Converting S Corp to C Corp: The Unseen Tax Trap That Surprises High-Earning California Owners
Most business owners believe an S Corp is always the best tax shelter for California’s high earners—until a single shift in revenue, liability need, or growth plan forces a drastic rethink. If you don’t understand the consequences of switching your S Corp to a C Corp, one tax mistake can wipe out years of savings (and flag you for an audit).
For the 2025 tax year, more S Corporations than ever are considering a conversion to C Corp status to attract investors or protect from liability. But is it the right move for your growing business or real estate portfolio? Let’s cut through the fog: we’ll show you how the switch really works, who benefits (and who gets burned), the step-by-step risks, plus real scenarios for every owner type. If you’re thinking about converting your S Corp to a C Corp, this is essential reading—even for experienced LLC and HNW taxpayers.
Your Quick Answer: What Really Happens When You Convert an S Corp to a C Corp?
Switching from S Corporation to C Corporation means you’ll pay corporate income tax directly at the entity level, lose the pass-through taxation benefits, and face potential double taxation on dividends. The upside: easier VC or outside investor access, more flexible equity, and no S Corp shareholder caps. The downside: shareholders may face higher total tax, complex compliance, and potential for costly built-in gains tax (see IRS S Corp termination instructions for details).
When an S Corp Conversion Makes (and Breaks) Owners in 2025
Most S Corp owners consider a switch when planning to raise new capital, offer preferred shares, or restructure for a major exit—but this move isn’t always about growth.
- Scenario 1: Startup Founder— Wants to attract institutional investors who require C Corp structure for easier equity.
- Scenario 2: High-Net-Worth Real Estate Investor— Needs advanced liability protection and succession planning beyond S Corp capabilities.
- Scenario 3: Multi-Member LLC— Outgrew S Corp limits (100 shareholders, single class of stock) and wants flexibility for new investors or eventual IPO.
For example, “James,” an S Corp owner in San Jose, posted $760,000 in profits in 2024. He’s considering a conversion to C Corp because he wants to issue new share classes for investors. If he moves forward:
- Profits up to $760,000 are now taxed at the federal corporate rate: 21% (plus California’s 8.84%)
- Distributions to shareholders are taxed a second time on their personal return (qualified dividends: up to 20% plus 3.8% NIIT)
- James could owe over $160,000 more in total taxes versus leaving as an S Corp in that transition year alone
Key takeaway: The switch can unlock new capital and limited liability—but only after careful, scenario-specific modeling.
KDA Case Study: Tech Entrepreneur Faces the S Corp to C Corp Dilemma
Marissa is a San Diego-based tech founder who owned 100% of her S Corp for five years, posting consistent profits over $400,000. In 2024, she received her first $1M VC term sheet. The investor insisted on a Delaware C Corp structure with multiple share classes and options. Marissa’s options:
- Remain an S Corp and risk losing the investor
- Convert to C Corp, triggering potential built-in gains tax and future double taxation
KDA mapped her exit scenario. Marissa’s S Corp had $350,000 of appreciated business assets. If she converted, IRS Publication 542 triggers a built-in gains tax if she sells within five years—costing her over $77,000 in extra tax if an exit came quickly. However, KDA helped her structure a tax-deferred asset sale to the new C Corp, stagger compensation, and build a plan for preferred and common stock that minimized double taxation. Result: She landed the investor, kept $53,000 in her pocket versus the “plain vanilla” conversion, and paid a $10,000 flat fee for the advanced blueprint.
Ready to see how we can help you? Explore more success stories on our case studies page to discover proven strategies that have saved our clients thousands in taxes.
Step-by-Step: How to Convert an S Corp to a C Corp (and Dodge Traps)
- Board Approval: Get directors/shareholders to approve the switch (document minutes—required by IRS and California FTB).
- File the Termination: Revoke S election by sending a signed statement to IRS Service Center (see IRS S Corp termination guide). Notify the California Franchise Tax Board.
- Check Your Timing: Changes filed by March 15 are retroactive to January 1, else effective next tax year.
- Assess Built-In Gains: Calculate asset appreciation. Built-in gains (BIG) tax is triggered if assets are sold within five years post-conversion. IRS Publication 542 and California FTB Publication 1060 lay out the specifics (FTB Pub 1060).
- Prepare Your New Tax Returns: Going forward, file Form 1120 for your C Corp—not 1120S. Prepare for different compliance, audit risk, and penalty schedules.
