Built-in Gains Within the Context of S Corporations
| Publication year | 2011 |
| Pages | 81 |
2011, July, Pg. 81. Built-in Gains Within the Context of S Corporations
July 2011
Vol. 40, No. 7 [Page 81]
Tax Law
Tax Law articles are sponsoredby the CBA Taxation Law Section to provide timely updates and practical advice on federal, state, and local tax matters of interest to Colorado practitioners.
Coordinating Editors
Adam Cohen, Denver, of Holland and Hart LLP-(303) 295-8000, acohen@hollandhart.com; Steven Weiser, Denver, of Foster Graham Milstein and Calisher, LLP-(303) 333-9810, sweiser@fostergraham.com
About the Author
Eric J. Zinn concentrates on the practice of tax law at the Denver law firm of Krendl Krendl Sachnoff and Way Professional Corporation-ejz@krendl.com.
This article discusses the application of the built-in gains tax under Internal Revenue Code § 1374. In particular, the article provides an overview of the policies underlying and the mechanics of § 1374, recent legislative amendments to that section, and a tax planning opportunity available under that section for the year 2011.
Sections 1361 through 1379 of the Internal Revenue Code of 1986, as amended (Code), comprise "Subchapter S" and govern the taxation of S corporations and their shareholders. S corporations generally do not pay income taxes; instead, the S corporation's shareholders pay the income taxes associated with their respective pro rata shares of the corporation's net income.(fn1) In addition, the S corporation's shareholders reflect on their individual tax returns their respective pro rata shares of the S corporation's net losses and deductions.(fn2) Thus, S corporations, like partnerships, generally are "flow-through" entities for income tax purposes.(fn3)
Although S corporations and partnerships typically are both flow-through tax entities, substantial differences exist between them. These differences make consideration of the choice of entity through which the entity's equity owners will conduct future business-either in the form of an S corporation or in the form of an entity taxed as a partnership-a very important decision for those owners.(fn4)
For example, a primary difference between an S corporation and a partnership is that an S corporation must affirmatively elect its flow-through statusby filing an S corporation election form with the Internal Revenue Service (IRS).(fn5) A partnership has its flow-through statusby default under the check-the-box regulations.(fn6) Furthermore, the character and number of shareholders in an S corporation are restricted. S corporations facially can have no more than 100 shareholders, and those shareholders must be either individuals who are not nonresident aliens or certain trusts, estates, and tax-exempt entities.(fn7) There are no restrictions on the number or character of partners that can be equity owners in a partnership.
Additionally, in certain instances, S corporations are subject to a separate income tax, paying tax in the same manner as a C corporation. Those taxes on an S corporation are an excessive passive investment income tax described at Code § 1375; a "LIFO" recapture tax described at Code § 1363(d); and a tax on certain "built-in" gains (built-in gains tax) of the S corporation described at Code § 1374.
This article focuses on the latter built-in gains tax. In this regard, the article provides an overview of the policies underlying § 1374, as well as its mechanics, recent legislative amendments, and a tax planning opportunity available for 2011.
Calculation of Built-in Gains Tax-§ 1374(b)
Code § 1374 imposes a corporate-level income tax on certain built-in gains recognizedby an S corporation. In particular, § 1374(a) states:
If for any taxable year beginning in the recognition period an S corporation has a net recognized built-in gain, there is hereby imposed a tax (computed under [§ 1374](b)) on the income of such corporation for such taxable year.
Under § 1374(b), the corporate-level income tax generally is equal to the highest corporate income tax rate (currently 35%) multipliedby the amount of net recognized built-in gain (NRBIG) triggeredby the S corporation during its taxable year.(fn8) In the event that the S corporation has a net operating loss carryforward from a previous year when it was a C corporation, the S corporation may reduce (but not below zero) the amount of its NRBIGby the amount of its carryforward to determine its gain that is subject to tax.(fn9) Moreover, if the S corporation has a business credit carryforward from a previous year when it was a C corporation, the S corporation may reduce (but not below zero) its income tax liabilityby the amount of that credit carryforward.(fn10) The following illustrates the application of these general rules.
Example 1
Assume that Corp, currently an S corporation, was once a C corporation. Immediately before making its S election, Corp had a net operating loss carryforward of $20 and a business credit carryforward of $5. In the current year (in which Corp is an S corporation), Corp generates $120 in NRBIG.
