C-corp to S-corp conversion

Technical topics regarding tax preparation.
#1
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Client is a family owned Ccorp with 5 shareholders (H-W & 3kids). They are considering an S-corp conversion to save on taxes and simplify their situation, not to mention save on taxes. I have advised them to stay a Ccorp for at least one more year since they still have a big NOL carryforward from a prior year. RE in the corp are about 750k, officers are taking big salaries which of course zeros out or creates a loss in income every year so any RE is from long time ago, and since this is my first year working with them I can’t even be sure it is accurate (but is reflected on last yrs balance sheet). H-W are looking at retiring in a few years, so the Scorp would give them passive income and tax free distributions in the future. I have advised them to lower the salaries, and for now we will create a loan to shareholder account if they need more $ until we decide what we are going to do(we have another year or two because of the NOL) I have read many of the pros and cons, and I deal with Scorps all the time so I am much more comfortable doing those, and I am sure the Scorp will save them in the long run- but after reading some articles, I am not entirely convinced that the H-W shouldn’t just form a separate Scorp and have the C-corp pay the Scorp a management/consulting fee to extract some of the RE and income. This way they can get the benefits of both, and I am thinking a full on conversion might be more complicated than what it is worth. Is there a problem with doing this? Any thoughts?
 

#2
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corrielee wrote: H-W are looking at retiring in a few years, so the Scorp would give them passive income and tax free distributions in the future.

Might want to rethink that one. There is, for one thing, a 5 out of 10 year rule. But if they have no passive losses, might be a good thing to have non-passive flow-thru income b/c it avoids the NIIT.

Hard to say about the distributions being “tax free.” Seems you’ll have AE&P. But if their salaries go away, we’d hope the S would generate enough profits so that any distributions come solely out of the AAA, leaving the AE&P intact.

Overall, seems to me your analysis is a bit short-sighted. You’re focusing on the parents (and really, their income only), but the fact is, this is a multi-generational business. If you leave this entity as a C, the kids simply inherit the “problem” of being a C. If an asset sale is ever contemplated, that would be problematic as a C (and not so much of a problem at all if converted to an S and the BIG period runs). Not sure if entity is cash or accrual. If cash basis, that creates some BIG issues, but they can be dealt with. You also haven’t addressed the parents stock, and what might come of it.
 

#3
Nilodop  
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I have advised them to lower the salaries, and for now we will create a loan to shareholder account if they need more $ until we decide what we are going to do(we have another year or two because of the NOL) Back in the olden days, this created a red flag that made IRS wonder about reasonable compensation and section 301.
 

#4
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Agree with Nilodop. This advice:
corrielee wrote: I have advised them to lower the salaries, and for now we will create a loan to shareholder account if they need more $ until we decide what we are going to do

...could (still today) be a recipe for disaster.
 

#5
Doug M  
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What is the built in gain and is the corp. filing on cash or accrual?
 

#6
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I don't think built in gain will be an issue since they have no intentions of selling it in the next 5 or even 10 years. They are accrual and on a fiscal year, so I would change that to a calendar year upon conversion. I don't think the reasonable compensation thing will be that much of an issue since the reality is the parents are taking a step back from the business and not working as much, and yes I realize that distributions would only be tax free from AAA, not AE&P.
 

#7
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All in all, I know an Scorp would be better in the long run, it just might be a headache in the short term since they are so used to doing it as a C (since 1975). I wanted to put my thoughts out there to other professionals to make sure I am doing what is best for my ciient (who happens to be a personal friend so I am more invested in this than usual).

During my research and thinking of all the pros and cons, I came upon an article about corporations being run by both entity types (C and S) getting the benefits of both. With C corps you don't have to worry so much about the fringe benefits of the shareholders(medical insurance, vehicles, 401k). It would be very easy to set up a new entity and have the C pay the S. In fact many lawyers do this for their clients to save on taxes (I have a client with a multi-million dollar trust that holds a partnership, 2 scorps and a Ccorp all interconnected) so I know this isn't unheard of.
 

