Built-in gain tax planning on sale of "subsidiary" stock.

Many corporations that elected S status after 1986 have less-than-80%-owned subsidiaries that had appreciated in value at the date of the S election. A sale of the stock of such a subsidiary is likely to trigger the Sec. 1374 built-in gain (BIG) tax.

The BIG tax, at the S corporation level, is presently 34%. The net gain reduced by the corporate BIG tax is taxable to the S shareholders. Therefore, the effective Federal rate is 52.5%, not including any state taxes. The following example of an S corporation with a built-in gain of $1,000 illustrates the effective tax rate.

Example:
  S corporation:
  BIG                       1,000
  BIG tax rate                34%
  BIG tax                   $ 340
  Shareholders:
  Gross taxable gain        1,000
  Reduced by BIG tax         (340)
  Taxable gain                660
  Individual capital
    gains rate                28%
    Shareholder tax         $ 185
  Combined tax:
  Corporate      340/1000)   34.0%
  Individual    (185/1000)  18.5 %
                             52.5%

The combined rate is the effective gain rate that would have resulted from a liquidation of a corporation after the repeal of the General Utilities doctrine.

One approach that can minimize the built-in gains tax is to have the C corporation "subsidiary" pay out its earnings and profits as a dividend before the sale. (As a practical business matter, the dividend should reduce the selling price on a dollar-for-dollar basis.) These dividends would flow through the S corporation to the shareholders as dividend income and would be taxed at a top rate of 31%. Since the dividends reduce the selling price of the stock, they also reduce the built-in gain dollar-for-dollar. The effective tax rate would thus be reduced to 31% and the shareholders' cash flow increased by 21.5% of the amount paid out as the dividend.

Paying a dividend shortly before the sale is not abusive if its sole purpose is to avoid the BIG tax; the "double tax" has been paid by virtue of the C corporation having paid its tax on its earnings while the shareholders are properly paying their tax on the dividend income.

Obviously, the C corporation's business needs, including cash flow, timing of the sale and the effect of the dividends to the non-corporate shareholders, must be examined, keeping in mind that the stock of the C corporation owned outside the S corporation is not subject to the BIG tax and would also receive any dividends paid.

From Stan Bazan, CPA, Stan Bazan & Company, Cleveland, Ohio