Why C Corp Retained Earnings Can Haunt Your S Corp Election—And How To Solve It

Every year, ambitious business owners in California make a critical move: they convert from a C Corporation to an S Corporation, hoping to slash their tax bills. But what most don’t realize is this: the IRS has strict rules about how retained earnings transfer during this switch—and a single misstep can trigger double taxation, surprise penalties, or worse.

If you’ve been told the transition is “just paperwork,” you’re missing out on a key planning opportunity (and risking a nasty IRS audit). Here’s what every founder, real estate investor, and high-net-worth taxpayer should know about the retained earnings C Corp to S Corp challenge—plus step-by-step strategies to keep more of your hard-earned profits.

Quick Answer
C Corp retained earnings at the time of S Corp election don’t just “disappear.” If not handled properly, they become “built-in gains,” potentially leading to double taxation if assets are sold within a 5-year window. Proactive planning, smart distributions, and the right entity guidance can mean the difference between a seamless conversion and a five-figure tax nightmare. (See IRS Instructions for Form 1120-S.)

How Retained Earnings Really Work When You Elect S Corp Status

Before you make an S Corp election, your C Corporation may have accumulated years of retained earnings. Here’s why this matters:

• Corp retained earnings = Profits that weren’t distributed, already taxed at the corporate rate (21% federal, plus California’s 8.84% state rate). These sit in your equity section.
• When you switch to S Corp, those retained earnings don’t convert to tax-free distributions. The IRS tracks them in an “Accumulated Earnings and Profits” (E&P) bucket.
• If you distribute these without a plan, you risk double taxation and throwing off your new S Corp’s tax treatment.

Real Example:
Emily runs a tech startup. Her C Corp has $220,000 in retained earnings built up over five years. If she flips the switch to S Corp without a transition plan, any payout of that $220,000 could be taxed again at Emily’s individual rate, instead of qualifying as a tax-free return of capital.

What If I Don’t Touch the Retained Earnings After Switching?

If you leave the money sitting in the business, you may avoid immediate tax. However, if the S Corp has “C Corp E&P” on its balance sheet, any new distributions from business profits get complicated. First, the IRS says you must distribute “S Corp earnings” before touching old C Corp E&P. Only careful tracking prevents reclassification and IRS fines.

Built-In Gains Tax—The Virgin Trap That Can Cost You Thousands

The number one way business owners get tripped up is with the built-in gains (BIG) tax. The IRS applies a built-in gains tax of 21% (plus state) to any asset appreciation that occurred while the business was a C Corp—if that asset is sold within five years after the S election. This can torch your transition savings if you sell real estate, equipment, or even inventory.

For a step-by-step breakdown on maximizing S Corp tax benefits, see our complete S Corp tax guide.

• If your C Corp owns rental property bought for $400,000, now worth $800,000 and you become an S Corp in 2025, a sale before 2030 means $400K is hit by the BIG tax—potentially erasing your S Corp savings entirely.

Red Flag Alert: Many business brokers and CPAs gloss over this trap. “Just flip to S Corp and start pulling profits at your personal rate!” they say. This advice gets owners audited every year.

How Do I Calculate the Built-In Gains Tax?

Add up all appreciated assets (property, equipment, securities) at the date of election. Any realized gain on sale of these within five years is subject to the BIG tax at 21%. Also, California applies its own version, so the hit can be even bigger for CA-based shareholders.

Distribution Planning: The $40K Difference for W-2 vs Owner-Operators

Individual tax outcomes change based on whether you’re a passive investor, W-2 shareholder, or active operator. Here’s what that looks like in numbers:

• Passive owner: Distributions traced to old C Corp E&P can be taxed up to 37% individually, on top of 21% corporate tax already paid = nearly 50% effective rate.
• Active operator/W-2 shareholder: May qualify for lower effective tax rates on “new” S Corp profits if tracked and distributed correctly.

Example: Daniel, a real estate broker, had his C Corp with $100,000 in retained earnings. After S election, he distributed $60,000. Because $40,000 was new S Corp earnings and $20,000 came from old C Corp E&P, the $20,000 was taxed again. Daniel’s CPA flagged this early, saving $7,700 in avoidable double-taxation by structuring distributions and using IRS ordering rules.

