S corporation built-in gains tax.

• Author: O'Neil, Cherie J.

In December 1992, the IRS issued proposed regulations(1) under Sec. 1374 to provide guidance on the built-in gains [BIG) tax imposed on certain S corporations. Previous guidance was limited to one revenue ruling,(2) one announcement(3) and two notices.(4) The proposed regulations are generally favorable to taxpayers and may offer an incentive for C corporations to convert to S status. This article will discuss the provisions of the new regulations, illustrate by example how to compute the tax on built-in gains and offer suggestions for improving the proposed regulations before they are issued in final form.

Background

The Tax Reform Act of 1986 significantly changed and expanded the tax on S corporation built-in gains as part of its repeal of the General Utilities doctrine.

Sec. 1374 imposes a corporate level tax on gains that an S corporation recognizes during a 10-year "recognition period" as a result of the disposition of any asset held on the date its S election takes effect, to the extent such gain was "built in" at the time the corporation converted to S status. Sec. 1374 applies only if an S corporation has a net recognized built-in gain and imposes a tax only with respect to that gain. All gain on disposition of any asset recognized during the recognition period is a taxable built-in gain unless the corporation establishes that it did not hold the asset on the date its election took effect or that no built-in gain with respect to that asset existed at that time. The recognition period is the 10-year period beginning with the first day of the first tax year on which the corporation became an S corporation.(5)

Under Sec. 1366(f)(2), the built-in gain is reduced by the amount of any built-in gains tax before it flows through to shareholders. This amount is treated as a loss. This loss adjusts shareholder basis and, subsequently, the accumulated adjustments account (AAA). Although a C corporation can control the timing of its dividend distributions, and thus the imposition of the tax on its shareholders, an S corporation cannot. When an S corporation is subject to the built-in gains tax, the gain is recognized and taxed to the corporation and then passed through and taxed immediately to the shareholders.

Net Recognized Built-in Gain

Since the purpose of Sec. 1374 is to tax gains on the disposition of appreciated assets by an S corporation in the same manner as if it were still a C corporation, limits are imposed to reflect what would have transpired if the conversion to an S corporation had not taken place. Under Prop. Regs. Sec. 1.1374-2(a), an S corporation's "net recognized built-in gain" (NRBIG) for any year is the smallest of three amounts.

1. Since only net built-in gains are taxed, taxable income is computed by applying the C corporation rules and considering only the recognized built-in gain (RBIG), recognized built-in loss (RBIL) and any recognized built-in gain carryover. This is referred to as the "pre-limitation amount."

2. This amount is compared to the "taxable income limitation." If the conversion to S status had not taken place, the corporation would not have paid tax unless it had taxable income for the year. Therefore, the built-in gains tax applies only if there is taxable income to the S corporation computed as if it were still a C corporation. This reduces the taxable built-in gain by any net operating loss (NOL) or capital loss recognized in that tax year.

3. The "net unrealized built-in gain limitation" is the excess of net unrealized built-in gain (NUBIG) over net recognized built-in gain for all prior tax years and is the upper limit on the amount of gain that will ever be recognized. Thus, the built-in gains tax will not be imposed beyond the total NRBIG generated in one year, or in excess of the total NUBIG at the date of conversion to S status.

Example 1: N, an S corporation, has an $8,000 NUBIG on electing S status. During its first S year, $6,000 of its NUBIG is recognized. In addition, N has a net profit from operations of $1,000 in its first year, so its total taxable income is $7,000. N has a taxable built-in gain in year 1 of $6,000 and a net unrealized built-in gain limitation in subsequent years of $2,000.

Furthermore, the amount of gain subject to the built-in gains tax in any given year cannot exceed the excess of the recognized built-in gains over the recognized built-in losses during that year.

Example 2: Assume the same facts as in Example 1, except that in year I another asset is sold that has a built-in loss of $1,500. N now has taxable income of $5,500 and taxable built-in gain of $4,500. Its net unrealized built-in gain limitation in subsequent years is $3,500.

