The S corporation built gains tax: commonly encountered issues.

• Author: Anderson, Kevin D.

Millions of corporations have found S corporation status to be beneficial for both federal and state income tax purposes. When a corporation makes an election to be taxed as an S corporation, its shareholders generally are taxed on their allocable shares of income and may--subject to limitations--deduct their allocable shares of the corporation's losses. However, when a corporation has converted its status from C corporation to S corporation or acquires assets from a C corporation in a tax-free transaction, it may be subject to a corporate-level "built-in gains" tax in addition to the tax imposed on its shareholders.

The concepts underlying this tax are relatively basic, but its application can be complex. This article examines some of the issues corporations commonly encounter in complying with the built-in gains tax.

If a C corporation converts its tax status to a partnership or a disregarded entity, the resulting actual or deemed liquidation, in most cases, would be a taxable transaction for both the corporation and its shareholders. In contrast, if a C corporation elects S corporation status, these immediate tax consequences are avoided. (1) If a corporate-level built-in gains tax were not imposed, a C corporation could make an election to be taxed as an S corporation (assuming it is otherwise eligible to do so) and sell all or part of its assets with a single level of tax. The built-in gains tax is imposed to prevent an S corporation election from being used to circumvent the effects of a taxable liquidation.

The tax is imposed upon an S corporation that has some history--however brief--as a C corporation before the effective date of its S corporation election. (2) It also is imposed on an S corporation that has always been an S corporation, if it acquires assets from a C corporation in a tax-free transaction, such as an acquisition of assets in a tax-free reorganization or the tax-free liquidation of a controlled subsidiary.1 The corporation must determine whether it has a net unrealized built-in gain (NUBIG) in its assets on the effective date of the relevant transaction. If the corporation has a NUBIG in its assets, it must track its dispositions of these assets for 10 years.4

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To the extent that gains recognized during this period represent recognized built-in gains (RBIGs), the tax is imposed at the highest rate of tax applicable to corporations (currently 35%) on the net RBIG. To prevent the tax from becoming significantly more onerous than the tax that would have been imposed on a C corporation, it is not imposed on an amount greater than the taxable income that would have been reported by the taxpayer had it remained a C corporation. (5) For any tax year in which the net RBIG of an S corporation exceeds its taxable income computed in this manner, the excess is carried over and is treated as RBIG in the subsequent year. (6)

The tax imposed on the corporation is in addition to-and not in lieu of-the tax that may be imposed on its shareholders under the rules generally applicable to S corporations. To replicate the effects of C corporation taxation, the shareholders are subject to tax on the corporate-level gain, net of the corporate-level tax. This result is achieved by permitting the shareholder to treat the corporate-level tax as a loss that has the same character as the gain that gives rise to the tax. (7) Thus, for example, if an S corporation recognizes a $100 long-term capital gain, all of which is treated as RBIG, the corporation generally incurs a $35 built-in gains tax. (8) The shareholders recognize their allocable share of a net $65 long-term capital gain for the same tax year.

The tax can be complex, but several issues are most frequently encountered. Five of these issues are explored in this article: (1) the desirability of obtaining a proper appraisal as of the beginning of the recognition period; (2) the treatment of sales of inventories during the recognition period; (3) the application of the tax to corporations using the cash receipts and disbursements method of accounting; (4) the efficient use of losses to reduce or eliminate the tax; and (5) the use of C corporation attributes, such as net operating losses (NOLs) and general business credits, to reduce or eliminate the tax.

Getting the Proper Appraisal

Statutory presumptions applicable to the built-in gains tax effectively require taxpayers to prove their case to the IRS's satisfaction. Thus, all gains recognized by an S corporation during the recognition period are presumed to be RBIGs, except to the extent the taxpayer establishes that a portion of the gain constitutes post-conversion appreciation or that the asset was not held at the beginning of the recognition period.9 Conversely, no loss recognized by an S corporation during the recognition period is treated as a recognized built-in loss (RBIL), except to the extent the taxpayer establishes that the asset was held at the beginning of the recognition period and further establishes the portion of the recognized loss that was built in at the...