Taxation is an area that most practitioners find intimidating because of the intricacies of the Internal Revenue Code, Treasury Regulations, and the technical jargon used to describe transactions and situations. While taxation is undoubtedly complex, it is important for an attorney to understand the fundamental concepts that can affect a corporate client.
Over the years, the Subchapter “S” Corporation (“S Corporation”) has played an important role in choice of formation for a business. However, if the S Corporation has had any history as a “C” corporation (“C Corporation”), a concept known as the built-in gains tax may surface. This article will briefly explain the important aspects of S Corporations and offer an overview of the associated built-in gains tax.
Overview of “S” Status
To understand the implications of the built-in gains tax, it is important to have some familiarity with “S” status. An S Corporation is essentially a C Corporation that elects “S” status.1 Electing “S” status combines the formal structure of a corporation under state law with a tax regime similar to that of a partnership or limited liability company. Thus, income, deductions and tax credits “pass through” to the shareholders of the S Corporation as opposed to being taxed at the entity level, creating only one level of tax for the shareholders.2
To be eligible for “S” status, the entity must meet some basic requirements. The electing entity must be a domestic corporation with only one class of stock.3 Additionally, the entity cannot have more than 100 shareholders.4 These shareholders must also be natural persons5 and US citizens or residents.6 Lastly, the IRC excludes insurance companies, financial institutions, and domestic international sales corporations from electing “S” status.7
Major Differences Between S Corporations and C Corporations
S Corporations differ from C Corporations, particularly with respect to the entity-level tax. The C Corporation will pay tax on income it generates, then, when the business distributes cash or property to its shareholders, the shareholders will also pay tax on the receipt of that cash or property. Since an S Corporation is a “pass through” entity, one layer of that “double tax” is removed. Accordingly, the shareholders of the S Corporation will only have to pay tax on the “passed through” income.8 Each shareholder will report the income based on his or her pro rata share of ownership.9
Another major difference is the treatment of distributions made to the shareholders. Cash distributions made by a C Corporation, are normally taxable.10 In this regard, C Corporations have limited flexibility in distributing cash to shareholders, which promotes shareholders to distribute cash through other means. For example, the owners of a C Corporation may be motivated to classify cash distributions as rent, salary or interest. While this strategy may be successful, the IRS scrutinizes these “distributions” and may classify them as taxable.
Conversely, an S Corporation provides a more flexible approach to distributing cash to its shareholders because cash distributions are generally not taxable.11 Furthermore, when a C Corporation distributes appreciated property to its shareholders, the IRC treats this distribution as if the corporation sold the property to its shareholders for the property’s then fair market value.12 This type of transaction results in taxable income for the corporation and the shareholders. An S Corporation, however, is generally not taxed on such a transaction.13
The Built-In Gains Tax
Hypothetically, if a C Corporation converts its status to an S Corporation, it may avoid immediate tax consequences. In that case, all C Corporations should convert if the shareholders are willing to relinquish C Corporation status to avoid the entity-level tax. However, the built-in gains tax prohibits such gamesmanship.14 The built-in gains tax was enacted by the 1986 Congress as part of the overhaul to the IRC. Since S Corporations are not taxed on the distribution of appreciated assets,15 Congress was concerned that some C Corporations would convert to S Corporations, circumventing a layer of double tax in distributing assets. Under URC § 1374, an S Corporation that was formerly a C Corporation is subject to an entity-level income tax, at the highest C Corporation tax rate,16 on disposition of appreciated assets.17 Notably, the tax will only result on the pre-conversion gain lurking in assets.
The threat of the built-in gains tax is not interminable because it only applies to the 10-year period starting from the date of conversion, known as the “recognition period.”18 In recent years, Congress reduced the recognition period for the built-in gains tax.19 This shortened recognition period is set to expire at the end of 2013 if Congress takes no action.
