Given the above high-level description of the conversion, a deeper dive explanation follows.
Capital Gain Treatment
Whether you own fee timber or have logging contracts with various parties, you most likely took advantage of the timber capital gains treatment afforded under Section 631(a).
Section 631(a) is a powerful tax strategy that converts what would otherwise be ordinary income into Section 1231 gains that result in preferential tax rate treatment.
In many cases, the magnitude of the Section 631(a) gain can convert all your income to capital gain income, with little impact to your day-to-day operations. As a C corp, this benefit wouldn’t exist as all income would be taxed at the C corp rates.
Note that once you make a Section 631(a) election, the calculation must be determined annually, regardless of benefit to the taxpayer. Unless the election can be revoked after conversion, a C corp would still need to determine its Section 631(a) gain, despite receiving little to no tax benefit.
If your company runs a sawmill, you might have been taking advantage of another ordinary income to preferential tax rate conversion strategy using an IC-DISC.
To the extent that you sold chips or finished goods such as lumber or plywood to foreign customers, either directly or indirectly, an IC-DISC has been able to help you convert ordinary income into qualified dividends. As a C corp, the tax rate benefit from the use of an IC-DISC would also be negated.
As an example, $1 million of S corp ordinary income would result in federal tax of $296,000—the highest individual rate after QBI benefit. This same income taxed as a capital gain, from Section 631(a), or qualified dividend, from IC-DISC, results in tax of $200,000. This is a permanent tax savings of $96,000.
In contrast, as a C corp, all income regardless of character would be taxed at 21%, resulting in a federal tax of $210,000.
The magnitude and proportion of your income able to be converted to preferential rates is an important factor in whether a S corp to C corp conversion makes sense.
As mentioned previously, S corp shareholders can receive distributions from the company tax free. Distributions are also required to be pro rata in the S corp environment.
To the extent that your company distributed funds that shareholders are accustomed to receiving and possibly rely upon in their personal situations, converting to a C corp could impact a company’s ability and incentive to continue distributing funds, as these distributions would no longer be tax free.
Cash flow needs of the shareholders should also be considered when determining whether a conversion makes sense.
Understanding your exit strategy and the long-term goals of the company are essential to determining if a conversion makes sense.
As an S corp, every dollar of earnings increases your stock basis, and every dollar of loss or distribution, decreases your stock basis. These adjustments accumulate over the life of the S corp and are extremely important when considering a sale of the company.
In simplified terms, you’ll compare the amount you sell the company to your stock basis to assess your tax gain on the sale. The closer your stock basis is to the sale price, the lower the gain, the more dollars stay in your pocket after considering taxes.
Conversely, once you switch to a C corp, your stock basis is essentially frozen at the time of conversion. All the earnings from the point of conversion to the time of sale don’t impact your stock basis.
At the time of sale, you’ll most likely have a much larger tax gain. In some cases, the entirety of tax savings experienced from switching to a C corp can be completely undone at time of sale.
Since the decision to convert to a C corp should be considered from multiple angles, there are several other items that should be addressed in detail with your tax provider, such as:
- Estate planning and wealth transfer plans may need to be reassessed given new corporate structure
- Conversion to C corp comes with a five-year restriction before converting back to an S corp, with some exceptions
- Tax planning around the strategic use of post-termination time period to distribute S corp earnings
- Last-in, first-out (LIFO) inventory and other gain deferral recognition upon conversion back to S corp
- Complexities with determining historical earnings and profits (E&P) if the entity was a C corp before initially converting to S corp
- The impact of conversion on current Qualified Subchapter S Subsidiaries (QSubs) and ramifications to overall tax reporting
- The necessity for a tax provision analysis for financial statement presentation purposes
- The impact of future law changes