Managing the S corporation built-in gains tax.

Subchapter S of the Internal Revenue Code allows qualified corporations to be taxed as a conduit so that income, gains, and losses pass through to the shareholder's tax return without tax consequences to the corporation. In the absence of restrictions, an S election would provide substantial tax avoidance opportunities for a C corporation holding appreciated assets that would yield taxable gains if sold.

For example, a corporation holding assets worth $500,000 in market value and having total adjusted bases of $150,000 has $350,000 of "built-in gain" on its balance sheet. Prior to making an S election, the disposal of these assets would generate a $350,000 gain that would be taxed to the C corporation. When the after-tax proceeds from this sale are distributed, they are subject to tax again at the shareholder level. If the corporation delays disposition of the assets until an S election is made, the typical tax treatment under Subchapter S would be to pass through $350,000 of income to the shareholders and thus avoid double taxation on gain which had actually accrued during the C corporation years. Section 1374, enacted in 1986, closes this loophole by assessing a tax on any "built-in gains" from C corporation years when they are realized within the first ten years of the S election.

The Section 1374 tax, known as the "built-in gains tax" or "BIG tax," is assessed annually on the netted amount of built-in gains and built-in losses realized during the tax year. Net built-in gains are subject to the maximum corporate tax rate, which is currently 35 percent. The total amount of gain subject to the built-in gains tax during the first ten years of an S election is limited to the "net unrealized built-in gains." This is the excess of the fair market value of the corporation's assets over the aggregate adjusted bases of those assets on the first day of the S election. Any of this gain that is not realized during the ten-year recognition period will not be subject to the built-in gains tax.

NET UNREALIZED BUILT-IN GAIN

Calculation of the unrealized built-in gain begins with the amount that would have been realized if the corporation had remained a C corporation and sold all of its assets at fair market value on the date of the S election to an unrelated party who assumed all of its liabilities. (1) This amount is reduced by any liability of the corporation that would be included in the amount realized on the sale (but only if the corporation would be allowed a deduction on the payment of that liability) and is also reduced by the aggregate adjusted bases of the corporation's assets at the time of the sale.

[ILLUSTRATION OMITTED]

Other adjustments may be required if the corporation has changed accounting methods or acquired a loss corporation. First, any positive or negative Section 481(a) adjustments that would have affected the sale must be included. These adjustments result from certain changes in accounting methods and are made to prevent omission of income or expenses. If the corporation has built-in loss that would not be allowed under Sections 382, 383 or 384, the net unrealized built-in gain must be increased by this amount. These sections relate to the use of unused losses or credits carried over from one corporation to another in a corporate acquisition or reorganization. Further investigation and calculation will be necessary if any of these provisions applies.

The formula for calculating net unrealized built-in gains appears in Exhibit 1.

A correct determination of the net unrealized built-in gain at the time of the S election is important since it serves as a limit on the amount of gain that will be subject to the built-in gains tax during the recognition period. Consider the following example:

Corporation X, a cash basis corporation, makes an S election that is effective on January 1, 2002. On December 31, 2001, the corporation has assets and liabilities as follows:

                      FMV      BASIS

Assets
Factory             475,000    200,000
Equipment           100,000    800,000
Accounts
  Receivable        300,000          0
Goodwill            250,000          0

Total             1,125,000  1,000,000

Liabilities
Mortgage            200,000
Accounts Payable    100,000

Total               300,000

If the corporation had sold all of its assets to a third party who assumed all of its liabilities, the amount realized would be $1,125,000. This is the $825,000 cash received and $300,000 liabilities transferred to the buyer. Due to a recent change in accounting methods, the corporation is also required to include a positive Section 481(a) adjustment of $30,000 in its income for each of the tax years 2000, 2001, and 2002. The net unrealized built-in gain would be as follows:

Amount Realized                   1,125,000
Liabilities assumed that result
 in deductions                     -100,000
Basis of corporation's assets    -1,000,000
Section 481(a) adjustment           +60,000
Net unrealized built-in gain         85,000

It is highly probable that Corporation X will be subject to the built-in gains tax. The unrealized receivables held by a cash basis corporation will generate built-in gain when collected. To a limited extent, they will be offset by the built-in losses realized by payment of the accounts payable. Since receivables exceed payables by $200,000, at least $85,000 of this potential gain will be subject to the tax if realized during the recognition period.

