S corporation built-in gains tax.

In December 1992, the IRS issued proposed regulations(1) under Sec. 1374 to provide guidance on the built-in gains [BIG) tax imposed on certain S corporations. Previous guidance was limited to one revenue ruling,(2) one announcement(3) and two notices.(4) The proposed regulations are generally favorable to taxpayers and may offer an incentive for C corporations to convert to S status. This article will discuss the provisions of the new regulations, illustrate by example how to compute the tax on built-in gains and offer suggestions for improving the proposed regulations before they are issued in final form.

Background

The Tax Reform Act of 1986 significantly changed and expanded the tax on S corporation built-in gains as part of its repeal of the General Utilities doctrine.

Sec. 1374 imposes a corporate level tax on gains that an S corporation recognizes during a 10-year "recognition period" as a result of the disposition of any asset held on the date its S election takes effect, to the extent such gain was "built in" at the time the corporation converted to S status. Sec. 1374 applies only if an S corporation has a net recognized built-in gain and imposes a tax only with respect to that gain. All gain on disposition of any asset recognized during the recognition period is a taxable built-in gain unless the corporation establishes that it did not hold the asset on the date its election took effect or that no built-in gain with respect to that asset existed at that time. The recognition period is the 10-year period beginning with the first day of the first tax year on which the corporation became an S corporation.(5)

Under Sec. 1366(f)(2), the built-in gain is reduced by the amount of any built-in gains tax before it flows through to shareholders. This amount is treated as a loss. This loss adjusts shareholder basis and, subsequently, the accumulated adjustments account (AAA). Although a C corporation can control the timing of its dividend distributions, and thus the imposition of the tax on its shareholders, an S corporation cannot. When an S corporation is subject to the built-in gains tax, the gain is recognized and taxed to the corporation and then passed through and taxed immediately to the shareholders.

Net Recognized Built-in Gain

Since the purpose of Sec. 1374 is to tax gains on the disposition of appreciated assets by an S corporation in the same manner as if it were still a C corporation, limits are imposed to reflect what would have transpired if the conversion to an S corporation had not taken place. Under Prop. Regs. Sec. 1.1374-2(a), an S corporation's "net recognized built-in gain" (NRBIG) for any year is the smallest of three amounts.

1. Since only net built-in gains are taxed, taxable income is computed by applying the C corporation rules and considering only the recognized built-in gain (RBIG), recognized built-in loss (RBIL) and any recognized built-in gain carryover. This is referred to as the "pre-limitation amount."

2. This amount is compared to the "taxable income limitation." If the conversion to S status had not taken place, the corporation would not have paid tax unless it had taxable income for the year. Therefore, the built-in gains tax applies only if there is taxable income to the S corporation computed as if it were still a C corporation. This reduces the taxable built-in gain by any net operating loss (NOL) or capital loss recognized in that tax year.

3. The "net unrealized built-in gain limitation" is the excess of net unrealized built-in gain (NUBIG) over net recognized built-in gain for all prior tax years and is the upper limit on the amount of gain that will ever be recognized. Thus, the built-in gains tax will not be imposed beyond the total NRBIG generated in one year, or in excess of the total NUBIG at the date of conversion to S status.

Example 1: N, an S corporation, has an $8,000 NUBIG on electing S status. During its first S year, $6,000 of its NUBIG is recognized. In addition, N has a net profit from operations of $1,000 in its first year, so its total taxable income is $7,000. N has a taxable built-in gain in year 1 of $6,000 and a net unrealized built-in gain limitation in subsequent years of $2,000.

Furthermore, the amount of gain subject to the built-in gains tax in any given year cannot exceed the excess of the recognized built-in gains over the recognized built-in losses during that year.

Example 2: Assume the same facts as in Example 1, except that in year I another asset is sold that has a built-in loss of $1,500. N now has taxable income of $5,500 and taxable built-in gain of $4,500. Its net unrealized built-in gain limitation in subsequent years is $3,500.

To prevent S corporations from avoiding the built-in gains tax by disposing of assets with unrealized built-in gains during years with no taxable income, a carryover rule was created. Any recognized built-in gain from a year not taxed as a result of the income limitation rule is subject to taxation in the remaining years of the 10-year recognition period. This is accomplished by requiring the excess of the prelimitation amount over the taxable income limitation to be carried forward as a "recognized built-in gain carryover."(6) This carryover is then included in the prelimitation amount for each succeeding tax year in the recognition period.

