Key Takeaways:
- Converting C-Corp to S-Corp requires filing Form 2553 with IRS consent
- Built-in Gains (BIG) Tax: 21% corporate-level tax on gains recognized on assets that appreciated before conversion, applies for 5 years post-conversion
- Earnings & Profits (E&P) tracking required: Distributions from accumulated E&P are taxed as dividends even after S-Corp election
- Accumulated Adjustments Account (AAA) begins at $0 upon conversion
- Converting S-Corp to C-Corp is simpler: Just revoke S election—but restarts QSBS clock
- Under OBBBA 2025, new C-Corp stock gets enhanced QSBS benefits (tiered holding periods, $15M cap)
- Earlier conversion (when assets have less appreciation and less E&P) is generally easier and less costly
Converting your C-Corporation to S-Corporation status sounds straightforward—file Form 2553 and you’re done. The election itself is simple. But the tax consequences can follow your company for years.
The built-in gains tax penalizes appreciated assets at the corporate level for five years after conversion. Accumulated earnings and profits create dividend traps that surprise shareholders who thought they were getting tax-free distributions. And if you’re considering the opposite direction—S-Corp to C-Corp—you need to understand how conversion affects QSBS benefits and future planning.
This guide covers what happens when you convert between C-Corp and S-Corp status: the mechanics, the tax traps, and the planning considerations that should shape your decision.
Table of Contents
Why Convert C-Corp to S-Corp?
Before diving into mechanics, let’s understand why businesses make this conversion.
Avoiding Double Taxation Going Forward
C-Corp double taxation costs shareholders roughly 36-40% on distributed profits. Converting to S-Corp eliminates this going forward—profits pass through to shareholders and are taxed only once, at individual rates.
Example:
- C-Corp with $200,000 profit, distributed as dividend
- Corporate tax (21%): $42,000
- Dividend tax (23.8%): $37,604
- Combined tax: $79,604 (39.8% effective rate)
After S-Corp conversion:
- $200,000 passes through to shareholders
- Taxed at individual rates (potentially 37%, minus QBI deduction)
- Combined tax: Potentially $59,200 (29.6% with 20% QBI deduction)
The savings compound annually.
Accessing the QBI Deduction
S-Corporations qualify for the Section 199A Qualified Business Income deduction—up to 20% off qualified business income. C-Corps do not qualify.
For businesses in the 37% bracket:
- C-Corp effective rate on retained income: 21% (but double tax on distribution)
- S-Corp effective rate with QBI: Potentially 29.6%
Simpler Exit Planning
S-Corp asset sales can be more straightforward than C-Corp. No double taxation at exit means more proceeds to shareholders.
Owner Needs Distributions
If the business generates significant cash that owners want personally, pass-through taxation is more efficient. The math doesn’t work to pay corporate tax, then dividend tax, when you could tax only once.
Why Convert S-Corp to C-Corp?
Conversions also go the other direction—and they’re increasingly common for growth companies.
Venture Capital Fundraising
Most VCs require C-Corp structure. They want preferred stock, multiple stock classes, and corporate governance—none of which work with S-Corp limitations.
If you’re planning to raise institutional capital, converting to C-Corp before the funding round is typically necessary.
QSBS Planning
Section 1202 QSBS tax exclusion requires C-Corp status. The exclusion—up to $15 million in capital gains excluded under OBBBA—can save over $3.5 million in federal taxes on a successful exit.
Converting S-Corp to C-Corp starts the QSBS clock. Stock issued after conversion can qualify (assuming all other requirements are met).
Foreign Shareholders
S-Corps cannot have foreign shareholders. If you’re bringing on a foreign co-founder, investor, or buyer, C-Corp is the only option.
Multiple Stock Classes
S-Corps allow only one class of common stock (voting and non-voting differences are permitted). C-Corps can have unlimited classes—preferred stock, convertible notes, various equity compensation arrangements.
