Practical problems of professional corporations electing S status.

• Author: Bakale, Anthony S.

In December 1994, the Service issued final regulations under Sec. 1374. These regulations will have significant impact on closely held C corporations electing S status after December 1994, especially professional corporations that use the cash method of accounting. Under Sec. 1374, a corporation electing to be taxed under subchapter S is required to calculate its net unrealized built-in gain as of the effective date of its S election. Regs. Sec. 1.1374-3(a) defines the net unrealized built-in gain as the total of the amount that would be realized as of the effective date of the S election, if the corporation had sold all of its assets at fair market value (FMV) to an unrelated party who assumed all liabilities. This amount is reduced by any liabilities that would be included in the amount realized on the sale that would create a deduction to the corporation on payment, plus the aggregate adjusted basis of the corporation's assets. Finally, the amount is further reduced by any outstanding negative Sec. 481 adjustment, net of any positive Sec. 481 adjustment outstanding as of the time of the S election, and any built-in loss that would not be allowed as a deduction under Sec. 382, 383 or 384 on a deemed sale.

For professional corporations using the cash method of accounting, unrecorded accounts receivable would increase the net unrealized built-in gain, and unrecorded accounts payable and accrued liabilities would decrease it. From a planning standpoint, a professional corporation electing S status could reduce its net unrealized built-in gain by accruing compensation due to shareholder-employees to the extent they were instrumental in rendering the services that created the unbooked accounts receivable. This, in effect, could offset the net increase due to accounts receivable in excess of accounts payable and other accrued liabilities. (This concept was specifically provided for in the committee reports to the Tax Reform Act of 1986.) However, due to the existence of goodwill and potential appreciation in other assets held by the professional corporation, it will generally still have a net unrealized built-in gain after accounting for accrued compensation to the shareholder-employees. In addition, the regulations put further limitations on the use of accrued compensation to reduce the built-in gains tax.

Once it has been determined that an S corporation has a net unrealized built-in gain, it will owe a tax on the net recognized built-in gain...