To determine the income tax amount it owes on its NRBIG under § 1374(b), Corp first will reduce the amount of its NRBIGby the amount of its net operating loss carryforward.(fn11) In this instance, that reduced taxable income amount equals $100 ($120 - $20). The initial corporate income tax amount owing on this $100 sum is $35 ($100 andtimes; .35).(fn12) Nevertheless, Corp's final income tax liability equals $30, which is the difference between Corp's $35 initial tax liability and its $5 business credit carryforward.(fn13)
The Policy Underlying the Built-in Gains Tax-§ 1374(c)(1)
Section 1374(c)(1) generally provides that the built-in gains tax is not applicable to any corporation that had an S election in effect for each of its taxable years-that is, where the corporation has been an S corporation from its inception.(fn1)4 This provision underlies the policy behind the enactment of the built-in gains tax.
The tax was designed to prevent C corporations from converting to S corporations before recognizing built-in gains so as to avoid a layer of tax on the gains that accrued on the corporation's assets while it was a C corporation.(fn15) For instance, when a C corporation recognizes a gain from the sale of an asset, that gain is subject to two layers of tax. The corporation itself first pays tax on the gain at ordinary income tax rates, and that gain then is taxed again when the proceeds from the gain are distributed to the C corporation's shareholders in the form of a dividend.(fn16) The following illustrates this double layer of tax.
Example 2
Assume Corp, a C corporation, holds Asset A, which has a basis of $10 and a fair market value of $20. In Corp's hands, Asset A is a capital asset described in § 1221 that Corp has held for more than one year.(fn17) Corp sells Asset A for $20 cash and then distributes the after-tax proceeds to Individual, its sole shareholder. Before the asset sale, Corp has accumulated earnings and profits (EandP) of $30.
When Corp sells Asset A, it generates a $10 long-term capital gain ($20 amount realized - $10 adjusted basis).(fn18) This $10 gain generates a $3.50 tax liability for Corp (assuming a flat 35% corporate tax rate) and increases Corp's EandP. Corp distributes the remaining $16.50 in cash ($20 cash - $3.50 income tax) to Individual. Because Corp has EandP in excess of the cash distribution to Individual, the entire cash distribution is taxed as a dividend to Individual.(fn19) Assuming a flat 35% rate of tax on dividends receivedby individuals, Individual will pay $5.78 in income taxes on the $16.50 distribution.(fn20) In this instance, Corp's $20 of cash proceeds are reduced by $9.28 in total tax payments. In this regard, it is interesting to contrast the tax results in Example #2 with the tax results that would accrue in the event that Corp had been an S corporation from its inception and at the time of Asset A's sale.
Example 3
Assume Corp, an S corporation, holds Asset A, which has a basis of $10 and a fair market value of $20. In Corp's hands, Asset A is a capital asset described in § 1221 that Corp has held for more than one year. Corp sells Asset A for $20 cash and then distributes the proceeds to its sole shareholder, Individual. As an S corporation from its inception, Corp has no EandP. Individual has an outside basis in his stock in Corp of $30 before the sale of Asset A.(fn21)
When Corp sells Asset A, it generates a $10 long-term capital gain ($20 amount realized - $10 adjusted basis).(fn22) Corp pays no tax on this gain; instead, the gain is taxed as a long-term capital gain to Individual.(fn23) Individual pays $1.50 of federal income tax on this gain.(fn24) Individual's outside basis in his Corp stock increases to $40 because of the gain.(fn25) On receiving the $20 cash distribution from Corp, Individual recognizes no additional income, and his stock basis decreases to $20.(fn26) In this instance, Corp's $20 of cash proceeds are reducedby $1.50 of total tax payments.
The above differences in tax and net distributable cash proceeds clearly illustrates the motivation underlying a C corporation's desire to convert to S corporation status before triggering gains from the sale or exchange of its assets. As a point of illustration, however, it is interesting to consider the tax consequences associated with a C corporation's conversion to a partnership, another tax flow-through entity.
Treas. Reg. § 301.7701-3(g)(1)(ii) provides that when a corporation converts to partnership status, the corporation is deemed to distribute all of its assets and liabilities to its shareholders in liquidation; immediately thereafter, the shareholders are deemed to contribute all of the distributed assets and...
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