RECOGNITION PERIOD

The built-in gains tax applies only to built-in gains recognized during the ten-year recognition period that begins on the day of the S election. This 120-month period applies not only to C corporations making S elections but to all S corporations that acquire assets from a C corporation in a transaction in which the assets' basis is determined by reference to the C corporation's basis. This type of transfer is known as a Section 1374(d)(8) transaction and is subject to built-in gains tax even if the S corporation has never been a C corporation.

In the event of such a transfer, the ten-year recognition period for any built-in gain on the transferred assets begins on the date of the transfer. If the recognition period ends within the S corporation's taxable year, the amount of net realized built-in gains for the year must be determined as if the corporation's books were closed on the last day of the recognition period.

NET RECOGNIZED BUILT-IN GAIN

The net recognized built-in gain for any year is the excess of built-in gain realized over built-in loss realized within that year. The amount that will be taxed is limited to the taxable income of the corporation calculated "as if" it were a C corporation. If realized built-in gain for the year exceeds this limitation, the excess is carried over and included in the built-in gains for the next year. (2) The net recognized built-in gain is also limited to the excess of net unrealized built-in gain (see Exhibit 1) over the total amount of built-in gain recognized thus far in the recognition period.

Under these rules, the amount of net recognized built-in gain that will be subject to the built-in gains tax within any tax year is the lesser of:

a. The recognized built-in gain and recognized built-in loss for the year, increased by any carryover of built-in gains from the previous year.

b. The corporation's taxable income, determined by application of C corporation rules for calculating taxable income, without regard to the dividends-received deduction or the net operating loss deduction. In determining its taxable income limitation for this purpose, the corporation must use the same accounting methods it uses for tax purposes as an S corporation.

c. Excess of net unrealized built-in gain over net recognized built-in gain for all prior taxable years in the recognition period.

Continuing the previous example, suppose Corporation X collects $100,000 of receivables and pays $40,000 of accounts payable during 2002, the first year of the S election, resulting in a net built-in gain of $60,000. The S corporation's taxable income for the year (calculated as if it were a C corporation) is $50,000. The excess of net unrealized built-in gain over previously recognized built-in gain is $85,000. The amount of net recognized built-in gain for the year is the lesser of the $60,000 net recognized built-in gain, the $50,000 corporate taxable income, or the $85,000 of unrealized built-in gain that has not been recognized. Thus, the amount of built-in gain subject to the built-in gains tax for the year is $50,000. The remaining $10,000 of built-in gain is carried over to the next year to be included with the built-in gains and losses in Step One (see Exhibit 2) of the calculation for that year.

Recognized built-in gain includes all gains realized during the recognition period, unless the S corporation can establish that the asset was not owned on the first day of the S election or that the gain realized is attributable to appreciation occurring subsequent to the election. A built-in loss is recognized on the sale or exchange of an asset if the S corporation can establish that the asset was owned at the initiation of the recognition period and that the decline in value occurred prior to that date. It is quite clear that the burden of proof in these cases is on the corporation. This emphasizes the importance of documenting the value of assets and liabilities on the first day of the recognition period.

Section 1375 imposes a tax on "excess net passive investment income" for certain S corporations. It provides an explanation for co-ordination with Section 1374 and permits the reduction of passive income that is subject to tax under Section 1375 by any built-in gain subject to the built-in gains tax during the recognition period. Thus, recognized built-in gain is subject to only one tax under Section 1374 and will not be taxed again under Section 1375.

Built-in Gains Tax Computation 

The presence of built-in gains provides an S corporation with the opportunity to benefit from unused net operating loss carryforwards, capital loss carryforwards, unused business tax credits and minimum tax credit carry-forwards from the C corporation years. These losses and credits are carried over and applied in the same manner as if the corporation had continued to be a C corporation. (3)

The regulations under Section 1374 describe the calculation of the built-in gains tax as a four-step computation. The general calculation is outlined in Exhibit 2.

The amount of net recognized built-in gain in Step One is the amount available after applying all appropriate limitations. The tax rate to be used in Step Three is the maximum income tax rate for corporations in Section 11(b).

A Section 1374(d)(8) transaction in which the S corporation derives its basis in a transferred asset from a former C corporation will require a calculation unique to that transaction. This could occur, for instance, when a parent S corporation elects to treat a wholly owned domestic subsidiary as a "Qualified Subchapter S Subsidiary" (QSS). (4) Under such an election the subsidiary is deemed to be liquidated into the parent on the date of the election. Thus if the QSS was formerly a C corporation the built-in gains tax will apply to any net unrealized gain on the date of the election that is subsequently realized.

