The new five-year built-in gain recognition period.

• Author: Hesse, Christopher W.
• Position: For S corporation elections

On Jan. 2, 2013, the American Taxpayer Relief Act of 2012 (1)(ATRA) included another change to the 10-year recognition period during which the Sec. 1374 built-in gains (BIG) tax applies to C corporations that elect S status. Under the ATRA amendment, for 2012 and 2013, the built-in gain recognition period was reduced to five years.

This new provision differs from the earlier temporary provisions that were enacted for 2009 and 2010 that provided that the built-in gain recognized more than seven years after the S election was not subject to the tax. This seven-year reference was reduced to five years for 2011. The ATRA provision eliminates the built-in gain carryover that would otherwise apply if the new five-year temporary provision is not extended. (It also eliminates a technical error in the 2009 and 2010 built-in gain rules for calculating the recognition period.)

Background

S corporations that were once C corporations are potentially subject to the BIG tax. (2) The BIG tax was added to the Code in 1986 by the Tax Reform Act (TRA) of 1986 (3) as part of the repeal of the General Utilities (4) doctrine that had allowed corporations to distribute appreciated assets to their shareholders or sell appreciated assets without recognizing gain. Under the General Utilities doctrine, it was possible for C corporations to avoid double taxation when they liquidated. (5) Sec. 1374 was included in the TRA of 1986 to prevent a corporation from circumventing the repeal of General Utilities by converting to S corporation status before distributing appreciated assets to its shareholders or selling appreciated assets.

The BIG tax prevents the "leakage" of income tax. Under the tax, an S corporation may be subject to tax on gains from the sale of assets held at the time it converted to S corporation status if it sells the assets within a specified period of time after making its S election (the recognition period). (6) The maximum amount of gain on which an S corporation can be taxed under the BIG tax is based on the corporation's net unrealized built-in gain, which is determined on the effective date of the S election. (7) An S corporation's net unrealized built-in gain is the amount (if any) by which the fair market value of its assets as. of the beginning of the first year of its S election exceeds the aggregate adjusted bases of the assets.

When an S corporation disposes of an asset that it held at the time it made its S election, it generally will have a recognized built-in gain or loss on the disposal of the asset. The corporation's recognized gains and losses for a year are used to determine its net recognized built-in gain. Net recognized built-in gain is, with respect to any tax year in the recognition period, the lesser of the amount that would be the taxable income of the S corporation for that tax year if only recognized built-in gains and losses were taken into account, or the corporation's taxable income for that tax year. (8) When an S corporation has a net recognized built-in gain, (9) the BIG tax is imposed on that gain (subject to limitations) at the highest C corporation tax rate (currently 35%), (10) regardless of the character of the gain.

An S corporation's net recognized built-in gain and payment of the BIG tax is limited by the S corporation's taxable income, determined as if the corporation were a C corporation. (11) The excess of a corporation's net recognized built-in gain over its taxable income is treated as recognized built-in gain in the succeeding tax year (12) subject to that succeeding year's limitations. If the succeeding year is a year after the recognition period has expired, the gain escapes the BIG tax. And, finally, the total amount of recognized built-in gain on which the BIG tax is paid cannot exceed the amount of net unrealized built-in gain determined on the effective date of the S election. (13)

Note: The examples in this article assume that the S corporation has not recognized all its net unrealized built-in gain within the recognition period.

Earlier Provisions

A seven-year provision applied to years beginning in 2009 and 2010. For either year, if the seventh tax year in the recognition period had ended before that year, no tax was imposed on the net recognized built-in gain of the S corporation for that year. (14) Although this provision was often...