S Corporations—Transition Issues

• Pages: 461-474
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

461

Chapter 15

S CORPORATIONS—

TRANSITION ISSUES

15.01 From C Corporation to S Corporation

An existing C corporation may elect S corporation status so long

as it is a small business corporation (i.e., it satisfies the requirements

set forth in § 1361(b) relating to the maximum number of

shareholders (100), maximum number of classes of shares

outstanding (one), and so on). That election will be effe ctive for the

corporation’s next taxable year, except that the election will be

effective for the current taxable year if it is filed within the first 2½

months of the year.

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Once the election is effective, the corporation is

subject to Subchapter S and is taxed as described previously.

However, because the corporation has a C corporation history, it is

also subject to some special Subchapter S rules to transition from C

corporation to S corporation status.

(a) Shareholder Taxation of Distributions

In general, profits earned by a C corporation are taxed twice,

once when earned by the corporation and a second time when

distributed to the corporation’s shareholders. However, not all

distributions from a C corporation to its shareholders are taxable

dividends: Distributions exceeding the corporation’s earnings and

profits are treated as a non-taxable recovery of the shareholder’s

stock basis, with any excess taxed as gain from the sale or exchange

of shares of stock. § 301(c). Every C corporation must maintain an

“earnings and profits” account, and distributions are taxed as

dividends only to the extent of this account.

In contrast, the earnings of an S corporation are typically taxed

only once. If the S corporation has no accumulated earnings and

profits (even if it was previously a C corporation), its distributions

are taxed to its shareholders under § 1368(b). Under this provision,

the distribution is first a tax-free recovery of the shareholder’s stock

basis, with any excess treated as gain from the sale or exchange of

stock. Cf. § 301(c)(2)–(3).

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§ 1362(b)(2). Even if the election is filed within the first 2⅓ months of the

year, the election is treated as made for the subsequent taxable year if (i) the

corporation did not qualify as a small business corporation during the taxable year

before the election is made or (ii) one or more persons who were shareholders during

the taxable year but before the election date did not consent to the election. Id.