How to Convert a C Corp to an S Corp

The Mechanics Are the Same Form 2553 Election

An existing, already-operating C corporation elects S status the same way a brand-new corporation does: by filing Form 2553, signed by every shareholder who held stock during the relevant period, within two months and fifteen days of the tax year the election should apply to, or anytime during the prior year. See our guide on how to elect S corporation tax status for the filing mechanics. What makes converting an existing C corporation different isn't the election itself, it's the tax history the corporation brings into S status with it.

Built-In Gains Tax Under Section 1374

If a C corporation has appreciated assets, property or investments worth more than their tax basis, converting to an S corporation doesn't erase the corporate-level tax on that built-in appreciation. Per 26 U.S.C. § 1374, if the S corporation sells or disposes of an asset it held at the time of conversion within a five-year recognition period, and the sale realizes gain that existed at conversion, the corporation pays tax on that gain at the highest corporate rate, currently 21%, before any pass-through treatment applies to the remaining amount. This tax exists specifically to prevent a C corporation from converting to S status right before selling appreciated assets to avoid corporate-level tax.

LIFO Inventory Recapture

A corporation that uses the last-in, first-out (LIFO) method to value its inventory faces a separate rule under 26 U.S.C. § 1363(d). It must include a "LIFO recapture amount," generally the excess of inventory value under the first-in, first-out method over its LIFO value, in gross income for its final tax year as a C corporation. The resulting additional tax can be paid in four equal annual installments rather than all at once.

Accumulated Earnings and Profits From C Corporation Years

Profit a corporation earned and retained while it was a C corporation becomes "accumulated earnings and profits" that carry over into its life as an S corporation. This creates two ongoing issues: distributions have to be tracked separately between the S corporation's own post-election earnings (its accumulated adjustments account) and the older C corporation earnings and profits, which are taxed differently when distributed, and the leftover earnings and profits can trigger the passive income rule below.

The 25% Passive Income Trap

Per 26 U.S.C. § 1375, an S corporation that has accumulated earnings and profits from its C corporation years and also has passive investment income, interest, dividends, rents, and royalties, among other categories, exceeding 25% of its gross receipts for the year owes a corporate-level tax on the excess passive income. Per 26 U.S.C. § 1362(d)(3), if this condition continues for three consecutive tax years, the S election terminates automatically. A corporation with significant retained C corporation earnings and substantial passive income should watch this ratio closely.

Accounting Method Considerations

Some accounting methods and elections available to a C corporation work differently, or require adjustment, once a company becomes an S corporation. Review your accounting method, inventory valuation, and any outstanding elections with a tax professional as part of the conversion, rather than assuming everything carries over unchanged.

Why Companies Convert Anyway

Despite these transition issues, many profitable, closely held C corporations still convert to S status to avoid ongoing double taxation on future profit and to let working owners potentially reduce self-employment tax exposure through the salary-versus-distribution structure. The built-in gains tax and LIFO recapture are one-time or time-limited costs measured against ongoing annual tax savings, which is why modeling the numbers before converting matters.

Get a Valuation Before You Convert

Since built-in gains tax depends on the difference between an asset's value and its tax basis at the moment of conversion, getting a professional valuation of the corporation's assets as of the conversion date creates a clear record if the IRS later questions the built-in gains calculation on a future sale.

This Often Needs a Tax Professional, Not Just a Form

While the election form itself is simple, the built-in gains tax, LIFO recapture, and accumulated earnings and profits issues require real tax analysis specific to your corporation's financial history. Treat the conversion as a tax planning project, not a one-page filing, especially for a corporation with significant retained earnings or appreciated assets.

Time the Conversion Around Planned Asset Sales

If you're planning to sell a significant appreciated asset, like real estate, in the next few years, model the built-in gains tax cost of selling it within the five-year recognition period against waiting until after it expires, since the tax can be substantial on a large gain.

This Isn't Tax Advice

Built-in gains tax, LIFO recapture, and accumulated earnings and profits rules are technical and fact-specific. Talk to a tax professional before converting an operating C corporation to S status.