Practical problems of professional corporations electing S status.

In December 1994, the Service issued final regulations under Sec. 1374. These regulations will have significant impact on closely held C corporations electing S status after December 1994, especially professional corporations that use the cash method of accounting. Under Sec. 1374, a corporation electing to be taxed under subchapter S is required to calculate its net unrealized built-in gain as of the effective date of its S election. Regs. Sec. 1.1374-3(a) defines the net unrealized built-in gain as the total of the amount that would be realized as of the effective date of the S election, if the corporation had sold all of its assets at fair market value (FMV) to an unrelated party who assumed all liabilities. This amount is reduced by any liabilities that would be included in the amount realized on the sale that would create a deduction to the corporation on payment, plus the aggregate adjusted basis of the corporation's assets. Finally, the amount is further reduced by any outstanding negative Sec. 481 adjustment, net of any positive Sec. 481 adjustment outstanding as of the time of the S election, and any built-in loss that would not be allowed as a deduction under Sec. 382, 383 or 384 on a deemed sale.

For professional corporations using the cash method of accounting, unrecorded accounts receivable would increase the net unrealized built-in gain, and unrecorded accounts payable and accrued liabilities would decrease it. From a planning standpoint, a professional corporation electing S status could reduce its net unrealized built-in gain by accruing compensation due to shareholder-employees to the extent they were instrumental in rendering the services that created the unbooked accounts receivable. This, in effect, could offset the net increase due to accounts receivable in excess of accounts payable and other accrued liabilities. (This concept was specifically provided for in the committee reports to the Tax Reform Act of 1986.) However, due to the existence of goodwill and potential appreciation in other assets held by the professional corporation, it will generally still have a net unrealized built-in gain after accounting for accrued compensation to the shareholder-employees. In addition, the regulations put further limitations on the use of accrued compensation to reduce the built-in gains tax.

Once it has been determined that an S corporation has a net unrealized built-in gain, it will owe a tax on the net recognized built-in gain that arises during the 120-month period beginning with the effective date of its S election. Under Regs. Sec. 1.1374-2, the net recognized built-in gain is equal to the recognized built-in gain in excess of the recognized built-in loss plus the recognized built-in gain carryover for the tax year. This amount is then limited to taxable income for the year and the corporation's overall net unrealized built-in gain not previously recognized.

The concepts of built-in gain recognized and built-in loss recognized during the year are areas that can create significant problems for a cash-basis professional corporation electing S status. Regs. Sec. 1.1374-4 sets forth very specific rules on the amount and timing of the recognition of built-in gains and losses. Of specific concern to the professional corporation is the amount of gain recognized on its accounts receivable and the timing of built-in losses attributable to accrued compensation. Although accounts receivable are only included in the calculation of net unrealized built-in gain to the extent of their FMV, for purposes of determining the amount of the recognized built-in gain attributable to these receivables, any amount collected during the recognition period will be considered a recognized built-in gain.

Example 1: ABC, a cash-basis architectural corporation, elects to be taxed under subchapter S on Jan. 15, 1995, effective as of Jan. 1, 1995. As of the effective date, ABC has unreported accounts receivable with a face value of $50,000 and an FMV of $40,000 included in its net unrealized built-in gain of $100,000. During 1995, ABC collects the full $50,000 of these receivables. Under Regs. Sec. 1.1374-4(b), ABC is considered to have recognized $50,000 of built-in gain, even though the amount of gain with respect to these receivables contributed only $40,000 to the corporation's net unrealized built-in gain. Therefore, even though a corporation may have properly planned for the unrealized built-in gain with respect to its receivables by accruing additional compensation to its shareholder-employees to offset it, the recognized built-in gain from these receivables becomes inflated on collection.

The second problem relates to the recognition of the built-in loss related to accrued compensation of shareholder-employees. Under Regs. Sec. 1.1374-4(c), the corporation will be considered to have recognized a built-in loss with respect to accrued compensation to a more-than-5% shareholder-employee only if this compensation is actually paid within 2 1/2 months of the beginning of the initial S year. Therefore, in a typical situation in which a shareholder-employee is paid compensation evenly throughout the year, only a portion of this compensation would be deductible against the recognized built-in gain during the initial S year.

Example 2: Assume the same facts as in Example 1. ABC accrues $40,000 of compensation to its 100% shareholder-employee, to offset the net unrealized built-in gain from the accounts receivable. In addition, the shareholder receives compensation of $10,000 per month paid on the last day of each month, with the first $40,000 attributable to the prior-year accrual. Under these facts, ABC will recognize a built-in loss from the accrued compensation in its initial S year of only $20,000, since this is the amount paid within the first 2 1/2 months. Therefore, under these facts, the net recognized built-in gain in the initial S year equals $30,000 before limitations ($50,000 related to the collection of receivables -- $20,000 accrued compensation paid within 2 1/2 months).

The effect of this calculation is that ABC has accelerated the recognition of built-in gain attributable to other assets that may not be disposed of during the recognition period, resulting in an immediate double tax impact at the corporate and shareholder levels. Therefore, proper planning is critical to the cash-basis professional corporation. Under the facts of the examples, ABC could have reduced its net recognized built-in gain in its initial S year to zero without significantly altering the shareholder-employee's personal tax liability. If the shareholder-employee would have established a short-term loan with a bank and acquired the receivables at their FMV on the first day of the initial S year, the recognized built-in gain with respect to these receivables would have been $40,000. The corporation, with the cash received from the sale of its receivables, could then pay a $40,000 salary to the employee-owner during the first 2 1/2 months of the beginning of its year. This would allow the corporation to recognize the full built-in loss attributable to the accrued compensation, with a net recognized built-in gain for the initial year of zero. The shareholder-employee would then use the $40,000 compensation received to repay the bank loan. For the next five months, the shareholder-employee would not draw compensation from ABC, but rather would use the collection of the receivables to pay his normal living expenses. He would then resume his normal compensation level of $10,000 per month. In this situation, the shareholder-employee would recognize $110,000 of compensation income for the initial S year. In addition, he would recognize an additional $10,000 of income related to the collection of receivables, since the $50,000 collected exceeds his basis of $40,000. Even without selling the receivables, prepaying some of the shareholder-employee's salary could have mitigated the problem.

Finally, the overall limit of taxable income may be very helpful to professional corporations. Regardless of the calculations, if the professional corporation can zero out income for 10 years, no built-in gains tax will ever be paid. Since most professional corporations are used to zeroing out income as C corporations, this may not be too burdensome a task, unless, of course, the business is sold within 10 years.