C-Corp to S-Corp: The Conversion Process
Filing Form 2553 (S Corporation Election)
The mechanical process of converting requires filing Form 2553 with the IRS.
Key requirements:
- Eligible corporation: Must be a domestic corporation with eligible shareholders (individuals, estates, certain trusts—no partnerships, corporations, or nonresident aliens)
- 100 shareholders or fewer: S-Corps cannot exceed 100 shareholders (family members can elect to be treated as one shareholder)
- One class of stock: Only common stock with identical distribution and liquidation rights
- Shareholder consent: All shareholders must consent to the election by signing Form 2553
Timing the Election
To be effective for the current year, Form 2553 must be filed:
- No earlier than the first day of the tax year
- No later than 2 months and 15 days (2.5 months) after the start of the tax year
Example for calendar year corporation:
- To elect S-Corp status effective January 1, 2026
- File Form 2553 no earlier than January 1, 2026
- File no later than March 15, 2026
If you miss the deadline, the election becomes effective the following year—unless you qualify for late election relief under Revenue Procedure 2013-30.
State Considerations
Most states automatically follow the federal S election. Some require separate state-level elections:
- New York: Requires Form CT-6
- New Jersey: Requires separate S election
- California: Automatically follows federal, but imposes a 1.5% tax on S-Corp income
Check your state’s requirements—federal S election alone may not be sufficient.
Built-in Gains (BIG) Tax: The Conversion Penalty
The built-in gains tax is the primary tax cost of C-Corp to S-Corp conversion. It prevents corporations from converting to S status just to avoid double taxation on appreciated assets.
How the BIG Tax Works
When you convert from C-Corp to S-Corp, the IRS identifies all assets that have appreciated during C-Corp years. If you sell (or are deemed to sell) those assets within 5 years of conversion, the corporation pays a 21% tax on the built-in gain—on top of the pass-through taxation to shareholders.
The math:
- On conversion date, identify Fair Market Value (FMV) and tax basis of all assets
- “Net unrealized built-in gain” = Total FMV – Total basis
- If you sell an asset within 5 years, gain attributable to pre-conversion appreciation is taxed at 21% corporate rate
- The gain also passes through to shareholders (regular S-Corp treatment)
- Shareholders may get credit for corporate-level tax paid
BIG Tax Example
Facts:
- C-Corp converts to S-Corp on January 1, 2026
- Real estate owned: Basis $500,000, FMV on conversion $1,200,000
- Built-in gain: $700,000
- S-Corp sells real estate in 2028 for $1,400,000
Tax calculation:
Total gain: $1,400,000 – $500,000 = $900,000
Built-in gain (pre-conversion appreciation): $700,000
Post-conversion appreciation: $200,000
BIG Tax (on $700,000 at 21%): $147,000 (paid by corporation)
Pass-through to shareholder: $900,000 (taxed at individual rates)
Shareholder gets credit for portion of BIG tax paid
Net effect: The $700,000 of pre-conversion gain is essentially taxed twice—once at corporate level (BIG tax) and once at shareholder level (pass-through). This approximates what would have happened if you’d sold as a C-Corp.
The 5-Year Recognition Period
The BIG tax applies only to gains recognized within 5 years of conversion. If you wait until year 6 to sell appreciated assets, no BIG tax.
Planning implication: If you have significantly appreciated assets, either:
- Sell them before converting (pay C-Corp double taxation once)
- Wait 5+ years after converting to sell (avoid BIG tax entirely)
- Accept the BIG tax as a cost of immediate conversion
Calculating Net Unrealized Built-In Gain
At conversion, you should document:
- Fair market value of all assets
- Tax basis of all assets
- Individual built-in gains by asset
This documentation is critical. If you can’t prove the asset’s value at conversion, the IRS may treat the entire gain as built-in gain.
Assets to evaluate:
- Real estate and improvements
- Equipment and vehicles
- Inventory (at FIFO layer values)
- Intangibles and goodwill
- Accounts receivable (for accrual basis taxpayers)
- Cash (typically no built-in gain)
NUBIG vs. NUBIL
If your aggregate built-in gains exceed built-in losses, you have Net Unrealized Built-in Gain (NUBIG)—BIG tax applies.
