If you
are considering converting your C corporation to an S corporation, please be sure
that you understand the effects of a built-in gains tax that may apply when
appreciated assets held by the corporation at the time of the conversion are
subsequently disposed of and what we can do to minimize its impact.
Although
an S corporation is normally not subject to tax, where a C corporation converts
to S corporation status the tax law imposes a tax at the highest corporate rate
(35%) on the net built-in gains of the corporation. The idea is to prevent the
use of an S election to escape tax at the corporate level on the appreciation
that occurred while the corporation was a C corporation. This tax is imposed
where the built-in gains are recognized (i.e., the appreciated assets are sold
or otherwise disposed of) during the ten-year period after the S election takes
effect (referred to as the “recognition period”). The tax applies to the lowest
of the following:
(1) the amount that would be the taxable
income of the S corporation for the tax year taking into account only
recognized built-in gains and recognized built-in losses;
(2) the
corporation's taxable income for that tax year; or
(3) the excess of
the net unrealized built-in gain over the net recognized built-in gain for
earlier tax years during the recognition period.
The
tax may apply even if the S corporation does not make any unusual asset
dispositions. For instance, a cash method corporation that collects an account
receivable that accrued during the C corporation period or an accrual method
corporation that disposes of inventory that was acquired during the C
corporation period may be subject to the built-in gains tax.
Any C
corporation net operating losses (which are otherwise not usable in an S
corporation year) are allowed as a deduction against net recognized built-in
gain. Where net recognized built-in gain is not taxed because of the taxable
income limitation ((2) above), the gain is carried forward and may be taxed in
later years.
The
recognized built-in gain is passed through to the shareholders as income, in
addition to being taxed at the corporate level (at a 35% rate). This
unfortunate result is mitigated somewhat by treating the tax as a corporate
loss which passes through to the shareholders.
You
can see how important it is to plan for the impact of the built-in gains tax, since,
at a minimum, it is necessary to establish the amount of built-in gains (and
losses) at the time of the conversion to an S corporation. After the
conversion, one can plan by timing the sale of assets, matching gains and
losses, and so on. But first, the important thing is to value the corporation's
assets and have appraisals, where feasible, of the assets including inventory,
as of the date the S corporation election will take effect in order to ensure
that appreciation that takes place after that date will not be subject to the
built-in gains tax. We can assist you in getting the necessary appraisals, as
well as in identifying any built-in losses that could reduce the effect of the
built-in gain tax.
Our
firm would be happy to assist you with any questions concerning this issue.