Avoiding built-in gain recognition on distribution of appreciated property.

Facts

Canco was formed in 1972 and operated as a C corporation until the current year when an S election was made. On the date of election, Canco had net unrealized built-in gain of $450,000. The shareholders are considering redeeming the stock of one of the shareholders. In exchange for the stock, the corporation would distribute property valued at $90,000 (with a basis of $40,000); the property was valued at $102,000 and had a basis of $55,000 at the date of the S election. If the property were sold, the gain would be ordinary income. The shareholders have asked their tax adviser for advice. The tax adviser projects that the corporation will generate nonseparately stated (taxable) income of approximately $75,000 per year for the next few years.

Issue

Can a former C corporation avoid the built-in gains tax on distribution of appreciated property?

Analysis

Distribution of appreciated property by an S corporation with respect to its stock is treated as if the S corporation had sold the property to the shareholder at its fair market value (FMV). Thus, the distribution in redemption will cause Canco to recognize $50,000 ($90,000 -- $40,000) of gain. (In this case, the distribution of stock was used to redeem a shareholder's stock. However, any distribution of appreciated property to a shareholder causes the corporation to treat the transaction as if the property had been sold to the shareholder at its FMV.)

Since Canco was a C corporation before it elected to be taxed as an S corporation, the built-in gain provisions will apply. At the time of election, the built-in gain attributable to the asset distributed in redemption was $47,000 ($102,000 -- $55,000). This represents the maximum built-in gain that can be recognized at the corporate level with respect to that asset. (The built-in gains tax applies only to assets on hand on the date the S election becomes effective, and to substituted basis property received after the S election from a C corporation.)

If the distribution of property is made, Canco will recognize $47,000 of built-in gain. Canco will be subject to tax at the highest corporate rate on the lower of the $47,000 gain or the taxable income that the corporation would have reported had it been a C corporation.

The passthrough of the recognized built-in gain to the shareholders is not reduced by the amount of tax paid at the corporate level. Instead the corporate level tax is passed through as a loss sustained by the corporation. The corporate tax is assessed at the highest rate (35%) so the tax paid at the corporate level in this case is $16,450 (35% of $47,000). The passthrough to the shareholders includes the $50,000 gain recognized by the corporation (note that this is different from the built-in gain recognized) and the $16,450 "loss" (that is, the tax paid by the corporation).

The shareholders must be able to document that the built-in gain was $47,000. Otherwise, the IRS could contend that the total gain, $50,000, is taxable at the corporate level.

The tax adviser should determine whether the limitations on the built-in gains tax apply. if the gain cannot be reduced because of the limitations, the practitioner could recommend that the corporation distribute cash rather than property, to avoid triggering the gain on property distributions. (Note that a sale of the property by Canco, followed by a distribution of the sales proceeds, would not be an effective alternative; the sale would also be subject to the built-in gains tax.) If the cash is not available, the shareholders should consider having the corporation borrow the funds to avoid distributing assets subject to the built-in gains tax.

Conclusion

Distribution of property to shareholders can cause recognition of gain. in the case of Canco, $47,000 will be subject to the built-in gains tax. Distributing cash instead of property, or distributing property in a tax year that limitations on the built-in gain apply to, can reduce or eliminate the corporate level tax.

It is important to note that distributions, when made, should be to all shareholders and should be proportionate to the shareholders' stock ownership, since the Service may consider disproportionate distributions to be a second class of stock, which can terminate the S election.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--S Corporations, 4th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex. 1992.