If losses exceed gains, you have Net Unrealized Built-in Loss (NUBIL)—no BIG tax, and built-in losses can offset gains recognized during the 5-year period.
Earnings & Profits (E&P): The Dividend Trap
The second complication of C-Corp to S-Corp conversion: accumulated earnings and profits don’t disappear. They create ongoing complications for distributions.
What Is Accumulated E&P?
Earnings and profits (E&P) is a C-Corp concept measuring economic profits available for distribution. It’s similar to—but not identical to—retained earnings.
When you convert to S-Corp, any accumulated E&P from C-Corp years carries forward. It doesn’t go away.
The Ordering Rules Problem
S-Corp distributions follow specific ordering rules:
- First: Distributions come from the Accumulated Adjustments Account (AAA)—S-Corp earnings since conversion. Distributions from AAA are generally tax-free to the extent of shareholder basis.
- Second: Once AAA is exhausted, distributions come from accumulated E&P. Distributions from E&P are taxed as dividends (0%, 15%, or 20% plus potential NIIT).
- Third: After E&P is exhausted, distributions reduce stock basis (tax-free) then create capital gain.
E&P Trap Example
Facts:
- C-Corp converts to S-Corp January 1, 2026
- Accumulated E&P from C-Corp years: $500,000
- S-Corp earns $100,000 in 2026
- S-Corp distributes $150,000 to shareholder in 2026
Distribution treatment:
| Source | Amount | Tax Treatment |
|---|---|---|
| AAA (S-Corp earnings) | $100,000 | Tax-free (to extent of basis) |
| Accumulated E&P | $50,000 | Taxed as dividend (15% or 20%) |
| Total distribution | $150,000 |
The shareholder expected a tax-free distribution but owes dividend tax on $50,000.
Planning Around E&P
Option 1: Distribute E&P before conversion
Pay out accumulated E&P as dividends while still a C-Corp. Yes, you pay dividend tax—but you would anyway eventually. Clean the slate before S election.
Option 2: Make a “deemed dividend” election
Section 1368(e)(3) allows S-Corps with accumulated E&P to elect to treat distributions as coming from E&P first. This accelerates the dividend recognition and clears E&P faster.
Option 3: AAA bypass election
Shareholders can elect to have distributions come from E&P instead of AAA. This preserves AAA for later distributions while clearing E&P.
Option 4: Live with it
Track E&P carefully and understand that some distributions will be taxed as dividends until E&P is exhausted. For small E&P balances, this may be the simplest approach.
Accumulated Adjustments Account (AAA)
When you convert to S-Corp, a new account begins: the Accumulated Adjustments Account (AAA).
What Is AAA?
AAA tracks the S-Corp’s accumulated earnings that have been taxed to shareholders but not yet distributed. It’s essentially the S-Corp equivalent of retained earnings—but for tax purposes.
AAA starts at $0 upon conversion. It increases with S-Corp income, decreases with losses and distributions.
Why AAA Matters
Distributions from AAA are generally tax-free to shareholders (to the extent of stock basis). Distributions that exceed AAA come from E&P or create gain.
AAA Tracking
Each year, AAA is adjusted:
Increases:
- S-Corp ordinary income
- Separately stated income items
Decreases:
- Distributions (but not below zero from distributions)
- Losses and deductions
- Nondeductible expenses that reduce E&P
AAA can go negative from losses, but distributions cannot make AAA negative.
S-Corp to C-Corp Conversion
Converting in the other direction—S-Corp to C-Corp—is mechanically simpler but has its own planning implications.