Example 3: Assume the same facts as in Example 1, except that N has a net loss from operations of $10,000. No built-in gain is recognized in year 1 and the recognized built-in gain carryover is $6,000. If N has net income from operations of $5,000 in year 2, it must pay tax on a built-in gain of $5,000. There is a recognized built-in gain carryover to year 3 of $1,000, and a net unrealized built-in gain limitation in year 3 of $2,000.

Thus, unless the S corporation has no taxable income during the remainder of the 10-year recognition period, the Sec. 1374 tax cannot be avoided by recognizing a built-in gain only in a tax year that has losses in excess of the recognized net built-in gain.

Rules for Determining Recognized Built-in Gain and Loss

All assets the corporation holds on the date its S election takes effect are potentially subject to Sec. 1374. Thus, accounts receivable, inventory and other ordinary income property, as well as intangible assets, which may or may not appear on the corporation's balance sheet, are all subject to the built-in gains tax if they are appreciated on the date of the corporation's S election and disposed of in a taxable transaction during the recognition period. Existing liabilities giving rise to a deduction on the last day of the C corporation tax year are also included. If the taxpayer uses the cash method, assets and liabilities are based on a modified accrual method (discussed in greater detail later).

To determine the amount of NUBIG, start with the fair market value (FMV) of all assets and subtract their adjusted bases and any liabilities that would be allowed as a deduction on payment. Increase or decrease this amount by any Sec. 481 adjustments and any recognized built-in losses that would not be allowed under Sec. 382, 383 or 384.(7)

Example 4: X, a calendar-year C corporation, uses the cash method of accounting. X elects to become an S corporation on Jan. 1, 1995. X's assets and liabilities on that date are:

FMV Basis

Assets:

Factory                    $ 500,000             $900,000
Accounts receivable          300,000                    0
Goodwill                     250,000                    0
                           1,050,000             $900,000

Liabilities:

Mortgage                     200,000
Accounts payable             100,000
                           $ 300,000

In addition, X has a $60,000 Sec. 48 1 (a) gain in 1995. If on Jan. 1, 1995, X sold all its assets to a third party for cash plus assumption of liabilities, X would realize $1,050,000 and have a built-in gain of $1 10,000, computed as follows:

Amount realized                       $1,050,000
Basis of assets                      -   900,000
Deduction allowed                    -   100,000
BIG on assets                             50,000
Sec. 481 gain                        +    60,000
Net unrealized built-in gain           $ 100,000

Any gain recognized by an S corporation during the recognition period is presumed, under Sec. 1374(d)(3), to be a recognized built-in gain except to the extent the S corporation shows it did not hold the asset on the first day of the recognition period or the appreciation occurred since that day. Sec. 1374(d)(4) provides similar rules for built-in losses.

Allocation Rule

If an S corporation has numerous items generating income, gain, loss and deduction in the prelimitation amount, an allocation rule is used to compute the S corporation's net recognized built-in gain.(8)

Example 5: P, an S corporation, has a built-in gain of $100, computed as follows:

                               Built-in
               FMV    Basis   gain/(loss)

Sec. 1231

assets:

  A            $100   $150    $ (50)
  B             100     50       50
  C             100    100        0

Accounts

   receivabe    100      0      100
               $400   $300     $100

If P sells asset B for $100 and collects the accounts receivable in the same tax year, a gain of $150 is recognized. The recognized built-in gain of $100 consists of ordinary income of $67 from the accounts receivable and Sec. 1231 gain of $33 from the disposition of asset B.

If asset A were sold in the same year for $100, the net recognized built-in gain of $100 would be all ordinary income since the net Sec. 1231 gain is $0.(9)

Built-in Income Rules

The proposed regulations provide that these rules apply only to built-in gains and losses recognized in a transaction treated as a sale or exchange for Federal income tax purposes.(10) Gains or losses from other transactions are taken into account under the built-in income and deduction rules.(11) The proposed regulations use a tax accrual concept to determine whether an item is attributable to a C corporation tax year and is, thus, a built-in income or deduction item. Under this approach, if an item of income would have been accrued before the conversion date by an accrual-method taxpayer described in Secs. 446 and 451, realization of that income is treated as a net recognized built-in gain by a cash-method S corporation for purposes of the Sec. 1374 tax.(12) Under this rule, collection of preconversion accounts receivable by a cash-basis S corporation will be taxed as a built-in gain. However, accrual-basis taxpayers will have already recognized the income from accounts receivable, so no unrecognized built-in gain occurs.

