Increased opportunities for sec. 338(h) (10) elections.

• Author: Hesse, Christopher W.

President Barack Obama signed the Small Business Jobs Act of 2010 (1) on September 27, 2010. Section 2014(b) of the act changes the S corporation built-in gains (BIG) tax for tax years (and only for tax years) beginning in 2011. The act does not change the BIG recognition period from 10 years. Instead, Sec. 1374(d) (7)(B)(ii) merely states that no tax is imposed on the net unrecognized built-in gain of an S corporation if the fifth year in the recognition period precedes the 2011 tax year.

According to the committee report, the five-year period refers to the five calendar years from the first day of the first tax year for which the corporation was an S corporation. (2) For example, for corporations electing S status effective January 1, 2006, or earlier, no Sec. 1374 BIG tax will be assessed on gains from the sales of assets that contain unrecognized built-in gain at the election date. (This assumes that the S corporation in question did not receive assets from another C or S corporation through merger or other tax-free transaction after the election date.)

Most potential buyers of businesses operated by S corporations want to purchase the assets of the corporation (rather than S corporation stock) for a number of reasons. The buyer that purchases assets receives a tax basis in the assets equal to the purchase price. If the buyer purchases the stock of the S corporation, the tax basis of the underlying assets is unchanged. S corporations do not have an equivalent provision to subchapter K's Sec. 754 election, which allows a purchasing partner's basis in the interest to be stepped up or down based on the fair market value (FMV) of assets inside the partnership. In addition, the purchaser of stock indirectly acquires all the liabilities of the S corporation, known and unknown.

The selling shareholders, however, want to sell the stock of the S corporation. First, gain on the sale of stock will generate long-term capital gain at favorable tax rates, assuming the holding period requirements are met. Second, for the S corporation subject to the BIG tax of Sec. 1374 and still within the recognition period (based on S election or acquisition of C assets date) for any assets sold or deemed to be sold, the corporation is subject to a 35% tax on the unrecognized built-in gain of the corporation.

Other dynamics come into play. The corporation may hold contracts with vendors, customers, and employees that will require renegotiation unless the corporation remains in existence. Also, state taxes may make an asset sale more costly (e.g., some states subject the sale of tangible personal property to sales tax, even in a bulk sale of the business). Due to these tax and nontax issues, from the seller's perspective the sale of stock is a requirement.

The BIG "no tax" provision referred to above provides another opportunity to the S corporation. A buyer might not be willing to reimburse the selling shareholders for the cost of the Sec. 1374 tax but may be willing to "sweeten the deal" for other costs...