When tax season rolls around, we have all had that conversation with our S-Corporation clients. Why should they have to pay tax, when they claim to never receive any payments from their S-Corporation?
It’s important to treat the cancellation of an S-Election seriously. The corporation has a post-termination transition period (PTTP), which is defined in IRC § 1377(b)(1) if a voluntary revocation occurs under IRC § 1362(d)(1). PTTP is essentially described as:
the period beginning on the day after the last day of the corporation’s last taxable year as an S corporation and ending on the later of— (i) the day which is 1 year after such last day, or (ii) the due date for filing the return for such last year as an S corporation (including extensions).
For instance, under IRC § 1371(e)(1), a corporation has one year to transfer previously taxable earnings and profits after terminating an S-Corporation if there is money that has been collected in taxes but has not yet been distributed.
According to Public Law (P.L. 115-97), S-Corporations that meet certain standards are permitted to classify payments made after the PTTP as coming from the company’s Accumulated Adjustments Account (AAA). These payouts would be tax-free to the extent of the shareholder’s basis. Only S-Corporations that cancel their elections within the two years that P.L. 115-97 was passed.
During tax season, we have all had that conversation with clients who have S-Corporations. Why should they have to pay tax, they usually claim, when they never received any payments from their S-Corporation? You are taxed on profits, not payouts, is the straightforward response. Every time, It is best to advise the client to accept the payment. The same holds true for an S-Corporation that has renounced its election. Here, caution should be used. Any distribution from the converted S-Corporation would be a dividend to the new C-Corporation once the AAA has been used up, subjecting the profit to double taxation. The money is tax-free and can be used to get your clients adjusted to not receiving a distribution with their salary. Consider it as a one-year phase of transformation.
The taxes that will be paid when the owner sells the business is one of the most often asked questions concerning C-Corporations. IRC § 1202 Stock is the correct answer. A former S-Corporation can choose to have Sect. 1202 Stock. The ownership of the stock (we say stock, but in the case of an LLC, it may be membership units) must begin with the original shareholder. If the stock is kept for five years and then sold, the first $10 million is tax-free. The question is, who would buy a corporation’s stock? Simply said, the attorney who is part of the sale would indemnify the new owners of any potential liabilities, and everything would be perfectly all right.
An S-Corporation conversion to a C-Corporation involves a variety of factors, as you can see. However, no other entity can match the taxes that are paid as a C-Corporation.
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