Although the recognized built-in gain and loss rules apply during the recognition period to transactions treated as a sale or exchange for Federal income tax purposes, as well as items included in gross income using the accrual method of accounting, the built-in gains will not necessarily be the same amounts.

Example 6: X is a cash-method taxpayer that elects S status on Jan. 1, 1995. On Dec. 31, 1994, X has outstanding accounts receivable for services rendered with a face value of $50,000, a fair value of $40,000 and a basis of $0. If the accounts receivable are collected in 1995, the built-in gain under Prop. Regs. Sec. 1.1374-4(b) is $50,000, the amount that would have been included in gross income in 1994 had X used the accrual method of accounting.

However, if the accounts receivable were sold in 1995 for $45,000, the built-in gain under Prop. Regs. Sec. 1.13 74-4(a) would be $40,000.(13)

The preamble to the proposed regulations stated that the guidance provided by the proposed regulations should be "relatively simple for taxpayers to understand and comply with." To determine the correct built-in gain in Example 6, the taxpayer must know in advance whether the receivables will be sold or held for collection. What if the taxpayer values the receivables using the collection method and, due to cash flow problems, sells the receivables for less than their face value? Can the taxpayer reduce the total built-in gain as initially computed to reflect the lower value of the receivables? Strict application of the accrual method of accounting to a cash-method taxpayer seems inappropriate in this case. Consistent results could be obtained if the computation of the built-in gain for cash-method receivables was based on their sale or exchange value, rather than their face value, even if the intention is to collect the receivables.

To minimize the built-in gain on accounts receivable under the proposed regulations, cash-basis taxpayers should, on the last day of the C corporation tax year, reduce their accounts receivable balance by speeding up collection of outstanding receivables or by deferring billings.

The proposed regulations give two examples of when income recognized in the S corporation year is not subject to the built-in gains tax. Oil production payments do not trigger recognition of a built-in gain on a working interest in an oil well even if the working interest is substantially appreciated, provided the oil was not yet extracted from the ground at the beginning of the recognition period.(14) Also, service income deferred by an accrual-method taxpayer under Rev. Proc. 71-21(15) does not generate a built-in gain even though the amount was received before the corporation elected S status.(16)

The built-in gain rules apply to any open long-term contracts using the completed contract method. The Sec. 1374 tax applies to any deferred gain on these contracts at the time the S election takes effect.(17) Taxpayers using the completed contract method may wish to accelerate contract completion before electing S status.

Any income from discharge of indebtedness, during the first year of the recognition period, relating to a debt owed by the S corporation at the conversion to S status is a recognized built-in gain. Similarly, any bad debt deduction, during the first year of the recognition period, which arises from a debt owed to the corporation at the date of conversion to S status, will be considered a recognized built-in loss.(18)

Recognized built-in gain could also result from a domestic international sales corporation termination or disqualification occurring before the beginning of the recognition period.(19)

Either built-in gains or losses could result from adjustments under Sec. 481 due to a change of accounting method effective before the beginning of the second year of the recognition period.(20)

Built-in Deduction Rules

Any item properly taken as a deduction by an accrual-method taxpayer as described in Secs. 446 and 461 is a recognized built-in loss.(21) In general, any accrued deduction items must meet the economic performance test of Sec. 461(h). However, the proposed regulations exempt workers' compensation and tort liabilities(22) from the economic performance test.

Example 7: X Corp., a cash-method taxpayer, elects to become an S corporation on Jan. 1, 1995. In 1994, X loses a lawsuit and is obligated to pay damages of $150,000. Under Sec. 461 (h)(2)(C) this amount is not deductible until payment is made in 1995. The $150,000 deduction is allowed as a recognized built-in loss.(23)

Example 8: Assume the same facts as in Example 7, only X does not lose the lawsuit until 1995. Assuming X would not have been allowed a deduction with respect to the lawsuit before the beginning of the recognition period if it used the accrual method, the deduction is not a recognized built-in loss.(24)

The use of the economic performance test to determine built-in losses by cash-method taxpayers places an undue burden on the cash-method taxpayer and can be a trap for the unwary.

