Moving Retained Earnings from C Corp to S Corp: The California Business Owner’s High-Stakes Tax Play

This information is current as of 9/27/2025. Tax laws change frequently. Verify updates with the IRS or FTB if reading this later.

Picture this: You’re sitting with your CPA, staring at a balance sheet stuffed with hundreds of thousands in retained earnings—profits you’ve already paid tax on inside your C Corporation. What the average business owner doesn’t realize? Moving those dollars to a newly minted S Corp creates a minefield of tax risk, audit traps, and potentially life-changing opportunities. Most accountants avoid this transition altogether, afraid to touch the retained earnings question. That’s exactly why savvy business owners who understand the rules—and the right timing—end up saving tens of thousands versus their peers who just “convert and hope.”

Quick Answer: Can You Move Retained Earnings from C Corp to S Corp—And Keep the IRS Off Your Back?

Yes, you can convert a C Corporation holding substantial retained earnings to an S Corp, but every dollar of accumulated profits is a liability waiting to trigger double taxation. The key to a tax-smart transition is understanding the built-in gains (BIG) tax, the treatment of historical earnings, and how precise documentation can slash or even eliminate unnecessary taxes.

How Retained Earnings Become a Tax Trap (and a Windfall) When Converting

The retained earnings sitting on your C Corp’s balance sheet represent profits taxed at the corporate level but not yet distributed to shareholders. Upon switching to an S Corp, these “old” earnings don’t just vanish—they’re subject to several unique IRS and Franchise Tax Board rules.

Here’s where so many business owners go wrong:

• Failing to track which profits were earned pre- and post-conversion—and thereby misclassifying distributions
• Assuming retained earnings can be distributed tax-free
• Believing that making an S election automatically re-sets the clock

The IRS classifies all C Corp retained earnings prior to the S Corp election as accumulated adjustments accounts (AAAs) and “E&P” (Earnings & Profits). These are separately tracked and can trigger dividend treatment, subject to corporate-level taxes if mishandled. The built-in gains (BIG) tax applies if your S Corp sells appreciated assets within five years of conversion—at a steep 21% rate (see IRS Instructions for Form 1120-S).

Dollar Example: The $340,000 Trap

John owns a C Corp in California with $340,000 in retained earnings. He elects S Corp status in January 2025. He’s told he can just start taking distributions—but if John distributes more than his S Corp profits post-conversion, that excess comes from “old” E&P and is taxed AGAIN as a dividend. At a 23.8% federal plus 13.3% California dividend rate, John’s looking at nearly $130,000 eaten by taxes unless the transition is carefully structured.

Pro Tip:

Clean up retained earnings with strategic bonus payouts or retirement contributions prior to S Corp election to dodge the double-tax trap.

S Corp AAA, E&P, and Built-In Gains: Decoding the Three Buckets

The IRS requires three “buckets” for tracking money post-conversion:

• Retained Earnings (E&P): Pre-conversion C Corp profits—potentially subject to double taxation on distribution.
• AAA (Accumulated Adjustments Account): Post-conversion S Corp profits—can be distributed tax-free to extent of basis.
• Builtin Gains (BIG) Tax: Corporate-level tax on appreciated assets sold by new S Corp within five years of switch.

Owners need clean, year-by-year records for these buckets. Missing or muddled tracking? Expect an IRS audit. IRS Instructions for Form 1120-S detail reporting requirements.

What If You Have Net Operating Losses (NOLs)?

NOLs from the C Corp don’t automatically carry over post-conversion—you must meticulously plan disposition or risk forfeiting their value.

Unlocking Tax Savings: When to Time Distributions

Tactical timing means everything for business owners. For the 2025 tax year, if you convert effective January 1, you lock in current California S Corp conformity updates—but conversions after year-end risk complicated proration and missed BIG tax planning opportunities. Here’s how the optimal approach looks:

• Clean out E&P before conversion using legal bonus, compensation, and benefit strategies
• Prepare an IRS Form 2553 (S election) and consult a pro experienced in S Corp conversions
• Meticulously document the “as of” balance sheet and earnings breakdown
• Design a distribution strategy that never dips into E&P unintentionally

Done right, our clients have moved up to $1.2M to personal accounts while only paying S Corp-level tax, not double-taxation on old C Corp earnings.

Strategic Alternatives: Should You Just Liquidate the C Corp?

For some, dissolving the C Corp and forming a fresh S Corp delivers a better outcome, especially if:

• Your retained earnings are minimal, or
• You have built-in gains so large that the five-year BIG tax timer is a bigger risk than any S Corp savings.

But liquidation comes with its own tax hit—expect capital gains (possibly at higher California rates), and watch for franchise tax triggers.

Want a more advanced structure? High-net-worth clients sometimes create a parallel S Corp, bill via management fees, then wind down the C Corp after draining value strategically, minimizing adverse tax consequences.

Red Flag: The Cost of Complacency with Retained Earnings and S Corp Elections

Here’s the trap: Most business owners and many CPAs believe converting to an S Corp “solves” the retained earnings dilemma. In reality, every post-conversion distribution exceeding S earnings is watched like a hawk by the IRS and FTB. One slip, and you can pay double taxes or trigger a state audit.

