Minimizing built-in gains on inventory and accounts receivable.

Facts: Adam Corp. is a C corporation that reports on the cash basis and uses a calendar year. (The corporation's gross receipts are under $5 million, so it is able to continue reporting on a cash basis.) Jack, the sole shareholder, believes the company's income would be taxed at more favorable rates if the company was an S corporation. Jack asks his tax adviser if he should have the corporation elect S status to avoid double taxation, effective as of Jan. 1, 1999. On that date, assume the corporate assets will be as follows:

                                       Adjusted    Built-in
                            FMV         basis       gain

Cash                      $35,000      $35,000     $    --
Accounts receivable        55,000           --      55,000

Other assets               97,500       97,500          --
Totals                   $187,500     $132,500     $55,000

The corporation has no accounts payable. The tax adviser determines that the taxable income for the first S year will be approximately $60,000. (Taxable income would be the same if it were computed under the C corporation rules.) Jack is in the 31% tax bracket.

Issue: How can Adam Corp. elect S status and avoid the built-in gains (BIG) tax as its accounts receivable are collected?

Analysis

Potential BIGs are determined on the date a C corporation becomes an S corporation. If, on that date, an asset's fair market value (FMV) exceeds its adjusted basis, there is unrealized BIG attached to that asset. The BIG is recognized if the asset is disposed of during the 10-year recognition period beginning with the first day of the first S year. (In this case, the recognition period expires on Dec. 31, 2008.) A cash-basis corporation with accounts receivable faces the BIG tax when the accounts receivable are collected, normally during the year the election is first effective. Collection of an account receivable by a cash-basis taxpayer is a disposition of an asset and will result in BIG recognition. In this case, $55,000 from such collections will be subject to BIG tax. The tax (assessed at the highest corporate rate) will be 35% of $55,000, or $19,250. The taxable income of $60,000 will be passed through to Jack, and the corporate tax will pass through to him as a loss, resulting in a passthrough to Jack of $40,750 ($60,000 - $19,250) in net income.

Regs. Sec. 1.1374-4(b) provides that an S corporation's items of income or deduction generally are treated as recognized gain or loss if the item would have been taken into account before the recognition period by a taxpayer using the accrual method. This means accounts receivable collected by a cash-basis S corporation do not represent BIG unless the receivables would have been accruable at the date the S election became effective.

The tax adviser may suggest some techniques for reducing potential BIGs before the S election is made. For example, the C corporation might generate built-in losses. To accomplish this, it could declare reasonable bonuses to shareholder/employees and not pay them until the S election is effective; a cash-basis bonus to an individual who owns 5% or more of the corporation's stock does not represent a built-in loss unless the S corporation pays the bonus within the first two and one-half months of the recognition period. Alternatively, the corporation could delay paying operating expenses until the company is an S corporation. Deciding whether to delay these payments into the S year will require careful study and planning because the C corporation will lose corresponding deductions. However, these deductions could result in a tax savings of as little as 15% in the C corporation, while offsetting a built-in gain that would otherwise be taxable at a rate of 35%.

The taxable income limitation was modified for corporations that elect S status on or after March 31, 1988. For such corporations, recognized BIG is limited to their taxable income (computed under the C rules), but any BIG not recognized because of the taxable income limitation carries forward during the remainder of the 10-year recognition period.

If a reasonable choice exists, it seems preferable to defeat the BIG tax at the time of conversion to S status with a bonus or other accrual, rather than to rely on the taxable income limit each year during the 10-year recognition period.

Nevertheless, the taxable income limit can be a useful planning tool. Recognized BIG in a given year cannot be more than the taxable income for that year computed under the C rules. If Jack increased his salary by $60,000 in total, there would be no taxable income and, consequently, no BIG tax. Increasing salaries will provide a deduction at the corporate level, and the income will be taxed only once, at the shareholder level. For this strategy to be effective, the salaries would have to be reasonable. Service businesses may be in a better position to structure salaries each year to reduce taxable income to zero. If done throughout the entire l0-year period, this strategy eliminates the recognition of any BIG. Conversely, for nonservice businesses, it will be more difficult to rely on the taxable income limitation. Large amounts of profits may be difficult to offset by shareholder compensation because of the reasonable compensation limitation.

Other strategies for avoiding the BIG tax revolve around offsetting BIGs with other losses, carryovers or credits. For instance, if Adam Corp. shows a loss (computed under the C rules), there is no BIG tax imposed in that year. Or, if the corporation has a net operating loss carryforward from a year when it was a C corporation, the loss carryforward can offset the BIG. Also, capital loss carryovers from a C year can offset the capital gains portion of BIG. Likewise, unused business and alternative minimum tax credits from a C year can be used.

A Sec. 1031 tax-deferred exchange can also be an effective device to avoid the recognition of BIGs. A tax-deferred exchange of an asset does not trigger the BIG inherent in that asset. Rather, the unrecognized BIG and the unexpired portion of the recognition period transfer to the asset received in the exchange. If the new asset is retained until the expiration of the 10-year recognition period (beginning with the date the S election became effective), no BIG is recognized.

Another strategy for reducing exposure to the BIG tax is to sell the receivables to the shareholders before the S election becomes effective. Also, built-in losses can offset BIGs.

Conclusion

Adam Corp. will be taxed on BIGs of $55,000 from the collection of accounts receivable, resulting in a tax of $19,250. BIGs can cause a significant amount of tax in the year the S election becomes effective. This is because collections of accounts receivable by a cash-basis taxpayer are considered a disposition of an asset (with the taxpayer having a zero basis in the receivables). Here, tax planning opportunities revolve around using built-in losses, reducing the corporation's taxable income and selling the receivables to shareholders.

A difficult aspect of implementing the BIG rules is measuring the unrealized gain at the time of the election. Gain on the disposition of assets is assumed to be built-in unless the taxpayer can prove otherwise. It is clear that the taxpayer's estimate of the FMV may not be acceptable. Appraisals of corporate assets should be made when the S election is made, and these appraisals should be stored in a retrievable manner in case of an IRS audit.

S corporations that cannot substantiate the value of their assets on the date the election became effective can end up paying significantly more tax than they should. Unless they are careful, even S corporations with no BIGs can become liable for the tax. For instance, assume an S corporation has an asset that would produce no gain if it were sold on the date the S election became effective. Assume that assets of that kind became scarce and in a subsequent year the asset is sold for a gain of $100,000. The presumption is that all of the gain is built-in. It is the taxpayer's responsibility to show that conditions occurring after the S election were responsible for the appreciation.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--S Corporations," 11th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 1998.