Example 9: Refer to Example 6. Assume the built-in gains on the accounts receivable is based on the income recognition value of $50,000, and X accrues wage expense of $50,000, anticipating this would generate a recognized built-in loss. The accounts receivable are collected in 1995, but due to a cash flow problem, the accrued salary is not paid until Sept. 1, 1995. The 8 1/2-month rule of Sec. 461(h)(3) for recurring items will invalidate the accrual, presumably denying the taxpayer the right to claim the accrued wages as a built-in loss. By not meeting the economic performance test, the taxpayer's net built-in gain of $0 ($50,000 accounts receivable - $50,000 accounts payable) becomes a net built-in gain of $50,000.

Must a cash-method taxpayer wait 8 1/2 months after electing S status to compute its net unrealized built-in gain? Also, what if the salaries were paid within the 8 1/2-month period, but collection of the receivables did not occur until the next tax year? Since there is no built-in loss carryover, must the taxpayer recognize a built-in gain in 1996? To preserve built-in deductions, an S corporation must carefully comply with the economic performance test of Sec. 461(h) and time recognition of built-in gains and built-in losses to occur within the same tax year.

Even for an accrual-method taxpayer, there appear to be instances when expenses that are clearly attributable to C status will not be taken into account for purposes of Sec. 1374. Secs. 404 and 267, which prevent accrual prior to the recognition period, will also prevent an item from being treated as a built-in deduction. For example, suppose a company declares a bonus to a more-than-50% shareholder but fails to pay the bonus by year-end. Under Sec. 404, a built-in deduction offset would be permitted only if accrued compensation were paid in the first 2 1/2), months of the following year; but for compensation accrued to a more-than-50% shareholder, the deduction would never be allowed due to Sec. 267. Because special rules postpone deductions in these cases, these amounts would not be taken into account by an accrual-method taxpayer even though they are true liabilities of the corporation. Thus, to qualify as a built-in deduction or loss, the item must have accrued economically before the effective date of the S election and must be an allowable deduction during the recognition period.

Installment Sales

The proposed regulations may require an S corporation to pay built-in gains taxes beyond the normal recognition period when some or all of a gain is deferred through an installment sale. Under the regulations, if the corporation sells an asset either before or during the recognition period and recognizes income from the sale under the installment method, the income is subject to the built-in gains tax to the extent it would have been taxed if the corporation had elected not to use the installment method. If the corporation sells the assets before the recognition period, the entire amount of income from the sale not previously reported will be treated as having been reported in the first year of the recognition period.(25)

In the first of two installment sale examples in the proposed regulations, an installment sale of an asset with a built-in gain is assumed to occur in the first year after electing S status, with full collection in year 5. If the corporation has sufficient taxable income in years 1 through 5, all of the built-in gain will be taxable on collection of the note in year 5, regardless of the taxable income limitation in the fifth year.(26) If taxable income during the first five years is less than the entire built-in gain, the recognized built-in gain in year 5 is the lesser amount. Thus, some of the built-in gain could permanently escape the built-in gains tax if taxable income were limited to zero in years beyond the installment note collection period, but within the 10-year recognition period.

Example 10: On Jan. 1, 1995, the date of converting to S status, X Corp. owns an asset with an FMV of $120,000 and an adjusted basis of $20,000. X sells the asset in 1995 for a $120,000 note with the principal amount due in 1999. X has an NOL of $60,000 in 1995 and $0 net income in 1996 through 1999. If X elected not to use the installment method, 1995 taxable income would have been $40,000. Therefore, X has a $40,000 net recognized built-in gain in 1999 (the year of collection), and a $60,000 recognized built-in gain carryover to succeeding tax years in the recognition period.

Example 11: Assume the same facts as in Example 10, only the installment sale occurs in the last C corporation tax year (1994). When the note is collected in 1999, the entire $100,000 is a recognized built-in gain since the taxable income limitation does not apply to a C corporation tax year.

The installment sale regulations offer a planning opportunity to minimize the built-in gains tax by timing the installment sale of the asset to occur after, rather than before, the S election is made. As Example 11 illustrates, there is no income limitation on computing the amount of built-in gain in the C corporation tax year, but there is an income limitation on the recognition of the built-in gain should the sale occur after electing S status. Careful monitoring of S corporation net income during the limitation period could result in a permanent deferral of all or part of the built-in gain.

However, having the final collection on a note receivable occur beyond the 10-year recognition period will not allow the taxpayer to bypass payment of the built-in gains tax.