#8
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So the shareholders in my post from last year decided to convert to an Scorp, I faxed the 2553 a few weeks ago, and today I was just at a federal tax update seminar where the instructor was talking about the BIG tax upon conversion, how it was finalized to last just the 5 years, but then she said it was on inventory as well at the time of conversion, which scared me and now I am in research panic mode.

The former Ccorp ending inventory on the last tax return was about half a million- the instructor seemed to think we needed to get it down to zero before conversion otherwise we have to pay the BIG tax on all the inventory that is sold as an Scorp. This just seems ridiculous to me since it is accrual method, and there was absolutely no appreciation or built in gains, I can't remember offhand whether they use fifo/lifo but will check tomorrow in the office. They do not produce inventory it is product bought to resale, so the value at the time of conversion was the price paid for it, so there is no difference between the basis/fmv at time of conversion, as I said, so no appreciated inventory asset.

Am I wrong, do we need to rescind the S election? Any steps I should take before the end of the year? I can't seem to find a definite answer on this beside the whole LIFO recapture thing, which is confusing as well.
 

#9
sjrcpa  
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Inventory is an item that has built in gain or loss - the difference between its FMV and tax basis at the time of conversion to S corporation. So are Fixed Assets. For that matter, potentially all assets (except cash) and liabilities on the Balance Sheet, as well as non balance sheet intangibles such as goodwill.
You (or someone) needs to do the built in gain calculation. The amount needs to be shown on the 1120S
 

#10
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I semi understand what you are saying, but that doesn't help me. We were not concerned about BIG since they will not be selling anything in the business before the conversion for atleast 5 years( besides inventory), so only that is what I am worried about. It's fair market value is the ending inventory value its basis is what they bought it for so I don't see how it has any built in gain. I need to know if they will have to pay BIG tax on the 500k of inventory as they sell it next year, and whether or not I should rescind the Selection.
 

#11
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The seminal case in this area is Reliable Steel Fabricators. It’s a decent case, but not a great one, because the taxpayer didn’t produce any credible evidence as to the Inventory’s value. I would also note that that case involved a manufacturer and the inventory in question was WIP.

I totally see what you are saying and I have confronted this issue before. Although ultimate retail price might be relevant, that doesn’t tell the whole story. What we’re after here, when it comes to a willing buyer, as part of the willing buyer/willing seller analysis, is a buyer that is in the same business of the taxpayer. See the -7 Reg as to that point. So, Corrielee’s argument goes like this:

Inventory on client’s books is $500k. Let’s say it has a retail value of $750k. That doesn’t paint the real picture, because the willing buyer isn’t a multitude of retail customers. Rather, the willing buyer is a similarly situated reseller, someone just like the taxpayer. So, would another reseller really pay $750k for this inventory? I think not: The buyer/other reseller would certainly not pay $750k for inventory that he himself could only sell for $750k. That would be a 0% profit margin and would make no sense. The buyer/other reseller would go somewhere else and purchase the inventory for $500k, in my view, assuming he had the connections and capability to do so. But then again, the buyer/other reseller might be willing to pay something more than $500k for the inventory, but less than $750k if buyer could easily sell it or otherwise easily incorporate into his sales stream. It could also be that buying in bulk like this might reduce a bulk buyer’s purchasing costs. And it could be that selling in bulk might reduce some costs the seller would otherwise incur, thereby making the seller amendable to a bulk sale. At the end of the day, if we end up somewhere between $500k and $750k, the $250k profit basically gets split between your client and the buyer/other reseller. That position would mean that your client, and the buyer, would be willing to accept something less than full profit.

Also, in this example, even if the client could sell the inventory for $750k, that fact alone ignores all the selling costs that go into converting the inventory to cash. That is, even if client could make a $250k gross profit on it, the net margin would be much less, after overhead and selling costs. These costs should factor into the BIG calculation. Let’s say these costs are $100k, so the net profit would be $150k.

