your company is a corporation, and you have not recently consider whether to make an S Corp election, you should discuss this option with your advisors.