Example 12: Assume the same facts as in Example 10, except that all of the installment receivable is collected in year 11. The net recognized built-in gain in the eleventh year is $40,000. The remaining gain of $60,000 escapes the built-in gains tax since taxable income beyond the eleventh year is outside the recognition period.

The proposed regulations do not address how gain is reported if a series of payments on the note goes beyond the 10-year period. There are two possible methods of reporting the tax in this circumstance. First, the built-in gains tax could be calculated by taxing the gross profit reported in each year. Alternatively, a reverse cost recovery approach could be used to accelerate recognition of the built-in gain by making all cash collections taxable until the gain is fully recovered. Also, it appears the taxpayer can avoid built-in gain recognition beyond the tenth year by incurring NOLs sufficient to offset the recognized built-in gain (the taxable income limitation amount).

Partnership Interests

To prevent C corporations from "hiding" substantially appreciated assets in a partnership before electing S status, the proposed regulations provide rules for determining recognized built-in gain when the S corporation owns an interest in a partnership. The regulations use an aggregate approach that looks through the partnership directly to its assets. Thus, if the partnership disposes of partnership assets, the gain flows to the S corporation partner, potentially triggering the built-in gains tax.

For S corporations with a small ownership interest in a partnership, it may be difficult to get the information necessary to make this calculation. In keeping with the simplicity intent expressed in the preamble, the proposed regulations include a de minimis rule. The lookthrough rules do not apply when the S corporation owns less than a 10% capital and profits interest in a partnership, provided the total value of the partnership interest owned is less than $100,000.(27)

If the de minimis exception does not apply, the proposed regulations treat an S corporation's distributive share of the partnership items as recognized built-in gain or loss to the extent that the distributive share would have been treated as a recognized built-in gain or loss had the items originated in and been taken into account directly by the S corporation. Prop. Regs. Sec. 1.1374-4(h)(1) provides a four-step approach:

* Step 1: Apply the rules of Sec. 1374(d) to the S corporation's distributive share of each partnership item to determine the extent to which each would have been treated as recognized built-in gain (or loss) if the items had originally been taken into account directly by the S corporation. These are referred to as "partnership 1374 items."

* Step 2: Determine the S corporation's net recognized built-in gain without the "partnership 1374 items."

* Step 3: Determine the S corporation's net recognized built-in gain with the "partnership 1374 items."

* Step 4: Subtract the amount in step 2 from the amount in step 3. The excess is the S corporation's "partnership RBIG" (or "partnership RBIL" if a negative number). The S corporation's net recognized built-in gain is the sum of the amount computed under step 2 plus the partnership RBIG. If there is a partnership RBIL, the S corporation's net recognized built-in gain is the amount computed under step 2 less the partnership RBIL.

However, the application of the lookthrough rules is generally limited by the S corporation's built-in gain or loss in its partnership interest.(28) If the S corporation disposes of its partnership interest during the recognition period, the amount treated as recognized built-in gain or loss on the disposition is adjusted to reflect amounts treated as recognized built-in gain or loss under the lookthrough rules.(29)

An S corporation's RBIG or RBIL limitation is computed by starting with the amount realized if the corporation sold its partnership interest at FMV to an unrelated party on the first day of the recognition period. This amount is decreased by the corporation's adjusted basis in the partnership interest, and increased or decreased by the corporation's allocable share of the partnership's Sec. 481(a) adjustments. If the result is positive, the S corporation has an "RBIG limitation" equal to that amount and an "RBIL limitation" of zero. However, if the result is a negative amount, the S corporation has an "RBIL limitation" equal to that negative amount and an "RBIG limitation" of zero.(30)

The regulations also contain two anti-abuse provisions that apply to contributions of property that have as their principal purpose avoiding the Sec. 1374 tax. One provision removes the limitation on partnership RBIG;(31) the other eliminates the de minimis exception for small partnership interests.(32)

If an S corporation holding a partnership interest at the beginning of the recognition period receives, in distribution, an asset that the partnership held at the beginning of the recognition period, when this asset is disposed of the S corporation will have to step into the partnership's shoes and recognize built-in gain to the extent the partnership had a built-in gain in the asset.(33)

The partnership interest rules are illustrated in the regulations with nine examples.(34) For S corporations not meeting the small partnership interest exemption, the information contained in these examples should be useful in computing any recognized built-in gain or loss.

