Built-in gains tax planning for cash-basis taxpayers.

• Author: Davis, Jon E.

Many personal service corporations (PSCs) on a cash basis are reluctant to switch to S status due to the potential built-in gains tax on the cash-basis receivables. However, there is a tax planning opportunity (in the final regulations under Sec. 1374) that may eliminate, or at least mitigate, the built-in gains tax on the receivables. The final regulations apply to transactions in which the S election occurred on or after Dec. 27, 1994. Under Regs. Sec. 1.1374-1(a), the gain recognized when the cash-basis receivables are collected (which is usually the first S year) can be reduced by "built-in losses" or "built-in deductions." Regs. Sec. 1.1374-4(c) provides that an amount deducted under Sec. 267(a)(2) is recognized as a built-in loss to the extent that (1) all events have occurred that establish the fact that the liability to pay the amount and the exact amount of the liability can be determined as of the beginning of the recognition period, and (2) the amount is paid either in the first 2 1/2 months of the recognition period or is paid to an individual who owns less than 5% of the corporation's stock.

The planning opportunity is to record and document an account payable for bonuses or wages to shareholders who own 50% or less of the corporation's stock and pay the bonus within the first 2 1/2 months of the first S year. The accrual is not deductible in the final C year, since the corporation retains its cash basis. However, when calculating the built-in gains tax, a recognized gain on the receivables can be reduced by the wages paid within the first 2 1/2 months, thus eliminating or reducing the built-in gains tax on the zero-basis receivables. The accrual/built-in loss must be attributable to services performed before the conversion to S status, which should be easy to establish for a PSC.

The legislative history to Sec. 1374 stated:

As an...