Revoking S-Corp status can significantly alter a company’s tax landscape. This decision, often driven by strategic business shifts or changes in ownership structure, carries substantial financial implications.
Understanding these consequences is crucial for businesses aiming to navigate the transition smoothly and avoid unexpected liabilities.
Tax Implications of S-Corp Revocation
When a business decides to revoke its S-Corp status, it transitions back to being taxed as a C-Corporation. This shift brings about a fundamental change in how the company’s income is taxed. Unlike S-Corps, which pass income directly to shareholders to be taxed at individual rates, C-Corporations face double taxation. This means the corporation itself is taxed on its earnings, and shareholders are taxed again on any dividends received. This dual layer of taxation can significantly impact the overall tax burden on the business and its owners.
The timing of the revocation is another critical factor. If the revocation is effective at the beginning of the tax year, the company will be treated as a C-Corporation for the entire year. However, if the revocation occurs mid-year, the business will have two short tax years—an S short year up to (but not including) the effective date and a C short year for the remainder of the year—which generally means filing separate short-year returns for each period. 1Legal Information Institute. 26 CFR § 1.1362-3 Treatment of S Termination Year
Additionally, the revocation may trigger the need to reassess the company’s accounting methods. S-Corps often use the cash method of accounting. After revocation, many small C-Corporations can continue using the cash method if they meet the “small business taxpayer” threshold, while others may need to use the accrual method. This change can affect the timing of income and deductions, potentially altering taxable income in the transition year.
Impact on Shareholder Taxation
The revocation of S-Corp status has profound implications for shareholders, particularly in how their income is taxed. Under S-Corp status, shareholders benefit from pass-through taxation, where the corporation’s income, deductions, and credits flow directly to them, avoiding the double taxation faced by C-Corporations. This means shareholders report their share of the corporation’s income on their personal tax returns, often resulting in a lower overall tax burden due to individual tax rates and potential deductions.
Transitioning to a C-Corporation changes this dynamic significantly. Shareholders no longer report the corporation’s income on their personal tax returns. Instead, they only report dividends received, which are taxed at the qualified dividend rate. This rate is generally lower than ordinary income tax rates but still represents an additional layer of taxation on top of the corporate tax. For shareholders accustomed to the pass-through benefits of an S-Corp, this shift can lead to higher overall tax liabilities, especially if the corporation distributes substantial dividends.
Moreover, the change in status can affect shareholders’ basis in their stock. Under S-Corp rules, shareholders’ basis is adjusted annually based on their share of the corporation’s income, losses, and distributions. This basis adjustment can impact the amount of gain or loss recognized on the sale of the stock. When the corporation converts to a C-Corp, these basis adjustments cease, potentially leading to unexpected tax consequences when shareholders eventually sell their shares.
Handling Built-In Gains Tax
The built-in gains (BIG) tax applies to S-Corporations that were previously C-Corporations and have appreciated assets when the S election took effect; it applies only during a five-year “recognition period,” and the tax is computed by applying the highest corporate rate to any net recognized built-in gain. 2Legal Information Institute. 26 U.S. Code § 1374 Tax Imposed on Certain Built-In Gains
If an S-Corp revokes its election mid-year, only gains recognized during the S short year can be subject to the BIG tax; after the effective termination date, the corporation is a C-Corp and section 1374 no longer applies to post-termination sales. Companies often plan the timing of asset sales around this line to manage exposure and administrative complexity.
Additionally, the calculation of built-in gains can be intricate. It involves determining the fair market value of the assets at the time of the initial S-Corp election and comparing it to their value at the time of sale. Any appreciation attributable to the C-to-S transition period is measured under the BIG rules, requiring accurate records and, in some cases, valuation support.
State-Level Tax Considerations
When revoking S-Corp status, it’s essential to consider the state-level tax implications, as they can vary significantly from federal tax rules. Each state has its own tax regulations, and the transition from S-Corp to C-Corp can trigger different state tax consequences. For instance, some states may impose additional taxes or fees on C-Corporations that do not apply to S-Corporations, potentially increasing the overall tax burden.
Moreover, states may have different rules regarding the treatment of built-in gains and other income. While the federal recognition period for built-in gains tax is typically five years, some states may have shorter or longer periods, or different methods for calculating the tax. This discrepancy can complicate tax planning and necessitate a detailed understanding of state-specific tax codes. Consulting with a tax professional who is well-versed in the tax laws of the relevant states can help navigate these complexities.
In addition to income tax considerations, states may also have varying requirements for franchise taxes, gross receipts taxes, or other business-related levies. These taxes can be particularly impactful for C-Corporations, which may face higher rates or different calculation methods compared to S-Corporations. Understanding these differences is crucial for accurate financial forecasting and budgeting.
Reporting Requirements and Deadlines
To revoke the S election, the corporation must file a revocation statement with the IRS service center, and shareholders holding more than half of the outstanding shares must consent; the revocation can be effective on the first day of the tax year if made by the 15th day of the third month, effective the next tax year if made after that date, or effective on a specified on-or-after filing date. 3Legal Information Institute. 26 CFR § 1.1362-6 Elections and Consents (Revocation) 4Legal Information Institute. 26 U.S. Code § 1362 Election; Revocation; Termination
If the election terminates during the year, the corporation must file a final S-Corp short-year return on Form 1120-S, and the due date for that S short-year return is the same as the due date for the C-Corp short-year Form 1120. Corporations taxed as C-Corporations generally file Form 1120 by the 15th day of the fourth month after the end of their tax year (special June 30 rules apply). 5Internal Revenue Service. Instructions for Form 1120-S 6Internal Revenue Service. Publication 509 (2025), Tax Calendars
State-level reporting requirements can further complicate the process. Each state has its own deadlines and forms for reporting the change in corporate status. Some states may require additional documentation or have different timelines for filing. Ensuring compliance with both federal and state requirements necessitates a comprehensive understanding of the relevant tax codes and deadlines. Engaging a tax professional with expertise in multi-state taxation can be invaluable in navigating these complexities.