Recent amendment to sec. 1374 provides limited opportunity for S corps.

• Author: Harris, Deanna Walton

On February 17, 2009, the American Recovery and Reinvestment Act of 2009, P.L. 111-5 (ARRA), was enacted. ARRA contains numerous tax breaks for individual and corporate taxpayers. Of particular relevance to S corporations is an amendment to Sec. 1374(d) that provides a temporary exemption from the application of Sec. 1374 to sales of assets in 2009 and 2010, but only for S corporations that meet certain requirements. This item discusses the limited opportunity with regard to those S corporations and some of the nuances in its applicability.

See. 1374 Generally

An S corporation generally is not subject to federal tax on the income generated by its operations. Instead, that income is allocated among the S corporation's shareholders in accordance with their stock ownership. Each shareholder then includes its allocable share of the S corporation's income on its own federal income tax return and pays tax on that income accordingly. In certain situations, however, the Code provides that an S corporation is subject to a corporate-level income tax under Sec. 1374.

In the Tax Reform Act of 1986, P.L. 99-514, Congress repealed the General Utilities doctrine, which had allowed a C corporation to make a tax-free liquidating distribution to its shareholders prior to the sale of the company (General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935)). As a result, when a C corporation with individual shareholders distributes appreciated assets or sells them in the course of a complete liquidation, there are generally two levels of tax, a corporate level and a shareholder level.

Sec. 1374 generally is designed to prevent a C corporation from circumventing the repeal of the General Utilities doctrine by converting to S corporation status before distributing appreciated assets to its shareholders or before selling appreciated assets and distributing the sale proceeds to its shareholders as part of a complete liquidation. To do so, Sec. 1374 generally provides that an S corporation is subject to tax at the highest corporate rate on any net recognized built-in gains (RBIGs) of the corporation recognized during the recognition period, which is generally defined in Sec. 1374(d)(7) as the 10-year period beginning with the first day of the tax year for which the corporation was an S corporation.

Example 1: X, a calendar-year C corporation, elected S status effective on January 1, 2009. X's recognition period begins on January 1, 2009, and ends at the close of the day on December 31, 2018.

Although a full analysis of RBIG is beyond the scope of this item, the Sec. 1374 tax generally will apply to any gain recognized on the disposition of assets by the corporation during the recognition period, except to the extent the corporation establishes that either: (1) the asset was not held at the time of the S election; or (2) the gain exceeds the built-in gain inherent in the asset at the time of the S election. Further, RBIG includes any item of income properly taken into account during the recognition period if that item would have been included in the gross income of an accrual-method taxpayer before the effective date of the S election.

The total amount subject to tax under Sec. 1374 is limited to the S corporation's net unrealized built-in gain (NUBIG). An S corporation's NUBIG generally...