• 4 min
• 02/22/2022

Choosing the business structure type is an important decision every new business must make. If you initially formed a C-Corp for your company, you may be wondering if there are any tax benefits, you’ll gain by changing your business structure to an S-Corp or a partnership. Here are some things to consider before changing your business structure.

How C-Corporations Are Taxed

For tax purposes, C-Corporations are treated as separate legal. What this means is the company is responsible for filing tax returns and for paying taxes at corporate tax rates. These taxes are paid after income has been offset with applicable credits, deductions, and losses.

Company shareholders are paid dividends on their shares of business earnings. Those dividends are taxed again at each shareholder’s individual income tax rate. This structure is referred to as “double taxation” because all income is taxed at corporate and individual levels.

How Partnerships and S-Corporations Are Taxed

The greatest different in taxation with Partnerships and S-Corporations is that they are not subject to double taxation. These business structures are “pass-through entities” which means income is not taxed at the company level.

S-Corporations and Partnerships are both required to file informational tax returns with the IRS and, depending on where you live, with state and local tax authorities as well. The company is not responsible for paying taxes on earnings, instead the individual shareholders (S-Corps) or partners (Partnerships) are taxed on their share of the earnings. The owners of both Partnerships and S-Corps are taxed on their share of the income made by the company made, regardless of whether that income is distributed to the owners.

Potential Tax Benefits of Converting to an S-Corp or a Partnership

The most obvious and biggest benefit is that the owner of an S-Corporation or a Partnership is that the company’s owners avoid double taxation of earnings. Depending on your business’ earnings and the shareholders’ tax brackets, this can mean significant savings.

S-Corporations may also benefit from additional tax savings by distributing earnings to shareholders as dividends, which are not subjected to payroll taxes. Under current tax laws, each shareholder employee must be paid a salary that is subject to payroll taxes and the salary may not be unreasonably low in the eyes of the tax authorities. If the IRS believes the salary is too low, they may recharacterize dividend income as salary and assess payroll taxes to the company.

Partnerships, on the other hand do not pay payroll taxes, their partners are considered self-employed and must pay self-employment taxes on income.

Potential Drawbacks of Converting to an S-Corp or a Partnership

If you are thinking about converting to an S-Corporation, your business may be subject to taxation on “built-in gains,” which may occur if the S-Corporation sells real estate or other assets originally held by the C-Corporation, at a profit. To avoid this tax, assets should be held by the S-Corporation for at least five years after conversion before being sold or distributed.

Another possible drawback is that the S-Corporation cannot pass the C-Corporation’s operating losses to its shareholders. Additionally, inventory “inherited” by the S-Corporation may be taxed, depending on the accounting method the company chooses.

After converting from a C-Corporation, your new entity may have to pay taxes on passive investment income such as retained earnings, rents or royalties, and interest. If passive investment income is more than 25% of the gross income for the S-Corporation, a separate tax will be assessed. If your company shows three years in a row of failing the 25% test, your company will lose its S-Corporation election.

You also need to consider the self-employment tax. Partners in a general Partnership are subject to this, whereas corporate shareholders are generally not.

Speak with a Tax Attorney Before Converting Your Business

If you’re considering converting your business structure from a C-Corporation to another type of entity you should first speak with an experienced attorney who can help you weigh out the pros and cons and help you determine whether this is a beneficial business decision. Our attorneys at Relevant Law are well-versed in this area and are happy to assist you.