Separate determinations of the built-in gains tax must be made for assets acquired in each 1374(d)(8) transaction or from the S election. Having more than one of these transactions essentially results in "pools" of assets with a potentially different recognition period for each pool and a separate application of the taxable income limitation. The taxable income limitation is prorated among these groups of assets.

CORPORATIONS SUBJECT TO THE BUILT-IN GAINS TAX

Code Section 1374 was enacted as part of the Tax Reform Act of 1986 and applies to corporations making S elections after December 31, 1986. There are two situations that will cause an S corporation to confront the built-in gains tax. Any C corporation with net unrealized built-in gain making an S election after December 31, 1986, is vulnerable. If the corporation has previously terminated an S election, a new election made after December 31, 1986, will cause it to be subject to the built-in gains tax. It is the most recent election that determines the corporation's vulnerability to the built-in gains tax.

As noted earlier, a corporation that has maintained an S election throughout its entire existence may still be vulnerable to the Section 1374 tax if it acquires assets from a C corporation in a Section 1374(d)(8) transaction (i.e., basis determined by reference to the C corporation's basis in the transferred assets).

Reduction of Pass-through 

To ease the bite of the built-in-gains tax, the amount of built-in gain that passes through to shareholders is reduced by any built-in gain tax paid at the corporate level. This brings the taxation of the S corporation and its shareholders closer to that of a C corporation that is taxed on the gain and makes an after-tax distribution to its shareholders. The results are not identical because the S corporation shareholders will be immediately taxed on the pass-through of the built-in gain, whereas a C corporation has discretionary control of the timing of a dividend distribution to its shareholders.

STRATEGIES FOR MINIMIZING THE BUILT-IN GAINS TAX

Pending S Election Strategies

First and foremost, the impact of the built-in gains tax must be considered when a decision to become an S corporation is contemplated. Normally, the focus of such planning is the tax position of the shareholders and the impact of the pass-through of anticipated gains and losses. The presence of built-in gains can alter the tax outcome considerably and could cause the tax costs of an S election to outweigh the benefits. If full consideration is given to the impact of built-in gains and an S election is still warranted, it should be made expeditiously to trigger the running of the recognition period as soon as possible. If the corporation is newly organized, the S election should be filed immediately to avoid spending its first year as a C corporation and creating built-in gains on appreciated assets.

Prior to making the election, it is imperative to obtain a professional and reasonable appraisal to determine if built-in gains exist. The appraisal will provide the information needed to limit the amount of built-in gains to be recognized or to document the absence of any built-in gain. Although there are no reporting requirements relative to built-in gains at the time of the election, the burden of proof will be on the taxpayer to show that gains from subsequent appreciation of assets did not exist at the time of the election. Therefore, it is extremely important that the corporation retain the appraisal to firmly establish any subsequent increase in value that is not subject to the built-in gains tax. The appraisal is equally important as evidence of existing built-in losses.

Certain measures can be taken to lessen the impact of the built-in gains tax when an election is pending. It may be prudent to accelerate the collection of any unrealized receivables if the C corporation's marginal tax rate is below the built-in gains tax rate of 35 percent. Conversely, delaying realization of built-in losses to be recognized during the recognition period will be a significant step in reducing the tax.

Caution should be exercised regarding the acquisition of built-in loss property or deductions when an election is contemplated. Anti-stuffing rules will disallow built-in losses acquired immediately prior to the election or during the recognition period if the principal purpose is to avoid the built-in gains tax. This rule can be circumvented if a business purpose can be shown for transferring the loss assets to the corporation.

Other long-term strategies might be initiated before the S election is made. Preserving allowable C corporation net operating losses available to offset built-in gains may be especially significant for corporations that were in the lower corporate income tax bracket of 15 percent of 25 percent but now face a 35 percent built-in gains tax. These carryovers from C corporation years essentially yield greater tax benefits when used to offset the higher built-in gains tax rate.

Post S Election Strategies

Once the election is made, there are two mechanisms available for avoiding the tax on built-in gains. One is to control the timing of the recognition of built-in gains and losses and the other is to control the limits that apply to recognized built-in gain.

The first major factor to consider is the expected future activity of the corporation for the next ten years. If it is possible to defer the sale of built-in gain assets beyond the ten-year recognition period, the tax will be avoided. This is clearly not always possible, particularly if there are net unrealized receivables at the time of the S election. In such cases, realizing built-in losses in the same year that gains are realized may significantly reduce the net built-in gains subject to the tax. Additionally, entering into a Section 1031 like-kind exchange may allow a company to defer recognition beyond the ten-year period, although the built-in gains will be reflected in the new asset.

