The built-in gains tax: The built-in gains tax applies to C corporations that make an S corporation election, and it can be assessed during the five-year period starting with the first tax year for which the S election is effective.

• Author: Markwood, Linda

A corporate liquidation generally is treated as a sale of the corporation's assets at fair market value (FMV), and gain or loss is recognized at the corporate level. C corporation liquidation gain is effectively taxed twice--once at the corporate level and again at the shareholder level as payment for stock surrendered. This makes S corporation status attractive because gain recognized upon liquidation generally will be taxed only once (at the shareholder level) due to the increase in stock basis that results from passthrough treatment. To discourage a C corporation from electing S corporation status just before a liquidation to avoid double taxation, a tax on "built-in gains" was imposed.

Overview of built-in gains tax

The built-in gains (BIG) tax generally applies to C corporations that make an S corporation election, and it can be assessed during the five-year period beginning with the first day of the first tax year for which the S election is effective. The BIG tax is imposed at the highest corporate rate as specified in Sec. 11(b) (Sec. 1374(b)(1)), which is 21%, and is triggered by the disposition of any asset that was on hand at the time the S election became effective. The term "disposition," however, is broadly defined for built-in gains purposes and includes certain routine transactions, such as the collection of cash-method zero-basis accounts receivable.

An asset not on hand when the S election became effective, such as equipment acquired after the corporation elected S status, ordinarily would not be subject to the tax. However, certain property may be subject to the tax if it is acquired from another corporation in a transferred (substituted) basis transaction. The BIG tax rate applies to recognized built-in gain, regardless of whether the gain is ordinary or capital.

S corporations that are not subject to the BIG tax

An S corporation is not subject to the BIG tax if any of the following situations apply:

* It was never a C corporation (Sec. 1374(c)(1));

* It had no net unrealized built-in gain (i.e., the aggregate basis of its assets exceeded their cumulative FMV) on the date the S election became effective;

* It has previously recognized built-in gains equal to the net unrealized built-in gain on the date the S election became effective; or

* The recognition period beginning with the date the S election was effective has expired, and there are no outstanding payments from installment sales that originated before or during...