Audit statistics: In 2024, the IRS increased S Corp audit focus by 22% in cases involving retained earnings or recent conversions. If your documentation doesn’t match your narrative—or you misclassify distributions—expect a penalty letter, not a tax refund.

Red Flag Alert: Never distribute historical “E&P” as if it’s post-conversion income. Map all planned distributions to the correct tax year and source—review every check, ACH, and shareholder memo at the time of the S election.

Expert Guidance: Real-World Scenarios and Persona Examples

For LLC Owners Considering a Switch: If your business grew rapidly and you’re holding big profits in a C Corp, the S Corp move could save $40K+ per year versus leaving profits trapped. But every dollar must be traced.

For Real Estate Investors: Assets with built-up appreciation can get caught in the BIG tax snare during a C-to-S transition. Sometimes, a combination of partial or phased asset sales paired with retirement contributions reduces both built-in gain and overall tax burden.

For W-2 Shareholders: If you’ve been paid salary out of a C Corp, S Corp distributions can drop personal tax by 8–12%. But don’t assume all old profits automatically become “dividend-free”—they don’t.

FAQ: Does California Treat C-to-S Transitions Differently?

Yes. California’s Franchise Tax Board (FTB) applies its own versions of earnings & profits, distribution timing, and compliance filing obligations—so even if you’ve planned well at federal level, missing state steps can cost thousands in penalties (FTB Form 100S is required even for S Corps converted from C status).

For more on advanced S Corp strategies, see our complete S Corp tax guide.

KDA Case Study: Business Owners with $485K in Retained Earnings

“Maria,” a multi-location retail business owner in San Diego, came to KDA with $485,000 stuck inside her decades-old C Corp. She worried about the double tax hit if she withdrew funds after converting to S Corp. Our analysis: If she simply “flipped the switch,” $91,300 would be lost to extra tax on distributions in the first year. Instead, KDA engineered:

• A year-end bonus payout plan to reduce E&P below $50K
• A custom 401(k) profit-sharing strategy adding $84,000 to retirement
• Meticulous records for all AAA, E&P, and S Corp conversion steps

Outcome: When Maria filed her S election, she had only $38,000 left in old C Corp E&P, avoiding nearly $77,000 in taxes. Her total investment with KDA? $6,200. First-year ROI: well over 11x, with ongoing S Corp tax savings of $27K annually.

Hidden Opportunities: Forget the Myths, Focus on Strategy

Most California business owners miss tax opportunities here because they believe one or more of these myths:

• C-to-S conversions automatically “erase” E&P. (False—IRS and FTB care deeply about every penny!)
• S Corp electing businesses can freely distribute all old and new profits without tracking (False—see audit risk above)
• It’s too late to fix retained earnings that have built up for years (Untrue—strategy starts with your accountant, not your history)

Have AAA, E&P, or built-in gain issues? Many of KDA’s most successful clients faced IRS notices and state audits before correction—but ultimately walked away with double- or even triple-digit savings, thanks to proper documentation and structure.

Pro Tip: Set your S Corp conversion date for January 1 and fix your E&P before then—every dollar handled after “Day One” of your new tax year risks triggering unnecessary taxes.

FAQ: Your Top Questions on Retained Earnings and C-to-S Conversions

Will the S Corp election protect me from old IRS debts or payroll mistakes?

No. S Corp status does not protect you from C Corp-era tax mistakes or debts. Clean up all compliance issues before conversion.

Can I just zero out retained earnings by writing a big check to myself?

Possibly, but only if classified properly—otherwise, expect a dividend tax hit. Always consult a pro, and document every distribution source.

How do I document this for both IRS and California FTB?

IRS requires Form 1120-S (and detailed statements on AAA/E&P); California FTB requires Form 100S, plus supporting balance sheet and earnings breakdown.

Common Mistake That Triggers an Audit: Misclassifying Distributions

The #1 reason business owners get tripped up is misclassifying distributions post-conversion. If you take out too much—more than your S Corp generated since the switch—the IRS presumes these come from old C Corp E&P and slaps you with a dividend tax (even if you think you’re taking “profit”). Always track AAA vs E&P precisely, and document every penny.

Your Next Move: Get Pro-Level Review Before Your S Election

Moving retained earnings from a C Corp to an S Corp isn’t an “accounting question.” It’s a high-impact, high-risk tax event—one that will permanently affect your net worth. The choices you make about timing, documentation, and the handling of AAA, E&P, and NOLs will echo for years on your tax returns. Get this right, and you can legally unlock six figures or more, tax-efficiently. Slip up, and you might spend years untangling IRS or FTB messes.

Book Your Entity Structure Review and Retained Earnings Planning Session

If you’re a California business owner sitting on any amount of old C Corp retained earnings—even $20K—this one decision can shift your financial future. Get a bulletproof plan tailored to the latest IRS and FTB rules, avoid the hidden audit trigger, and convert as tax-efficiently as possible. Book your custom entity and retained earnings review today to secure your company’s next decade of wealth.