Another strategy for minimizing the tax is to lower the amount of taxable income (calculated as if the S corporation were a C corporation), which limits the amount of built-in gain taxed in the current year. Deferring revenue or accelerating deductions can do this. As examples, a payment of compensation to shareholders or a charitable contribution will have the effect of reducing the taxable income limitation.

The built-in gains tax is also a relevant consideration in business reorganizations or restructuring. The exchange or sale of stock by shareholders rather than a direct sale of assets by the corporation will avoid triggering built-in gain. For example, if there is more than one shareholder and one is likely to withdraw, "retire" or die, the transfer of stock to other shareholders produces no realized built-in gain for the corporation. If the shareholders dispose of the business, a sale of all stock rather than the sale of assets results in no realized gain for the corporation.

Strategies for minimizing the built-in gains tax are summarized in Exhibit 3. They are categorized according to those that should be implemented when the S election is pending and those that are appropriate after the S election is made.

CONCLUSION

C corporations considering an S corporation election need to evaluate the potential impact of the built-in gains tax provisions of Section 1374. The S corporation election could conceivably create a higher tax burden than the corporation and its shareholders would have as a C corporation. However, careful planning can avoid or minimize the built-in gains tax.

EXHIBIT 1. Formula for Net Unrealized Built-in Gain

Amount that would be realized upon sale of all
assets as of first day of recognition period               XXX

Less: Liabilities included in amount realized
that are deducted when paid                               -XXX

Less: Aggregate adjusted basis of all assets              -XXX

Section 481 adjustments affecting sales on first
day of recognition period (if the company has
changed accounting methods)                        [+ or -]XXX

Plus: Built-in loss disallowed under Sections
382, 383, or 384 (if the company has been through
a corporate acquisition or reorganization)                +XXX

Net Unrealized Built-in Gain                               XXX

EXHIBIT 2.Four-Step Computation of Built-in Gains Tax

Step One:    Determine net recognized built-in gain.

Step Two:    Reduce net recognized built-in gain (but not below zero)
             by any net operating loss or capital loss
             carryforwards.

Step Three:  Compute the tentative tax by applying the appropriate
             tax rate to the amount derived in Step Two.

Step Four:   Compute the final tax by reducing the tentative tax
            (but not below zero) by any business tax credit or
             minimum tax credit carry-forward from C corporation
             years.

End Notes

(1) Net unrealized built-in gain is defined in Section 1374(d)(1) and Treasury Regulation 1.1374-3.

(2) This carryover provision applies only to corporations making S elections after 3-31-88. Section 1374(d)(2)(B) and Treasury Regulation 1.1374-2.

(3) Treasury Regulation 1.1374-5 notes that C corporation losses used are subject to all limitations that would apply under C corporation rules. Carryovers that are not specifically cited, such as charitable contribution carryovers or unused foreign tax credits, are not allowed to offset the Section 1374 tax.

(4) Section 1361(b)(3)(B).

RELATED ARTICLE: EXHIBIT 3. Strategies for Minimizing the S Corporation Built-in Gains Tax

Pending S Election Strategies:

* Consider cost of built-in gains tax relative to benefits of S election.

* Obtain and retain a professional appraisal to determine existence of built-in gains and to document asset values.

* Make S election immediately for newly organized corporation to avoid C corporation status

* Accelerate collection of unrealized receivables.

* Delay realization of built-in losses.

* Preserve any C corporation net operating losses, capital loss carryovers, and unused business tax credits and minimum tax credits.

* Acquire loss property if business purpose can be shown for acquisition.

Post S Election Strategies:

* Defer recognition of built-in gain beyond recognition period if possible.

* Use like-kind exchanges for replacement of assets.

* Attempt to realize built-in losses in the same year that gains are realized.

* Minimize taxable income limit through compensation to shareholders, deferment of revenue or other means.

* Opt for shareholders' sale of stock rather than direct sale of assets when reorganizing or selling the corporation.

Linda Burilovich, PhD, CPA 

Gary McCombs, CPA, MBA 

Linda Burilovich, a Professor of Accounting at Eastern Michigan University, earned her PhD at the University of Michigan in 1990. She was an Internal Revenue Agent for five years and has written extensively in the area of small business taxation. She can be contacted at [e-mail].

Gary McCombs, an Associate Professor of Accounting at Eastern Michigan University, earned his MBA at the University of Michigan. His numerous publications encompass all areas of the field of accounting. He can be contacted at [e-mail].