The Revocation Process
To convert S-Corp to C-Corp:
- Revoke S election: File a revocation statement with the IRS, signed by shareholders holding more than 50% of outstanding shares
- Timing:
- If filed in first 2.5 months of tax year, effective for that year
- If filed later, effective the following year
- Can specify a prospective effective date
- IRS Form: No specific form—submit a statement with corporation name, EIN, revocation language, and shareholder signatures
No BIG Tax Going the Other Direction
There’s no built-in gains tax when converting from S-Corp to C-Corp. The appreciated assets simply become C-Corp assets.
QSBS Clock Restarts
This is the critical planning point: QSBS holding period starts fresh after conversion.
Stock you held as S-Corp shares does not count toward the 5-year QSBS holding period. The clock begins when you convert to C-Corp and issue (or are deemed to issue) new C-Corp shares.
OBBBA Changes (post-July 4, 2025 stock):
- $15 million exclusion cap (up from $10M)
- $75 million gross asset threshold (up from $50M)
- Tiered holding periods: 50% at 3+ years, 75% at 4+ years, 100% at 5+ years
If you convert S-Corp to C-Corp after July 4, 2025, your new C-Corp stock qualifies for enhanced OBBBA QSBS benefits—but only after meeting the relevant holding period starting from conversion.
When to Convert S-Corp to C-Corp
Before fundraising: Convert before issuing shares to investors so everyone’s QSBS clock starts simultaneously
With sufficient time: If QSBS is your goal, convert early enough to meet the 5-year (or at least 3-year for partial exclusion) holding requirement before anticipated exit
When S-Corp limitations become binding: Multiple stock classes needed, foreign investors joining, approaching 100 shareholder limit
Conversion Timing Strategies
When C-Corp to S-Corp Conversion Makes Sense
Early in business life
- Less accumulated E&P
- Less asset appreciation (lower BIG tax exposure)
- Longer to benefit from pass-through taxation
Before significant appreciation events
- Convert before real estate development increases value
- Convert before business goodwill develops substantially
- Convert while equipment is newer (less built-in gain)
When distributions are needed
- If owners need cash from the business
- If double taxation is actively costing you money
- If QBI deduction would provide significant benefit
When S-Corp to C-Corp Conversion Makes Sense
Before raising capital
- Convert before investor shares are issued
- Everyone starts QSBS clock together
- Clean documentation for VC deal
With sufficient exit runway
- At least 3 years before expected exit (partial QSBS)
- Ideally 5 years before (full QSBS exclusion)
When S-Corp limitations become problematic
- Adding foreign shareholders
- Needing preferred stock for investors
- Complex equity compensation arrangements
Conversion Timing Checklist
Before converting C-Corp to S-Corp, evaluate:
- [ ] Total accumulated E&P (affects dividend trap)
- [ ] Built-in gains in all assets (affects BIG tax exposure)
- [ ] Plans to sell appreciated assets in next 5 years
- [ ] Shareholder eligibility requirements (all must qualify)
- [ ] State-level S election requirements
- [ ] Impact on any QSBS benefits already earned
Before converting S-Corp to C-Corp, evaluate:
- [ ] Timeline to expected exit vs. QSBS holding requirement
- [ ] Impact of losing pass-through taxation
- [ ] Need for QBI deduction (will be lost)
- [ ] Investor requirements and timing
- [ ] Equity compensation plans that need restructuring
Common Conversion Mistakes
Mistake 1: Ignoring Built-In Gains
Many businesses convert without documenting asset values at conversion. Years later, they sell an asset and have no evidence of what the built-in gain was. The IRS may treat the entire gain as built-in.
Solution: Get appraisals and document FMV of all assets at conversion.
Mistake 2: Forgetting About E&P
Owners assume S-Corp distributions are all tax-free and are surprised when accumulated E&P creates dividend income.
Solution: Calculate E&P before converting and decide whether to distribute it first.
Mistake 3: Missing the Election Deadline
Filing Form 2553 after March 15 (for calendar year corporations) means the S election isn’t effective until next year.
Solution: Know your deadlines. If you miss them, immediately file for late election relief.
Mistake 4: Converting with Ineligible Shareholders
If any shareholder is ineligible (corporation, partnership, nonresident alien), the S election is invalid from the start.
