The Tax Reform Act of 1986 overhauled Sec. 1374 by imposing a tax on built-in gains on conversion from C to S corporation status. Proposed regulations issued in 1992 generated critical comments from the public, particularly in nine key areas. This article analyzes the final Sec. 1374 regulations by comparing and contrasting them with the proposed rules and explaining the IRS's response to submitted AICPA comments.
At the end of 1994, the Treasury issued final regulations under Sec. 1374 relating to the built-in gains (BIG) tax imposed on certain S corporations.(1) The regulations are effective for tax years ending on or after Dec. 27, 1994, but only in cases in which the return for the tax year is filed pursuant to an S election or a Sec. 1374(d) (8) transaction occurring on or after that date.(2) The final regulations adopt with revisions the 1992 proposed regulations.(3) The preamble to the final regulations (PFR) identifies nine major issues contained in comments submitted on the proposed regulations. This article examines these issues and their resolution in the final regulations, and highlights comments submitted by the AICPA and the IRS's response.
Sec. 1374 was amended by Section 632(a) of the Tax Reform Act of 1986 (TRA '86) to prevent a liquidating C corporation from electing S status to circumvent the repeal of the General Utilities doctrine. Gain realized by the liquidating corporation on a sale or distribution generally is recognized by the S corporation and reported to shareholders, who include their pro rata shares of such gain on their returns. Without Sec. 1374, there would be no corporate-level tax on such gain.4 Shareholders would increase their bases in their S corporation stock by the gain, thereby reducing their capital gain potential on the liquidating distribution; thus, double taxation would be avoided.
Sec. 1374 prevents the circumvention of double taxation of C income by imposing a corporate-level tax on income or gain recognized by an S corporation to the extent reflective of unrealized appreciation attributable to C tax years. The tax is calculated by applying the highest corporate rate (currently, 35%) to the net recognized built-in gain (NRBIG) of the S corporation for any tax year beginning in a 10-year recognition period. The BIG tax is treated as a loss that flows through to shareholders.(5) Although conceptually straightforward, the operation of Sec. 1374 is complex, sometimes incongruous, and may be more onerous than the double taxation imposed by the C corporation rules.
Sec. 1374 generally applies to tax years beginning after 1986 of S corporations that were formerly C corporations, provided the S election is filed after 1986. However, a corporation that has always been an S corporation can be subject to BIG tax if it acquires assets in a transaction in which its basis in such assets is determined by reference to their basis in. the hands of a C corporation (a Sec. 1374(d)(8) transaction). Sec. 1374(d)(8) provides that assets so acquired are also subject to BIG tax, essentially distinct from any BIG tax computation to which other assets of the S corporation may be subject.
Example, 1: P, a C corporation, elected S status effective Jan. 1, 1994; thus, it has a 10-year recognition period with respect to all assets owned on that date. If Plater acquires another group of assets in a Sec. 1374(d) (8) transaction, a new 10-year recognition period begins with respect to those assets.
As previously mentioned, the BIG tax is largely a function of NRBIG. The principal components of NRBIG are RBIGs and recognized built-in losses (RBILS). Sec. 1374(d) (3) defines RBIG as any gain recognized by an S corporation on the disposition of an asset during the recognition period, except to the extent the S corpor-ation can show that (1) it did not hold the asset on the first day of the recognition period or (2) the gain exceeds the asset's unrealized appreciation on such day. In contrast, under Sec. 1374(d) (4), the taxpayer must prove that a loss is an RBIL. Regs. Sec. 1.1374-4(a) (1) provides that the rules of Sec. 1374(d) (3) and (4) apply only to recognized gain and loss arising from sales or exchanges.
Under Sec. 1374 (d) (5), any item of income or deduction (other than gain or loss arising from a sale or exchange)(6) properly taken into account by an S corporation during the recognition period is RBIG or RBIL, if it is attributable to periods before the recognition period (i.e., the C corporation period). Regs. Sec. 1.1374-4(b) provides that an S corporation's income or deduction items generally are treated as RBIGs or RBILs if they would have been taken into account before the recognition period by a taxpayer using the accrual method (accrual method rule).(7) As will be discussed, certain aspects of this ufle stimulated a strong objection from the AICPA.
