S corporation built-in gain tax.

The proposed built-in gain tax regulations for S corporations were simple, favorable to taxpayers and provided much-needed guidance (see "Finally, Guidance on the Built-In Gain Tax," JofA, Feb.94, page 77). In response to comments from the American Institute of CPAs tax division and others, the Internal Revenue Service clarified or changed certain provisions but generally retained the proposed regulations' approach. This article reviews the changes.

THE BASICS

Internal Revenue Code section 1374 imposes a corporate-level tax on S corporations' income or gain recognition to the extent of unrealized appreciation in a corporation on the date it switched from C to S status. The built-in gain tax is computed by applying the highest corporate tax rate (currently 35%) to the net recognized built-in gain for any taxable year beginning in the recognition period--the 10 years beginning on the date of conversion to S status.

The final regulations specify this period as the 10 calendar years (not the 10 taxable years) beginning on the first day the corporation is an S corporation. When the period ends during a taxable year (for example, a corporation changes from fiscal to calendar yearend), a corporation will calculate the built-in gain tax by closing its books at the end of the recognition period.

It had appeared from the proposed regulations that cash-basis S corporations might have to recalculate incomes on an accural basis if they would be required to use that method as C corporations. The final regulations say that in computing built-in gain, a corporation must use the accounting methods it follows as an S corporation.

SALES OR EXCHANGES

Recognized built-in gain generally includes any gain on the sale or exchange of an asset that must be reported during the period in question. The gain is limited, however, if it is greater than the excess of the asset's fair market value at conversion to S status over its adjusted basis at that time. The regulations still do not address how S corporations should establish such values; it may be advisable to have major assets appraised, as well as the entire business.

The final regulations add a provision to clarify that an S corporation's adjusted basis in oil and gas property equals the sum of the shareholders' adjusted basis in the holdings. Thus, the corporation's basis is affected by the amount of depletion claimed by shareholders.

ITEMS OF INCOME OR DEDUCTION

S corporations' income or deduction items, properly taken into account during the recognition period, are treated as recognized built-in gains or losses if they would have been taken into account using the accrual method before conversion to S status.

Liabilities requiring payment under the economic performance rules. The final regulations say deduction items are taken into account under the accrual method without regard to portions of the economic performance rules requiring payment for various liabilities. Such liabilities include tort, workers' compensation, breach of contract, violation of law, rebates, refunds, awards, prizes, jackpots, insurance contracts, warranty and service contracts and taxes.

The proposed regulations had restricted this exception to workers' compensation and tort liabilities. The final regulations contain an additional example that clarifies the computation of built-in gain for an income item when there has been a change in accounting method.

Payables to related parties and deferred compensation. Certain IRC provisions effectively put accrual method tax-payers on a cash basis with respect to expenses payable to related parties or deferred compensation not paid within two and one-half months after yearend. In the proposed regulations it had appeared such items incurred before the recognition period would not be recognized losses when paid. The final regulations extend built-in loss treatment for these items under certain conditions (see the exhibit on this page).

INSTALLMENT SALES

If a corporation sells assets before or during the recognition period and reports income under the installment method during or after that time, the built-in gain tax generally applies. The final regulations clarify that if income is reported under the installment method for a taxable year after the recognition period, remaining loss or credit carryforwards from C corporation years may be used. The S corporation's loss--recognized in a year after the recognition period--may not.

PARTNERSHIP INTERESTS

If an S corporation holds a partnership interest at the beginning of the 10-year recognition period, it must include its distributive share of partnership items when determining net recognized built-in gain or loss as if each item originated in and was accounted for directly by the S corporation--the so-called look-through rules. The proposed regulations had included a "small interest" exception from these rules for any year in the recognition period when a partnership interest's fair market value was less than $100,000 and represented less than 10% of partnership capital and profits at all times during the year.