Valuation of Inventory

The "big issue" addressed in the proposed regulations is the valuation of inventory when computing built-in gain. Unfortunately, the regulations limit the definition of FMV of inventory to one sentence and give no examples of how to value inventory. The proposed regulations use a "willing buyer and willing seller" standard rather than a retail sale approach for valuing inventory.(35) This approach assumes an FMV based on a bulk sale of inventory to someone who could use the inventory as part of a continuing business.(36)

The absence of specific guidance from the Service on the valuation of inventories was a perplexing issue for the many C corporations that adopted S status after the Tax Reform Act of 1986. Since most businesses in which inventory is a material asset have an inventory turnover greater than one, any built-in gain on inventory was probably recognized in the first year in which S corporation status was elected. It is unfortunate that it took the Service almost six years to issue regulations defining how inventory value should be computed and then stopped short of a comprehensive definition. In the absence of guidelines, many corporations electing S status may have used the bulk-sale formula,(37) While others may have taken a more conservative approach, valuing their inventories at a higher retail value. Companies using a higher value may be due a refund, provided the statute of limitations has not expired on the tax year in which the gain was recognized.(38) While it is not certain whether the IRS will approve any claim for refund, since the regulations specify a prospective effective date,(39) denying a claim for refund based solely on the prospective effective date would favor taxpayers who took a more aggressive approach by using the bulk-sale method at the expense of those who used a more conservative method.

The preamble offers considerably more guidance than the proposed regulations themselves. The preamble indicates that the Treasury and the IRS are investigating whether Rev. Proc. 77-12,(40) which gives guidance for valuing inventory when the assets of a business are purchased for a lump sum, should be modified to provide guidance for valuing inventory under certain sections, such as Sec. 1374, and whether the principles of relevant case law should be incorporated. Under Rev. Proc. 77-12, inventory is valued at replacement cost for raw materials. For retailers and wholesalers, a premium or discount from replacement cost may be appropriate under certain circumstances. For finished goods and work-in-process, the revenue procedure permits a comparative sales method or the income method. Under the comparative sales and income methods, deductions for estimated selling expenses and a fair return on the investment in the inventory are permitted.

The preamble to the proposed regulations suggests incorporation of the deciding principles of two court cases, Knapp King-Size Corp.(41) and Zeropack Co.,(42) into the revenue procedure. In Knapp King-Size, the court started with the retail selling price and used the following factors to determine the FMV of the inventory:

* A fair appraisal of the relative risks.

* The expenses and efforts already incurred by the seller as compared to those yet to be incurred in order to realize the aggregate retail price.

* The investment already put in as compared to those yet to be made to maintain the sales.

* The relative time span under which the seller and buyer had to expose themselves to financial risk.

Based on these factors, the court computed inventory value based on the retail value less costs of disposition and a return on the investment in the inventory. Should the final regulations incorporate the principles of Knapp King-Size and Zeropack, there could be a conflict with the bulk-sale approach, since the sale of inventory in the ordinary course of business assumes an item-by-item sales price, while a bulk-sale price assumes a single sales price. Also, selling costs would differ significantly under the two assumptions. in a bulk sale of inventory, in conjunction with the sale of the entire business, no additional transportation or storage costs would be incurred, and selling expenses would be minimal. But if the inventory is sold to a competitor, selling expenses could be substantial if the inventory has to be moved to another location. Although selling expenses, assuming a retail sales method, could be estimated from selling expenses incurred in prior years, the amount could be significantly different from estimated selling expenses assuming a bulk sale.

When computing a hypothetical sales price, the bulk-sale price may be only a fraction of the total retail price and could possibly be less than the cost or market value of the inventory, resulting in a built-in loss rather than a built-in gain.

Example 13: X Corp., an accrual-basis C corporation, operates a retail store. It elects S status on Jan. 1, 1995. Its inventory has a FIFO cost and replacement cost of $500,000 and a retail value of $750,000. Normal selling expenses average 10% of retail value and X's cost of capital is 15 %. Should the inventory be sold to a competitor in a bulk sale, the cost of counting, packing and moving the inventory to the competitor's warehouse would be approximately $50,000.

The bulk-sale value of the inventory is $450,000 ($500,000 - $50,000), while the net realizable value, assuming estimated selling expenses of $75,000 and a return on investment of $88,000, is $587,000 ($750,000 - $75,000 - $88,000). Thus, X could have a built-in loss of $50,000, or a built-in gain of $87,000, depending on whether a bulk-sale method or a comparative sales method is assumed.

