A smart tax strategy for S corporations considering C corporation conversion

S corporations may be reevaluating their structure in light of current tax pressures. For those ineligible for the 20% Qualified Business Income (QBI) deduction (i.e., Specified Service Trades or Businesses [SSTBs] like law, accounting, or consulting firms) the idea of converting to a C corporation to benefit from the 21% flat corporate tax rate may be appealing.

However, such a move requires thoughtful planning, especially when it comes to cash flow and preserving tax efficiency. One often-overlooked strategy can help business owners manage this transition wisely: issuing shareholder notes tied to the S corporation’s Accumulated Adjustments Account (AAA) prior to conversion.

Why Now Might Be the Right Time

For S corporations planning to revoke their S election, the tax treatment of any remaining AAA balance is a significant consideration. This previously taxed income can be distributed tax-free to shareholders. But there’s a catch: Once a company becomes a C corporation, that AAA balance typically disappears. The only opportunity to distribute it without triggering additional taxes is during the Post-Termination Transition Period (PTTP)—the first taxable year after conversion.

If the company lacks the liquidity to make these distributions in cash or prefers to preserve capital for growth, this window can feel like a trap. One solution is to issue notes to shareholders equal to the balance before the S election is revoked.

How It Works

Instead of making a large cash distribution, the S corporation issues promissory notes to shareholders equal to the AAA balance. These notes must be treated as bona fide debt, with clear documentation, scheduled repayments, and appropriate interest charges. The benefits include:

• Tax-free treatment ─ Both the issuance and repayment of the notes are tax-free for the shareholders (except for the interest, which is usually taxable as ordinary income).
• Preserved liquidity ─ The company retains capital to fund operations or investments.
• Tax efficiency ─ The C corporation is taxed at the typically more favorable 21% corporate tax rate versus the rate individual S corporation shareholders are subject to (up to 37% at the top rate) for passthrough income. Additionally, interest paid on the notes may be deductible for the corporation after conversion.

An Example

Consider a successful law firm, ABC Corporation, structured as an S corporation. As an SSTB, ABC Corp is ineligible for the 20% QBI deduction so its lone individual shareholder is subject to the full 37% tax rate. With a $10 million AAA balance and big plans for future expansion, the firm wants to convert to a C corporation to benefit from the 21% flat tax rate, but it also wants to avoid depleting cash reserves.

Working with advisors at Elliott Davis, ABC Corp. distributes its AAA balance by issuing five shareholder notes of $2 million each, to be paid out annually over five years. The strategy allows the business to simultaneously:

• Preserve cash for growth over a prolonged 5-year period.
• Maintain tax-free distribution treatment for the AAA balance beyond the 1-year post-conversion PTTP rule.
• Take advantage of the more favorable 21% corporate tax rate.
• Repay the notes on a tax-free basis (apart from interest).

Who Should Consider This?

This strategy is particularly relevant for:

• S corporations with significant AAA balances.
• Companies ineligible for the QBI deduction (e.g., SSTBs).
• Business owners seeking to maintain liquidity without sacrificing tax advantages.

Pre-Conversion Checklist for S Corporations Considering C Corporation Status

Use this checklist to determine if issuing shareholder notes may be a fit for your transition strategy:

Structure and Eligibility

▢ Your business is currently taxed as an S corporation

▢ You are classified as a Specified Service Trade or Business (SSTB) and ineligible for the QBI deduction

▢ You are considering converting to a C corporation to benefit from the 21% flat tax rate

AAA Balance and Distributions

▢ Your S corporation has a substantial AAA (Accumulated Adjustments Account) balance

▢ You do not have the liquidity to make a full cash distribution during the PTTP (Post-Termination Transition Period) OR

▢ You want to preserve cash (e.g. for growth, expansion, or investment needs)

Pro Tip: Don’t wait until the last minute. Timing is important. Plan ahead so you can issue notes before revoking your S election.

We Can Help

Businesses should regularly assess whether their tax structure aligns with their long-term goals. If your S corporation is considering a conversion to a C corporation, issuing shareholder notes prior to the transition could offer an opportunity to balance tax efficiency with capital preservation.

At Elliott Davis, we work closely with business owners to craft tailored solutions that improve financial outcomes—today and for generations to come. If you’re evaluating a C corporation conversion or looking for ways to improve tax efficiency while preserving liquidity, our advisors are here to help. Contact the Elliott Davis team to explore your options.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.