The impact a change of entity types has on general business credits…
Thinking about changing entity types? Make sure you have all the facts first. There are many reasons, tax-related and otherwise, why a company may decide to change from a C-Corp to an S-Corp or other flow-through entity. But before making that kind of change, it is important that shareholders know what will happen to any credits they or the business may be carrying forward.
Companies that take advantage of general business credits, like the Credit for Increasing Research Activities (more commonly known as the R&D credit), may find there are some years it can utilize its credits and other years when it cannot. If a company cannot utilize a credit in a given year, it may be able to carry the credit back or forward. The R&D tax credit, for example, can be carried back one year and forward up to 20 years. Depending on the entity type of the company, the carryback or carryforward is filed on different tax returns.
A C-Corp, for example, carries the R&D credit, along with other general business credits, on the corporate return. For an S-Corp, partnership or other pass-through entity type, unused credits are carried on the individual shareholders’ personal tax returns. When a company changes entity types, the general business credits the C-Corp had on its corporate return cannot be transferred over to the shareholders’ personal returns. Similarly, a credit being carried on a personal return cannot be shifted over to a corporate return. As a result, these credits are effectively suspended.
But the credits are not gone. For example, if the corporate structure changes back to its previous form, the credits can still be used, though time limits for carryforwards may apply. Additionally, when a C-Corp changes to an S-Corp, if that new S-Corp is sold, the old C-Corp’s tax credits can be used against the built-in gains tax arising from the sale. Because this tax is calculated and paid at the corporate level, it can be treated as ordinary income, even though it is ordinarily taxed as a capital gain, and the remaining suspended C-Corp credits can be used against it. Thus, if a C-Corp was carrying a large credit when it changed to an S-Corp, those credits are not necessarily completely lost.
Importantly, this only applies to C-Corp credits that are being carried back or forward. For an S-Corp or other pass-through entity, the story is different. Any credits being carried forward will be on the shareholders’ personal returns and will not be transferrable. Since the shareholders of an S-Corp are carrying forward general business credits on their personal returns, when the company switches to being a C-Corp, the credits remain with the shareholders. As a result, if the shareholders then decide to sell the C-Corp, those credits cannot be used against built-in gains tax, because this tax will still be calculated and paid at the corporate level. Equally, those credits will not transfer to the new shareholders.
In short, if you’re thinking about changing your company’s entity type in the next few years, consult with a tax professional first. If you are carrying forward any general business credits, they may become unusable or only usable under very specific circumstances. Depending on the amount of the carryforward, the cost of losing the ability to take those credits may outweigh the advantages of changing entity types. A tax professional will be able to help you make the best and most informed decision. iBi
For rules on carrying the R&D credit back or forward, visit irs.gov/pub/irs-pdf/i3800.pdf. Updates for 2012 are available at irs.gov/instructions/i3800.