The final regulations retain the look-through rules but the interest exception has been modified. It now generally applies for a taxable year if an S corporation's partnership interest is less than 10% of the partnership's capital and profits at all times during the current and prior taxable years in the recognition period and if it has a value less than $100,000 as of the beginning of the recognition period. However, if an asset held by an S corporation at the beginning of the recognition period is contributed to the partnership during the period, the fair market value of the partnership interest is determined as if the asset were contributed before the recognition period began, using the asset's fair market value as of the beginning of the period.

INVENTORY

To compute built-in gains or losses, the proposed regulations had said S corporations' inventory should be valued on the first day of the recognition period in an amount equal to what a willing buyer would pay a willing seller, if the buyer purchased all the S corporation's assets on that day. The final regulations clarify this rule and generally determine the value of an S corporation's inventory on the first day of the recognition period based on a sale of the entire business to a buyer that expects to continue operating the business.

The seller and buyer are presumed to have reasonable knowledge on all relevant facts including

* Inventory replacement cost.

* Inventory's expected retail selling price.

* A sales price that would provide a fair return for related inventory expenditures before sale.

* A purchase price that would provide a fair return for related inventory expenditures after purchase.

It is expected the value of the inventory will be less than its retail price but more than its replacement cost. The IRS is not planning to issue a safe harbor rule.

EFFECTIVE DATES

The final regulations are effective for taxable years ending on or after December 27, 1994, but only when a return for the year is filed under an S election made on or after that date. Special transitional rules may apply to certain S corporations, assets and transactions.

RELATED ARTICLE: EXECUTIVE SUMMARY

* THE INTERNAL REVENUE SERVICE has issued final regulations on computing the built-in gain tax for S corporations. Certain provisions were clarified or changed from the proposed regulations issued in 1992.

* INTERNAL REVENUE CODE SECTION 1374 imposes a built-in gain tax on an S corporation's income or gain recognition to the extent of unrealized appreciation on the date the entity switched from C to S status. The final regulations define the recognition period for this tax to be the 10 calendar years beginning on the first day the company is an S corporation.

* THE FINAL REGULATIONS CLARIFY computation of built-in gain for an income item in the event of an accounting method change. They also say that if income is reported on an installment basis for a taxable year after the recognition period, remaining loss and credit carryforwards from C corporation years may be used; the S corporation's loss in a year after the period may not.

* A "SMALL INTEREST" PROVISION FOR partnerships was modified so it applies only in certain circumstances. Also, an S corporation's inventory is valued on the first day of the recognition period based on a sale of the entire business to someone who expects to continue operating it.

* THE FINAL REGULATIONS ARE EFFECTIVE for taxable years ending on or after December 27, 1994, but only when a return is filed under an S election made on or after that date.

RELATED ARTICLE: Exhibit: Payables to Related Parties and Deferred Compensation

Example 1

Company X elects to become an S corporation on January 1, 1996. On this date, it has the following liabilities for services performed:

                          25%            3%
                       shareholder   shareholder
Accrued compensation    $50,000       $25,000

All events occurred at the date of the S election to establish the fact of these liabilities and their exact amount. These liabilities are both paid on June 1, 1996.

The $25,000 payment is a built-in loss in 1996; the $50,000 payment is not. The final regulations require payment be made to a 5%-or-more shareholder (by voting power and value) in the first two and one-half months of the recognition period. Attribution rules apply in determining stock ownership.

Example 2

Company Y elects to become an S corporation on January 1, 1996. On December 31, 1995, Mary, an employee who has worked 20 years for the company, is entitled to $1,000 per month for 15 years upon retirement under an unfunded nonqualified retirement plan. Mary retires on December 31, 1997. Company Y's deductions in the 10-year recognition period for paying Mary the $1,000 per month are recognized built-in losses because all events have occurred to establish the fact of the liability and the exact liability amount could be determined at January 1, 1996.

If the plan provided for Mary to receive an additional $100 per month for each year of service in excess of 20 years, Company Y's deductions for the additional $200 per month would not be a recognized built-in loss. All events had not occurred to establish the fact of the liability and the exact amount could not be determined at the beginning of the recognition period.