To prevent S corporations from avoiding the built-in gains tax by disposing of assets with unrealized built-in gains during years with no taxable income, a carryover rule was created. Any recognized built-in gain from a year not taxed as a result of the income limitation rule is subject to taxation in the remaining years of the 10-year recognition period. This is accomplished by requiring the excess of the prelimitation amount over the taxable income limitation to be carried forward as a "recognized built-in gain carryover."(6) This carryover is then included in the prelimitation amount for each succeeding tax year in the recognition period.

Example 3: Assume the same facts as in Example 1, except that N has a net loss from operations of $10,000. No built-in gain is recognized in year 1 and the recognized built-in gain carryover is $6,000. If N has net income from operations of $5,000 in year 2, it must pay tax on a built-in gain of $5,000. There is a recognized built-in gain carryover to year 3 of $1,000, and a net unrealized built-in gain limitation in year 3 of $2,000.

Thus, unless the S corporation has no taxable income during the remainder of the 10-year recognition period, the Sec. 1374 tax cannot be avoided by recognizing a built-in gain only in a tax year that has losses in excess of the recognized net built-in gain.

Rules for Determining Recognized Built-in Gain and Loss

All assets the corporation holds on the date its S election takes effect are potentially subject to Sec. 1374. Thus, accounts receivable, inventory and other ordinary income property, as well as intangible assets, which may or may not appear on the corporation's balance sheet, are all subject to the built-in gains tax if they are appreciated on the date of the corporation's S election and disposed of in a taxable transaction during the recognition period. Existing liabilities giving rise to a deduction on the last day of the C corporation tax year are also included. If the taxpayer uses the cash method, assets and liabilities are based on a modified accrual method (discussed in greater detail later).

To determine the amount of NUBIG, start with the fair market value (FMV) of all assets and subtract their adjusted bases and any liabilities that would be allowed as a deduction on payment. Increase or decrease this amount by any Sec. 481 adjustments and any recognized built-in losses that would not be allowed under Sec. 382, 383 or 384.(7)

Example 4: X, a calendar-year C corporation, uses the cash method of accounting. X elects to become an S corporation on Jan. 1, 1995. X's assets and liabilities on that date are:

FMV Basis

Assets:

Factory $ 500,000 $900,000 Accounts receivable 300,000 0 Goodwill 250,000 0 1,050,000 $900,000 Liabilities:

Mortgage 200,000 Accounts payable 100,000 $ 300,000 In addition, X has a $60,000 Sec. 48 1 (a) gain in 1995. If on Jan. 1, 1995, X sold all its assets to a third party for cash plus assumption of liabilities, X would realize $1,050,000 and have a built-in gain of $1 10,000, computed as follows:

Amount realized $1,050,000 Basis of assets - 900,000 Deduction allowed - 100,000 BIG on assets 50,000 Sec. 481 gain + 60,000 Net unrealized built-in gain $ 100,000 Any gain recognized by an S corporation during the recognition period is presumed, under Sec. 1374(d)(3), to be a recognized built-in gain except to the extent the S corporation shows it did not hold the asset on the first day of the recognition period or the appreciation occurred since that day. Sec. 1374(d)(4) provides similar rules for built-in losses.

Allocation Rule

If an S corporation has numerous items generating income, gain, loss and deduction in the prelimitation amount, an allocation rule is used to compute the S corporation's net recognized built-in gain.(8)

Example 5: P, an S corporation, has a built-in gain of $100, computed as follows:

Built-in FMV Basis gain/(loss) Sec. 1231

assets:

A $100 $150 $ (50) B 100 50 50 C 100 100 0 Accounts

receivabe 100 0 100 $400 $300 $100 If P sells asset B for $100 and collects the accounts receivable in the same tax year, a gain of $150 is recognized. The recognized built-in gain of $100 consists of ordinary income of $67 from the accounts receivable and Sec. 1231 gain of $33 from the disposition of asset B.

If asset A were sold in the same year for $100, the net recognized built-in gain of $100 would be all ordinary income since the net Sec. 1231 gain is $0.(9)

Built-in Income Rules

The proposed regulations provide that these rules apply only to built-in gains and losses recognized in a transaction treated as a sale or exchange for Federal income tax purposes.(10) Gains...