Solution: Verify all shareholder eligibility before filing Form 2553.
Mistake 5: Not Coordinating with State
Federal S election doesn’t automatically mean state S status everywhere. Some states require separate elections or impose taxes anyway.
Solution: Review state requirements and file necessary state elections.
Frequently Asked Questions
How do I convert my C-Corp to an S-Corp?
File Form 2553 with the IRS. All shareholders must consent by signing the form. File within 2 months and 15 days of the start of the tax year for the election to be effective that year. Verify eligibility requirements: 100 or fewer eligible shareholders, one class of stock, domestic corporation.
What is the built-in gains tax?
The built-in gains (BIG) tax is a 21% corporate-level tax on gains recognized when a converted S-Corp sells assets that appreciated during C-Corp years. It applies to gains recognized within 5 years of conversion, up to the net unrealized built-in gain at conversion. The BIG tax approximates the double taxation that would have applied if the assets were sold while still a C-Corp.
How long does the built-in gains tax apply?
The BIG tax recognition period is 5 years from the effective date of the S election. Gains recognized after 5 years are not subject to BIG tax, even if the appreciation occurred during C-Corp years.
What happens to accumulated E&P when I convert to S-Corp?
Accumulated E&P from C-Corp years carries forward. It doesn’t disappear. When the S-Corp makes distributions that exceed the Accumulated Adjustments Account (AAA), the excess is treated as dividends from E&P (taxed at 0%, 15%, or 20% plus potential NIIT). This continues until E&P is exhausted.
Can I convert S-Corp back to C-Corp?
Yes. Revoke the S election by filing a revocation statement with shareholders holding more than 50% of shares. No built-in gains tax applies going this direction. However, the QSBS holding period restarts—any time as an S-Corp doesn’t count toward the 5-year QSBS requirement.
Does converting to C-Corp affect QSBS?
If you’re converting S-Corp to C-Corp, the QSBS clock starts at conversion. Stock issued after conversion can qualify for QSBS (assuming all other requirements are met), but the holding period begins at conversion, not when the S-Corp was originally formed. Under OBBBA, post-July 4, 2025 stock has tiered exclusions: 50% at 3+ years, 75% at 4+ years, 100% at 5+ years.
Should I distribute accumulated E&P before converting to S-Corp?
Often yes. Distributing E&P while still a C-Corp (as dividends) clears the balance before conversion. You pay dividend tax either way—the question is timing. Clearing E&P before conversion simplifies post-conversion distribution planning and avoids surprise dividend income when shareholders expect tax-free distributions.
What’s the deadline for S-Corp election?
For the election to be effective for the current tax year, file Form 2553 no earlier than the first day of the tax year and no later than 2 months and 15 days (March 15 for calendar year corporations) after the start of the year. Late elections are effective for the following year unless you qualify for relief under Revenue Procedure 2013-30.
Next Steps: Planning Your Entity Conversion
Entity conversion has long-term tax implications. The wrong timing can cost tens of thousands in unnecessary built-in gains tax or dividend taxation. The right planning can minimize these costs and set up favorable tax treatment going forward.
Before converting, you should:
- Calculate built-in gains across all appreciated assets
- Determine accumulated E&P and evaluate distribution strategy
- Model the tax impact of different conversion timing scenarios
- Verify shareholder eligibility and get all consents
- Understand state-level requirements and elections
For C-Corporation tax services or help evaluating entity conversion for your business, schedule a consultation. We can model your specific situation and identify the most tax-efficient conversion approach.
Related Resources:
- C-Corporation Tax Guide – Complete overview of C-Corp taxation
- S-Corporation Tax Guide – Understanding S-Corp pass-through taxation
- C-Corp vs S-Corp Tax Comparison – Side-by-side entity analysis
- C-Corp Double Taxation Explained – Understanding and minimizing double taxation
- QSBS Guide – Section 1202 exclusion requirements
- Business Entity Tax Guide – Full entity selection framework