Liquidating an S corporation that is not subject to the BIG tax.

• Author: Markwood, Linda

This item illustrates the tax consequences and the shareholders' cash flow resulting from the liquidation of an S corporation that is not subject to the built-in gains (BIG) tax.

Observation: The analysis in this item applies to any S corporation after the expiration of the five-year BIG tax recognition period. In addition, this analysis applies to any S corporation that has always operated as an S corporation and is therefore not subject to the BIG tax.

Example. Liquidating an S corporation that is not subject to the BIG tax: Tine, has operated as a calendar-year S corporation for 12 years. The corporation has 15 shareholders, all of whom are unrelated individuals. As of the beginning of its current tax year, Thas assets and liabilities as shown in the table, "T's Assets and Liabilities."

The shareholders each invested $50,000 when the corporation was formed and as a group have a total tax basis of $750,000 in their stock. (If T has always been an S corporation, the shareholders' total tax bases in their stock would normally equal the corporation's adjusted tax basis in its assets.)

Assume in this example that either T operated as a C corporation before its S election or that shares of its stock changed hands among shareholders in the past at a loss, resulting in a lower stock basis in the hands of the current shareholders. Also assume that each of the 15 shareholders is considered a high-income taxpayer for purposes of Sees. 1(h) and 1411 and that any ordinary income from the transaction will be taxed at a 37% marginal rate (the highest individual tax rate). Therefore, the shareholders are subject to the 20% maximum tax rate for qualifying dividends and capital gains, and these amounts may be subject to the 3.8% net investment income tax (whether the surtax applies depends on each shareholder's unique tax circumstances).

The corporation has received an unexpected offer to sell its inventory for $700,000, its fixed assets for $2.5 million, and the intangibles for $1.8 million, for a total sales price of $5 million. If the corporation accepts the offer, it would retain its cash and collect its receivables, retire its debt, and liquidate shortly after the sale. The corporation's net income from operations from Jan. 1 to the date of the sale is projected to be $500,000, and the depreciation recapture from the proposed sale would be $800,000.

Because T filed its S election over five years ago (and thus avoids the BIG tax), the only taxes...