Editor: Michael D. Koppel, CPA, PFS, CITP, MBA (Retired Partner)
December 1, 2018
The significant reduction in the corporate tax rate (from 35% to 21%) brought about by the law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115-97, has many S corporations considering whether to convert to a C corporation to take advantage of the lower rate. Before electing to make the change, taxpayers should understand the many ramifications of converting. The IRS released Rev. Proc. 2018-44, which modifies Rev. Proc. 2018-31, to reflect the statutory amendments made by the TCJA relating to the revocation of an S election.
S corporation status may be terminated by revocation only if shareholders holding more than one-half of the shares of stock of the corporation on the day on which the revocation is made consent to the revocation (Sec. 1362(d)). Rev. Proc. 2018-44 discusses how certain S corporations that change from the cash method of accounting to the accrual method of accounting due to a revocation of their S election either must or can elect to take into account positive or negative Sec. 481(a) adjustments for the change over a six-year period. To be eligible, the company must: (1) have been an S corporation on Dec. 21, 2017; (2) have had the same owners of stock, in identical proportions, on Dec. 22, 2017; (3) have the same owners of stock, in identical proportions, on the date of revocation; and (4) elect to revoke S corporation status after Dec. 21, 2017, and before Dec. 22, 2019.
An S corporation that converts to a C corporation is generally required to change from the cash method of accounting to the accrual method of accounting. However, a terminated S corporation may remain a cash-basis taxpayer if its average gross receipts for the three previous tax periods are less than $25 million.
Keep in mind that a taxpayer generally must secure the IRS’s consent before changing a method of accounting for federal income tax purposes. However, Rev. Proc. 2018-31 provides procedures by which a taxpayer may obtain the IRS’s automatic consent to a change in method of accounting and contains the current list of automatic changes.
If an S corporation chooses to make the revocation during the tax year, on or before the 15th day of the third month of the year, the revocation will be effective retroactively to the first day of the tax year. If the election is made after that later date, the year will be divided into a short tax year as an S corporation for the time up to the termination, and a short tax year as a C corporation for the portion of the year following the revocation.
For an eligible terminated S corporation required to convert to the accrual method as a result of its S corporation election revocation, as soon as the IRS accepts the change of accounting method, the taxpayer will be required to account for the change over a set period of time. Sec. 481(d)(1) requires an eligible terminated S corporation to take into account ratably during the six-year period beginning with the year of change any adjustment required by Sec. 481(a)(2) that is attributable to the corporation’s revocation of its S election.
Under Rev. Proc. 2018-44, an eligible terminated S corporation that is permitted to continue to use the cash method after the revocation of its S corporation election, and that changes to an accrual method under Rev. Proc. 2018-31 for the first tax year that it is a C corporation, can elect to take the Sec. 481(a)(2) adjustment for the change into account ratably during the six-year period beginning with the year of change. If it is electing the optional six-year period, the taxpayer must indicate in the statement required by line 26 of Form 3115, Application for Change in Accounting Method, that it is making the change in method of accounting with the spread period permitted under Section 15.01(3)(a)(ii)(B) of Rev. Proc. 2018-31 (as amended by Rev. Proc. 2018-44) on its timely filed Form 3115.
A taxpayer changing its method of accounting must compute a Sec. 481(a) adjustment, as follows:
- Reflecting the accounts receivable, accounts payable, inventory, and any other item determined to be necessary to prevent items from being duplicated or omitted;
- Including in the adjustment any item of income accrued but not received that was worthless or partially worthless (within the meaning of Sec. 166) on the last day of the year immediately prior to the year of change; and
- Taking into account the resulting positive or negative adjustment during the six-year period beginning with the year of change.
Weighing the costs and benefits
Although there may be a tax rate differential, taxpayers should consider whether the complexities required to change accounting methods outweigh the benefits. C corporations are still subject to double taxation, which can limit the benefit of the lower corporate tax rate. Similarly, the 20% deduction for qualified business income under new Sec. 199A means certain passthrough entities have tax advantages that may offset the reduced tax rate for C corporations. Also, the administrative process of changing from an S corporation to a C corporation may be costly.
This article was originally published in the AICPA “Tax Adviser” on December 1, 2018.