Pro Tip: Before pulling the trigger, have your CPA model at least three scenarios: keep as S Corp, convert to C Corp, and sell to a new C Corp entity. For a complete breakdown of S Corp strategies, see our comprehensive S Corp tax guide.
Hidden Tax Costs in S Corp to C Corp Conversions
What the IRS won’t tell you: The timing and structure of your conversion can create “phantom” tax events that most owners (and even many accountants) miss. These include:
- Triggering built-in gains taxes on appreciated assets
- Losing losses carried forward under S Corp status
- Start of double taxation on future profits
- Penalties for mishandling share classes or investor eligibility post-conversion
For high-income businesses or real estate entities that sit on large unrealized gains, this step can mean a six-figure surprise tax bill even if you don’t make a big sale. Most owners get burned because they:
- Misjudge timing (file too late or without enough documentation)
- Fail to model the transition year’s combined S and C taxes (exposing profits to overlapping liabilities)
- Don’t account for state-level traps (California adds up to 13.3% on top of federal taxes for some C Corps)
Red Flag Alert: Most Business Owners Underestimate Double Taxation—Here’s How That Really Looks
Business owners expect only “slightly higher” taxes post-conversion. Here’s reality: if your C Corp earns $500,000 in profit, you’ll pay 21% federal and 8.84% California corporate rates at the entity level. The remainder—about $350,800—can then be distributed as dividends. Those dividends could face up to 23.8% combined capital gains and NIIT for shareholders, shrinking after-tax proceeds to about $267,200. That’s over $232,000 in combined entity and personal taxes—a far cry from an S Corp’s single-layer pass-through. See IRS Publication 542 for reference.
Pro Tip: Dividends the C Corp pays to non-resident shareholders can also trigger additional California withholding requirements. Don’t forget to check your state residency status and reporting rules.
What If You Want to Undo the Conversion? Is It Possible?
Once you revoke S status and operate as a C Corp, it’s tricky—but not impossible—to “re-elect” S Corp treatment. After a five-year waiting period, a C Corp can make a new S Corp election (details here). But:
- You’ll still owe built-in gains tax on appreciated assets from the prior conversion
- You may face audit scrutiny for “flip-flopping” entities to dodge tax liabilities
- There are complex eligibility and timing rules—speak with a CPA who’s handled reversals before
Pro Tip: If you’re unsure, don’t wait until you’ve already filed the paperwork. Modeling the outcomes of S Corp vs. C Corp with year-by-year projections will save you $20,000 or more in wasted taxes and compliance fees—especially in California.
Frequently Asked Questions for S Corp to C Corp Switchers
How do I know if built-in gains tax applies to my S Corp assets?
If you have appreciated assets (such as real estate or equipment) and switch to a C Corp, you’re exposed to built-in gains tax on those assets if sold within five years. The tax is calculated on the difference between the fair market value on the conversion date and the adjusted basis. Reference: IRS About Publication 542.
Can a real estate LLC use this strategy?
Yes, but with extreme caution. Rental property LLCs can restructure as an S Corp and later convert to C Corp, but must account for California’s Franchise Tax, loss limitations, and transfer tax risk. See FTB Publication 1060.
Will converting to a C Corp trigger an IRS or FTB audit?
Conversions do increase audit risk, especially if there’s large asset appreciation or a sudden change in shareholder base. Good documentation, advance modeling, and use of an experienced CPA is key to audit-proofing your move.
What are the compliance pitfalls after switching?
C Corps require stricter payroll, formal board meetings, different tax filings (Form 1120), and may owe estimated taxes quarterly to both IRS and FTB. Missing these requirements results in costly penalties—see IRS Form 1120 instructions and FTB 100 Booklet.
The IRS Isn’t Hiding These S Corp Conversion Traps—You Just Weren’t Taught How to Spot Them
The biggest risk isn’t the paperwork—it’s not seeing how this move impacts years of future profits. Only a custom analysis based on your real-world figures (and goals) tells you if the switch is worth it. If you want to raise capital, restructure for a sale, or just feel uncertain about making the leap, get side-by-side projections and IRS compliance help before you pull the trigger. Most owners regret waiting until after the fact.
This information is current as of 10/7/2025. Tax laws change frequently. Verify updates with the IRS or FTB if reading this later.
Book Your Tax Conversion Strategy Session Now
Thinking about converting your S Corp? Don’t risk a hidden tax bill or FTB audit—book a 1-on-1 session with our senior team to model all scenarios before making the move. We’ll show you if, when, and how to switch (or stay put) so you keep more of your profit. Start your conversion strategy session now.