As an example of how the built-in gains tax applies, suppose that XYZ, Inc., holds an asset that has a value of $10,000 and a basis of $5,000 and converts from a C Corporation to an S Corporation in Year 1. In Year 3, XYZ, Inc. sells that asset for its then fair market value of $15,000. There is a total gain of $10,000 resulting from the sale of the asset; however, part of that gain, $5,000, is considered built-in gain because it is the excess of the fair market value over the basis at the time of conversion. Assuming that the highest corporate tax rate is 35%, XYZ, Inc. shareholders will pay $1,750 in built-in gains tax on the sale of the asset. The calculation for determination of built-in gains can be quite complex. The applicable Treasury Regulations provide a rigorous formula for determining built-in gains. The goal of this calculation is to determine the net tax consequences to the corporation in a hypothetical liquidating sale of the entire business.20
Navigating the Built-In Gains Tax
One significant issue that arises with conversion is the appraisal of the business’ assets. A higher fair market value at the time of conversion risks greater potential for built-in gains to arise. To reduce the tax liability associated with conversion, it is imperative to obtain a proper appraisal of the assets at the beginning of the recognition period.
Proper appraisal will ensure that the IRS cannot dispute amounts relating to the appreciation of assets and increase the built-in tax gains tax. The onus is on the taxpayer to establish that a portion of the gain on the sale constitutes post-conversion appreciation.21 To achieve a proper appraisal, the appraiser should possess the relevant qualifications for valuing assets in similar businesses and should also be familiar with the IRC and the Treasury Regulations. This will ensure that the IRS has little room to dispute pre-conversion fair market value. Another issue that emerges in the conversion is the sale of inventories. Surprisingly, the built-in gains tax applies to the sale of inventory during the recognition period.22 Since the built-in gains tax may apply to individual sales of products during the recognition period, day-to-day operations may trigger the built-in gains tax.
This can create a serious problem for an S Corporation not utilizing the “last in-first out,” or LIFO, inventory system. Generally, if the S Corporation does not use LIFO, the corporation will be required to treat the inventory items on hand at the beginning of the recognition period as the first items sold during the recognition period. This means that if inventories generally turn over at least once each year, the gain lurking in inventory may be subject to the built-in gains tax.23 Yet another important concern that arises in the conversion is the use of favorable tax attributes. Throughout its lifespan, a C Corporation may accumulate a number of tax attributes that can be carried forward or back to lower its tax liability. These tax attributes include net operating losses, excess charitable contributions or certain tax credits.
However, an S Corporation generally cannot carry forward or back favorable tax attributes.24 This is contrary to the underlying policy of the built-in gains tax, which is to treat the S Corporation as if it remained a C Corporation. To reconcile this disparity, the IRC allows an S Corporation to use some of those favorable tax attributes obtained as a C Corporation to reduce the built-in gains tax.25 However, it is important to note that the IRC does not permit full use of all favorable tax attributes, such as excess charitable contributions.26 Practitioners advising a converted S Corporation should be fully aware of the favorable tax attributes that may reduce potential built-in gains tax.
The conversion to an S Corporation may seem simple from a mechanical standpoint, but the built-in gain lurking in the corporation’s assets may complicate matters and subject the S Corporation to an additional tax. Attorneys representing business owners wishing to convert or that have converted in the past should take care in planning dispositions of assets to minimize the potential for built-in gains tax.
Jon H. Ruiss, Jr. is an associate at Ruskin Moscou Faltischek, PC, in Uniondale, and is also a Certified Public Accountant.
1. See IRC 1362(a).
2. See IRC § 1366.
3. IRC § 1361(b).
4. IRC § 1361(b)(1)(A).
5. IRC § 1361(b)(1)(B). See IRC § 1361(c)(1)(A), (B) for exceptions.
6. IRC § 1361(b)(1)(C).
7. IRC § 1361(b)(2).
8. See IRC § 1363.
9. See IRC § 1366(a)(1).
10. See IRC § 301 et. seq.
11. Some distributions to S Corporation shareholders may be taxable. See generally IRC § 1368 and Treas. Reg § 1.368-3.
12. IRC § 301(b)(1).
13. See IRC § 1368.
14. See IRC § 1374.
15. See discussion, supra.
16. IRC § 11(b).
17. IRC § 1374(d)(7)(A).
18. IRC § 1374.
19. See American Recovery and Reinvestment Act of 2009, Pub. L. No. 111–5, 123 Stat. 115 (2009), and Small Business Jobs Act of 2010, Pub. L. No. 111–240, 124 Stat. 2504 (2010).
20. IRC § 1374(b. See also Treas. Reg. §§ 1.1374-1 & 1.1374-2.
21. IRC § 1374(d)(3).
22. Treas. Reg. § 1.1374-7(a).
23. See Treas. Reg. § 1.1374-7(b).
24. IRC § 1371(b)(1).
25. IRC § 1374(b)(2), (3).
26. See IRC § 170(d)(2).
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