Converting a Delaware C-Corp to an S-Corp: Tax Traps to Avoid

Introduction

Many small business owners and tech founders eventually consider converting their Delaware C-Corporation into an S-Corporation to avoid double taxation.
While the conversion can reduce tax liabilities, it also carries several federal and state-level tax traps that must be carefully managed.
This guide explains how to convert a Delaware C-Corp to an S-Corp in 2025, including eligibility requirements, tax implications, and common pitfalls to avoid.

Step 1: Understanding the Difference Between C-Corp and S-Corp

A C-Corporation is taxed separately under IRC §11, meaning the corporation pays taxes on profits and shareholders pay taxes again on dividends.

An S-Corporation, under IRC §1361, is a pass-through entity where profits and losses flow directly to shareholders’ personal returns, avoiding double taxation.

Key differences:

Step 2: Verify Eligibility for S-Corp Election

Before filing the election, ensure your Delaware corporation meets IRS eligibility requirements under IRC §1361(b):

1. Must be a domestic corporation.
2. Must have no more than 100 shareholders.
3. All shareholders must be U.S. citizens or residents.
4. Can have only one class of stock.
5. Cannot be an ineligible corporation such as a bank or insurance company.

If your Delaware C-Corp has foreign investors, preferred stock, or complex equity terms, you must restructure before converting.

Step 3: File Form 2553 with the IRS

To convert to an S-Corp, file Form 2553, Election by a Small Business Corporation, with the IRS.

Timing:

• File within 2 months and 15 days after the start of the tax year you want the election to take effect.
• Late elections may be accepted if you demonstrate reasonable cause under Rev. Proc. 2013-30.

Signatures:
All shareholders must sign the form, confirming their consent to S-Corp status.

Step 4: Understand the Built-In Gains (BIG) Tax Trap

When a C-Corp converts to an S-Corp, the built-in gains tax under IRC §1374 can apply.

This tax occurs if the S-Corp sells appreciated assets that were held during its C-Corp years within five years after conversion.

Example:
A Delaware C-Corp owns software valued at $1 million with a $400,000 cost basis.
If sold within five years after conversion, the $600,000 gain is subject to the 21 percent corporate tax even though the company is now an S-Corp.

Step 5: Adjust for Accumulated Earnings and Profits (AEP)

Any undistributed C-Corp earnings prior to conversion are treated as Accumulated Earnings and Profits (AEP).
If you distribute these funds improperly after conversion, they can be taxed as dividends rather than S-Corp distributions.

Tip:
Pay out C-Corp earnings before filing Form 2553 to avoid dividend treatment later.

Step 6: Handle Passive Investment Income Limits

An S-Corp with AEP and passive investment income exceeding 25 percent of gross receipts for three consecutive years may lose its S-Corp status under IRC §1362(d)(3).

Example:
If your Delaware S-Corp earns more from interest and royalties than from operations for three years, it can automatically revert to C-Corp status.

Step 7: State and Delaware Franchise Tax Considerations

Delaware does not distinguish between C-Corp and S-Corp for franchise tax purposes.
All corporations must file the Delaware Annual Report and pay the annual franchise tax based on authorized shares or assumed par value.

Minimum franchise tax: $175
Maximum: $200,000 (for large authorized share structures)

Even after conversion, your Delaware S-Corp must continue filing annual franchise reports and maintaining good standing.

Step 8: Federal and State Filing Adjustments

After conversion:

1. File a final Form 1120 for the C-Corp up to the date of conversion.
2. File Form 1120-S for the remaining part of the year.
3. Update IRS records, EIN accounts, and payroll systems.
4. Continue paying Delaware franchise tax as usual.

If you operate in other states, file updated state income or franchise tax elections to reflect S-Corp status.

Step 9: Consider Future Investors and QSBS Impact

Converting to an S-Corp disqualifies the stock from QSBS benefits under IRC §1202.
Founders planning to raise venture capital or qualify for the $10 million QSBS exclusion should remain a Delaware C-Corp.

Example:
If your AI startup plans a Series A round, keeping C-Corp status ensures investor compatibility and QSBS eligibility.

Conclusion

Converting a Delaware C-Corp to an S-Corp can reduce taxes for smaller businesses, but the process requires careful planning.
Understanding built-in gains, accumulated earnings, and state franchise tax rules helps you avoid costly mistakes.
Before filing Form 2553, evaluate long-term goals such as fundraising, ownership structure, and QSBS eligibility.

Call to Action

For expert guidance on Delaware C-Corp to S-Corp conversion, tax planning, and compliance, contact Anshul Goyal, CPA EA FCA, a U.S.-licensed Certified Public Accountant, Enrolled Agent authorized to practice before the IRS, and cross-border tax expert helping Delaware businesses manage corporate transitions efficiently.

Disclaimer

This article is for educational purposes only and does not constitute legal or tax advice. Always consult a CPA before converting your Delaware C-Corp or filing Form 2553.

Top 5 FAQs

1. What form is needed to convert a C-Corp to an S-Corp?
   IRS Form 2553.
2. Can a Delaware C-Corp with foreign shareholders convert to an S-Corp?
   No. All shareholders must be U.S. citizens or residents.
3. Does conversion eliminate past C-Corp taxes?
   No. Built-in gains and accumulated earnings still apply.
4. How long does the built-in gains tax period last?
   Five years after conversion.
5. Does Delaware reduce franchise tax after S-Corp election?
   No. Franchise tax applies equally to C-Corps and S-Corps.

About Our CPA

Anshul Goyal, CPA EA FCA is a Certified Public Accountant licensed in the United States, Enrolled Agent admitted to practice before the IRS, and cross-border tax expert assisting Delaware corporations with conversions, tax elections, and state compliance.