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PATH Act Permanently Changes Tax Impact of Conversion of C Corporations to S Corporations

S corporations are a creature of the Internal Revenue Code. They are corporations which have timely filed an S election with the IRS to be treated as a "pass through" entity; meaning that they generally pay no corporate-level federal income tax. The federal income tax attributes flow through to the shareholders of the corporation. Most small business entities are "pass through" entities-either S corporations or limited liability companies, taxed as partnerships or sole proprietorships.

Sometimes due to lack of advice, lender requirements and other considerations, clients form corporations and do not make an S election. These corporations are called C corporations. This situation can result in double taxation of net revenues, especially upon the sale of the corporation's assets.

The Internal Revenue Code provides a mechanism for a C corporation to convert to an S corporation. The conversion mechanism calls for a converting corporation to report and pay a corporate level tax known as the "built-in gains tax" on certain appreciated assets that the corporation disposes within a period of time known as the "recognition period". The built-in gains tax is assessed at the highest corporate income tax rate. Historically, the recognition period has been 10 years, resulting in few C corporations making the conversion to S corporations because of the extremely high tax costs.

On December 18, 2015, the Protecting Americans from Tax Hikes Act of 2015 (the "PATH Act") was signed into law. The PATH Act permanently sets the recognition period at five years. With the recognition period being cut in half, now might be a good time to analyze and consider converting to an S corporation.

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