Minimizing built-in gains on inventory and accounts receivable.

• Author: Ellentuck, Albert B.
• Position: Case study

Facts: Adam Corp. is a C corporation that reports on the cash basis and uses a calendar year. (The corporation's gross receipts are under $5 million, so it is able to continue reporting on a cash basis.) Jack, the sole shareholder, believes the company's income would be taxed at more favorable rates if the company was an S corporation. Jack asks his tax adviser if he should have the corporation elect S status to avoid double taxation, effective as of Jan. 1, 1999. On that date, assume the corporate assets will be as follows:

Adjusted Built-in FMV basis gain Cash $35,000 $35,000 $ -- Accounts receivable 55,000 -- 55,000 Other assets 97,500 97,500 -- Totals $187,500 $132,500 $55,000 The corporation has no accounts payable. The tax adviser determines that the taxable income for the first S year will be approximately $60,000. (Taxable income would be the same if it were computed under the C corporation rules.) Jack is in the 31% tax bracket.

Issue: How can Adam Corp. elect S status and avoid the built-in gains (BIG) tax as its accounts receivable are collected?

Analysis

Potential BIGs are determined on the date a C corporation becomes an S corporation. If, on that date, an asset's fair market value (FMV) exceeds its adjusted basis, there is unrealized BIG attached to that asset. The BIG is recognized if the asset is disposed of during the 10-year recognition period beginning with the first day of the first S year. (In this case, the recognition period expires on Dec. 31, 2008.) A cash-basis corporation with accounts receivable faces the BIG tax when the accounts receivable are collected, normally during the year the election is first effective. Collection of an account receivable by a cash-basis taxpayer is a disposition of an asset and will result in BIG recognition. In this case, $55,000 from such collections will be subject to BIG tax. The tax (assessed at the highest corporate rate) will be 35% of $55,000, or $19,250. The taxable income of $60,000 will be passed through to Jack, and the corporate tax will pass through to him as a loss, resulting in a passthrough to Jack of $40,750 ($60,000 - $19,250) in net income.

Regs. Sec. 1.1374-4(b) provides that an S corporation's items of income or deduction generally are treated as recognized gain or loss if the item would have been taken into account before the recognition period by a taxpayer using the accrual method. This means accounts receivable collected by a cash-basis S corporation do not...