Can I Just Pay Myself a Big Bonus Before Switching?

Yes, but it demands precision. If you bonus out retained earnings (as officer compensation or dividends), you trigger W-2 tax withholdings or double taxation (if as dividends). There are ways to zero out C Corp E&P before conversion, but missteps can draw IRS scrutiny and even risk your S election.

KDA Case Study: VC-Backed Startup Avoids $112K Tax Penalty

Meet “GreenGrid Analytics,” a software company with $950,000 in gross revenue, $280,000 in retained earnings, and two major investors. The founders wanted S Corp flow-through for 2025. Their initial legal team missed the E&P issue—if they’d converted “as is,” any S Corp distribution risked double taxation, and an asset sale of their $360K IP portfolio would trigger the built-in gains tax. KDA’s strategy:

• Ran a detailed C Corp E&P reconciliation, earmassing reserves for accrued corporate liabilities,
• Accelerated bonus payouts to top officers (saving $41,200 in long-term taxes),
• Distributed “safe” post-election profits by IRS priority (S Corp earnings first),
• Delayed sale of IP for 5 years to avoid built-in gains tax,
• Filed all required IRS notices and supporting documentation.

Result: $112,000 in tax was avoided across federal and California returns, with a strategy fee of $12,000 (9.3x ROI, first year).

IRS Paperwork and Documentation—What You Must File

Switching C Corp to S Corp requires more than a simple Form 2553:

• Form 1120-S—used for annual S Corp returns post-election
• C Corp’s final Form 1120, covering activity until election date
• S Corp “E&P Table” and supporting schedules must clearly track old vs new earnings
• Detailed corporate minutes showing approval of distributions and strategy
• For California S Corps: File FTB Form 100 (C Corp final) and FTB 100S (S Corp)

Missing a step—especially in tracking E&P—means the IRS can reclassify years of S Corp distributions, forcing you to pay back taxes, interest, and stiff penalties. A proper entity blueprint prevents this pain.

Pro Tip: Don’t Rely on QuickBooks Alone

Standard accounting software doesn’t automatically track “C Corp E&P” vs “S Corp AAA” (Accumulated Adjustments Account). Ask your tax strategist for a CPA-level tracking sheet that keeps IRS ordering rules visible at a glance—especially if you’re running hybrid business operations post-conversion.

For a comprehensive look at advanced S Corp strategies, review our S Corp Tax Strategy Guide.

What Most Owners Get Wrong About C-to-S Corp (And How to Fix It)

Too many owners assume the IRS “starts fresh” when they switch to S Corp. Wrong. The agency scrutinizes how retained earnings at the switch are tracked and distributed.
Red Flag: Distributing cash from the business without sequencing S Corp E&P vs C Corp E&P triggers higher taxes and possible S Corp revocation. Most brokers and attorneys don’t handle this correctly—always get a CPA with deep S Corp experience involved in your transition.

FAQ: C Corp to S Corp Retained Earnings—Top Reader Questions

How do I know if my C Corp has E&P?

You probably do if:

• Your balance sheet shows “Retained Earnings” positive at the moment of S election
• You’ve never cleaned out prior-year profits through bonuses or dividends
• Your CPA can clarify this in your year-end workpapers

Can I time asset sales to avoid built-in gains tax?

Yes. Wait 5 years post S election before selling appreciated assets held as a C Corp. If possible, distribute cash (not appreciated property) to shareholders during this period to avoid triggering BIG tax.

What happens if I ignore these rules?

The IRS will force you to retroactively pay corporate-level tax on distributions, possibly void your S election, and apply back penalties and interest. For California filers, you’ll also owe the Franchise Tax Board (see FTB 100S for state details).

Your Next Step: S Corp Success Blueprint

Stop gambling with six-figure tax risks. Every C Corp-S Corp transition has unique traps (and major savings). Work with an expert who will design your playbook, track E&Ps, and keep you compliant on both IRS and California state returns.

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

Book Your Entity Transition Tax Strategy Session

If your corporation has accumulated earnings and you’re ready for S Corp status, you cannot afford to get this wrong. Book a deep-dive session with our transition team—we’ll analyze your retained earnings, map out the optimal order of distributions, and prevent double taxation.
Click here to lock in your personalized transition plan.