C Corp to S Corp Conversion

The company stays the same legal entity. It files Form 2553, and from the effective date it files Form 1120-S rather than Form 1120. The corporation must meet the eligibility rules : domestic, no more than 100 shareholders, only eligible shareholders, one class of stock, and not an ineligible corporation type.

The timing comes from Example 2 in the Form 2553 instructions . A calendar-year C corporation can file from the first day of its last C year through March 15 of the year it wants S status. For a 2027 start, that is any time in 2026 through March 15, 2027, a Monday. A form filed after that generally waits for 2028 under section 1362(b)(3) , unless late election relief applies.

Section 1374 taxes the S corporation itself on gain that built up during the C years, if that gain is recognized during the recognition period. The period is the 5 years beginning on the first day of the first S year. The rate is the top corporate rate, 21% under section 11(b) .

Illustrative example. A calendar-year C corporation elects S status effective January 1, 2027. On that date its assets are worth $600,000 more than their combined tax basis, including a building worth $1,200,000 with a $700,000 basis. Its recognition period runs through December 31, 2031.

The tax is treated as a loss to the corporation under section 1366(f)(2) , so shareholders pick up $395,000 of gain rather than $500,000. They still pay their own tax on it, which is the second layer. The example assumes taxable income is at least the gain and ignores NOLs, credits, and state tax.

Five details change the answer in real conversions:

• Overall caps. Total taxed gain is capped at the company-wide net unrealized built-in gain, and each year's amount is limited by taxable income, with any excess carried forward within the period.
• The burden of proof is on you. Gain in the period is presumed built-in unless the corporation shows the asset was not held at conversion or the gain exceeds the built-in amount. A valuation at the conversion date is the cleanest evidence.
• Receivables count too. Income earned in C years and collected during the period, such as a cash-method company's receivables, is treated as built-in gain. That reaches service businesses with no appreciated property.
• C year NOLs help here. They can offset net recognized built-in gain under section 1374(b)(2), even though they generally cannot carry into S years otherwise.
• Installment sales do not escape. Under Regulations section 1.1374-4(h) , a sale made inside the period can stay subject to the tax even if payments arrive after it ends.

The tax is reported on Schedule D (Form 1120-S), Part III .

If the C corporation used LIFO in its last C year, section 1363(d) includes the LIFO recapture amount in income for that year. The amount is inventory at FIFO over inventory at LIFO. The tax is payable in 4 equal installments with no interest for the extension: the first with the last C year return, the other three with the next three years' returns.

Illustrative example. FIFO inventory of $900,000 against LIFO inventory of $650,000 is a $250,000 recapture. At 21%, that is $52,500 of tax, or $13,125 in each installment. Inventory basis steps up by the recapture, which helps later. Companies that do not use LIFO can skip this section. The installments go on Form 1120-S, line 23a .

Accumulated earnings and profits (E&P) from the C years stay with the company, and S years generally do not add to or reduce them under section 1371(c) . A new account also starts: the accumulated adjustments account (AAA), which opens at zero on the first S day and tracks S period income.

Under section 1368(c) , distributions come out of AAA first, then E&P as a dividend, then basis. Illustration: with $100,000 of AAA and $200,000 of E&P, a $150,000 distribution is $100,000 from AAA and $50,000 of dividend. That is the C corp's old double tax, delayed. With every affected shareholder's consent, the company can elect to distribute E&P first or make a deemed dividend, which can clear the balance in a year when the dividend rate suits the owners.

E&P also triggers the section 1375 tax . If a company has accumulated E&P at year end and passive investment income over 25% of gross receipts, it pays 21% on excess net passive income. Passive investment income means royalties, rents, dividends, interest, and annuities, with section 1362(d)(3) setting the terms.

Illustration: gross receipts of $400,000 include $200,000 of passive income, with $150,000 of net passive income. The excess over 25% of receipts is $100,000, half of the passive income, so excess net passive income is $75,000. The tax is $15,750, subject to the taxable income limit. Rents from an active rental business, where the corporation provides significant services or incurs substantial costs, can fall outside the definition under Regulations section 1.1362-2(c)(5) , so test this before assuming a rental company has a problem.

There is no IRS form. The corporation files a statement with the service center listed in the Form 2553 instructions : Kansas City, MO 64999 or Ogden, UT 84201, depending on your state. Our Form 2553 page lists the states.

1. Get consents. Shareholders holding more than half of the issued and outstanding shares, including nonvoting stock, must consent under section 1362(d)(1) .
2. Write the statement. Regulations section 1.1362-6(a)(3) requires the corporation to say it revokes the election and to state the shares outstanding. Name the effective date you want.
3. Attach the consents. Each gives the shareholder's name, address, taxpayer ID, shares, acquisition dates, and tax year end, plus the corporation's name and ID, signed under penalties of perjury.
4. Pick the date carefully. With no date named, a revocation by the 15th day of the 3rd month applies from the start of that tax year. After that, it applies from the start of the next year. A named date must be on or after the filing date.
5. Mail it with proof. Use certified mail and keep the receipt.

A mid-year revocation splits the year into an S short year and a C short year under section 1362(e). And a revocation can be rescinded before it takes effect.

Two rules matter after that. Section 1362(g) generally blocks a new election until the 5th tax year after the first year the revocation took effect, unless the IRS consents. So a 2027 revocation effective January 1, 2027 generally means a new election cannot start before 2032. And cash distributions during the post-termination transition period , at least one year or until the final S return due date with extensions if later, can come out against basis up to AAA under section 1371(e) .