The application of the RBIG or RBIL rules can lead to incongruous results. BIG potential that exists due to an asset's anticipated (but not yet accrued) large revenue stream will not be subject to BIG tax as long as the asset is not sold; thus, a corporation can reap the economic benefit of the asset through realization of the income stream and avoid BIG tax. On the other hand, if the economic benefit were realized by a sale or exchange of the asset, BIG tax would apply. For instance, in Prop. Regs. Sec. 1.1374-4(b) (3), Example 2, the sale of oil extracted from a well in which a corporation holds, as of the first day of the recognition period, a substantially appreciated working interest does not trigger RBIG during the recognition period, provided the oil had not yet been extracted from the ground at the beginning of the recognition period.(8) Because the interest is not sold, the income is not RBIG under Sec. 1374(d) (3); because the oil had not been extracted at the beginning of the recognition period, the sale does not trigger RBIG under Sec. 1374 (d) (5). Final Regs. Sec. 1.1374-4(a) (3), Examples 1 and 2, retain and augment the proposed regulation's example by addressing the calculation of RBIG on the sale of an oil and gas property.
An item can yield a different RBIG amount, depending on whether Sec. 1374(d) (3) or (d) (5), applies. This inconsistency(9) is illustrated by Regs. Sec. 1.1374-4 (b) (3), Example 1, in which a cash-basis C corporation has accounts receivable of $50,000, with a fair market value (FMV) of $40,000 on the date of conversion to S status. The receivables arose from services rendered prior to the conversion date. The taxpayer collects all the receivables after the conversion, resulting in RBIG of $50,000.10 However, had the corporation sold the receivables for $45,000 after the S election, rather than collecting them, RBIG would be limited to $40,000. Thus, the excess of an asset's FMV over its basis at the beginning of the recognition period is the maximum amount of RBIG under Sec. 1374(d) (3) if the asset is sold; this excess does not limit the amount of RBIG if the asset is converted to cash other than through a sale or exchange.
After the RBIGSsand RBILs are determined, the next step in calculating BIG tax is to compute NRBIG. Regs. Sec. 1.1374-2 (a) defines NRBIG as the least of (1) the pre-limitation amount; (2) the taxable income limitation; or (3) the NUBIG limitation.
The pre-limitation amount, according to Regs. Sec. 1.1374-2 (a) (1), is the amount of an S corporation's taxable income determined by using aH rules applying to C corporations and by considering only its RBIGs, RBILs, and RBIG carryover. The RBIG carryover, defined in Regs. Sec. 1. 1374-2 (c), is the amount by which an S corporation's pre-limitation amount exceeded its taxable income limitation for the preceding tax year. The RBIG carryover is designed so that BIG tax generally cannot be avoided by manipulating swings. in taxable income so that operating losses are incurred in periods of large RBIGs. If a taxpayer is able to report net losses for all tax years in the 10-year recognition period, however, no BIG tax will be paid.
Regs. Sec. 1.1374-2 (a) (2) defines the taxable income limitation as the S corporation's taxable income determined by using all rules applying to C corporations, but without regard to the net operating loss (NOL) and dividends-received deductions. In determining its taxable income for prelimitation amount and taxable income limitation purposes, Regs. Sec. 1.1374-2 (d) requires a corporation to use the accounting methods it uses for tax purposes as an S corporation. The accounting methods issue is discussed below.
The NUBIG limitation is the amount by which NUBIG exceeds NRBIG for all prior tax years. NUBIG is defined by Sec. 1374 (d) (1) as the amount by which the FMV of the S corporation's assets as of the date of conversion from C status (or of the Sec. 1374(d) (8) acquisition) exceeds their aggregate adjusted bases on that date. Regs. Sec. 1.1374-3 takes a hypothetical arm's-length sale approach in determining NUBIG.(11) The NUBIG limitation ensures that the amolmt subject to the BIG tax over the course of the recognition period will not exceed the NUBIG identified on the date of conversion from C status.
The next step in computing the BIG tax is to reduce NRBIG by certain C carryforwards. Sec. 1374(b) (2) provides that NOL and capital loss carryforwards from C years arc allowed as deductions against NRBIG. Regs. Sec. 1.1374-5(a) provides that the loss carryforwards are allowed as deductions only to the extent their use is allowed under C corporation rules. No other loss carryforwards (e.g., charitable contribution carryforwards) can be deducted against NRBIG.(12)
A tentative BIG tax is then computed by applying the highest corporate rate to NRBIG as reduced by loss carryforwards. Similar to the loss carryforward rules, Sec. 1374(b) (3) (B) allows Sec. 39 business credit carryforwards and Sec. 53 minimum tax credits attributable to C years to reduce...