I’ll admit it’s a difficult issue and it’s one that many people just brush over without thinking it through. But I can say, in nearly even business sale I’ve been involved with, the inventory allocation is done on a dollar-for-dollar basis, despite all the theories out there.
 

#12
sjrcpa  
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I agree the inventory value is somewhere between 500K and 750K in Jeff's example.
 

#13
JR1  
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It won't help much, but do realize that all that's happening is that they're just paying C corp taxes as they would have anyway! No difference. Now, also realize that the BIG tax is ONLY due when there are profits. Hint hint. So create some bonuses to wipe out the profits. For 5 years. Problem solved, tho' you'll be paying some SS/Med taxes...probably still much cheaper.
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#14
jon  
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Inventory IS NOT adjusted to FMV, unless I think the examples are jewelry,precious metals or the like. PPC does a great job on explaining. You can only get dividends out of the previously taxed by election and current distributions both have to be according to stock ownership or you can terminate the S election. Review BIG - LIFO reserves are automatically recaptured, goodwill, 1245 gains. The 5 year holding period I believe was made permanent. Goo luck...
 

#15
Doug M  
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Inventory is an item that has built in gain or loss - the difference between its FMV and tax basis at the time of conversion to S corporation.


I don't agree with this assertion. I think we need corrielee to clarify a couple of items. How about some real numbers. What is the cost basis of the inventory, nature of the inventory, and do the books carry the inventory at cost.

Bulk sale rules apply here for valuation purposes of the inventory. If you are talking typical widgets in inventory, a buyer will pay cost, not retail.

Did they address the BIG carryover in the newest law changes?

One more edit-I am curious why the first strategy (which I strongly agree with) of using up the NOL before converting was not utilized?
 

#16
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Thanks for all the info. I think I understand fully now. In all actuality, the CCORP has a sophisticated software system for their particular industry that tracks the buying and selling of inventory in real time, so we always book to match the ending inventory at the close of the year with what the software actually spits out. In this case, the ACTUAL tax basis (what they bought the inventory for) was actually 22k more than what we booked as ending inventory in the last year as a CCorp, writing the rest down to COGS.
So, if we do a valuation analysis on the total company and estimate what a willing buyer would pay, I think we could argue that the price we put on the inventory valuation at the time of the sale would be equal to or LESS than the value of the ending inventory transferred into the Scorp. Basically, the bulk of the NUBIG in this particular company is mainly intangible (Goodwill,Customer list, Blue sky), as the only other assets are vehicles, equipment and leasehold improvements-they do not own their own building. The amount of the calculated NUBIG, based on what we think the entire company would sell for, less the tax basis, will just be listed on the 1120S going forward, and will never be actually realized since they will not be selling the company for the next 5 years anyway. Furthermore, if I don't want any potential headache with the BIG, we should make sure the net income from the business is as low as possible for the next 5 years. Am I on the right track?
 

#17
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One more edit-I am curious why the first strategy (which I strongly agree with) of using up the NOL before converting was not utilized?
-
NOL was fully utilized in the last CCorp return that was just filed. I can give you some numbers:
Current Assets
Cash 50000
Shareholder loans 105000
inventory 650000
A/R 100000


Fixed Assets 400000
Accum Dep 300000

TOTAL ASSET 905,000

Current Liabilities
A/P 100000
Current Liabilities 50000
bank loan 30000
common stock 7000
APIC 15000
Retained earning 703000

Total Liab & Equity 905,000

method of valuing inventory is lower of cost or market
 

#18
Nilodop  
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My contribution is that debits don't appear to equal credits, but I can't cite a Code section that is violated by that.
 

#19
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These aren't the exact numbers from the balance sheet I just did a quick estimation
 

#20
sjrcpa  
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Doug Post 15
Are you saying inventory won't generate built in gain per se?
Or that tax basis and bulk sale/quick sale value is most likely equal?
 

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