The preamble to the regulations suggests a safe harbor rule to value the S corporation's recognized built-in gain on its inventory by subtracting from gross receipts the cost of goods sold and direct selling expenses from one inventory turn after the first day of the recognition period and grossing up these amounts by a "designated percentage" for costs that add value to the inventory but were not taken into account in determining the inventory's gross profit. Thus, recognized built-in gain from inventory for the first year of the recognition period would be equal to the inventory's gross profit, net of direct selling expenses, for that year divided by the number of inventory turns in that year multiplied by the designated percentage. The number of inventory turns in the first year of the recognition period would be equal to the cost of goods sold for that year divided by that year's opening FIFO value. In the case of a LIFO taxpayer, no gross profit from inventory would be treated as recognized built-in gain until the taxpayer invades LIFO layers in existence on the first day of the recognition period. No explanation of the "designated percentage" adjustment is offered. Presumably, it is intended to take into account those costs adding value to the inventory that are incurred between the valuation date and the date of sale.

Example 14: Assume the "designated percentage" in Example 13 is 10%. The built-in gain would be $117,500 [$750,000 - (($500,000 + $75,000) x 1.10)], since this method does not permit a deduction for a rate of return on investment in the inventory and increases the gain by a designated percentage.

While this safe harbor may be simple, it certainly does not favor the taxpayer because it will likely result in inventory being valued at or near its retail value, rather than at a bulk-sale value. A better safe harbor would rely on the Zeropack formula, which starts with replacement cost and allows a deduction for estimated costs to count, transport and store the inventory to the purchaser's place of business, and another deduction for the investment in the inventory, using some nominal rate of return. Any safe harbor rule should be based on a bulk-sale value, which assumes a single purchaser, rather than on a retail-sale value, which assumes many purchasers.

Another issue that needs to be addressed by either regulation or ruling is what impact the Sec. 263A costs have on the built-in gain. Should the Sec. 263A costs increase the cost basis in the inventory, thus reducing the built-in gain, or are Sec. 263A costs an adjustment to income that do not affect the value of the inventory? A pro-taxpayer solution would be to subtract from the built-in gain in the inventory any Sec. 263A costs capitalized on the last day of the C corporation's tax year.

Since recognized built-in gain is generally limited to gain on assets owned on the date of conversion to S status, a corporation with substantial inventory could have difficulty in identifying when specific inventory items are sold. The proposed regulations ease the burden somewhat by permitting taxpayers to use their own method of accounting (LIFO or FIFO) to determine which inventory has been sold for the purposes of calculating the NRBIG. Thus, a corporation using the LIFO method would not recognize a built-in gain on sale of inventory during the 10 years after conversion, except to the extent that a LIFO layer existing before the beginning of the first tax year as an S corporation is invaded. However, a corporation using the FIFO method would be subject to the built-in gains tax within the first tax year after converting to S status if the bulk-sales valuation is greater than its FIFO cost, unless the company has an inventory turnover ratio less than one.(43)

To prevent a C corporation from using the LIFO method to avoid the built-in gains tax, Sec. 1363(d)[f] requires a C corporation for its last tax year before electing S status to recognize as income a LIFO recapture amount. The LIFO recapture amount is the amount by which inventory computed under the FIFO method exceeds the inventory's value under the LIFO method. The provision effectively eliminates the possibility of avoiding the built-in gains tax by not invading pre-S election inventory layers.

The proposed regulations appear to block adopting the LIFO method, either before or immediately after the S election is made, to obtain tax deferral benefits, by providing that if a corporation changes its method of accounting to the LIFO method with a principal purpose of avoiding the tax imposed under Sec. 1374, it must use the FIFO method to identify its dispositions of inventory.44

Property Acquired in Other Nontaxable Transactions

Sec. 1374(d)(3)(a) provides that the built-in gains tax applies only to gains recognized on assets owned on the date of conversion to S status. At first glance, this provision appears to permit avoidance of the built-in gains tax through a tax-free corporate reorganization or a like-kind exchange of built-in gains property. This, however, is not the case. An S corporation acquiring assets from a C corporation in a tax-free reorganization has a built-in gain under Sec. 1374(d)(8), which uses rules similar to those applicable to a C corporation converting to S status. There are two important special rules. First, the 10-year recognition period begins on the date of the reorganization or acquisition of the like-kind asset. Second, the tax applies to all S corporations subject to Sec. 1374, even if they have never been C corporations. Thus, the built-in gains tax applies even though the transferee corporation has always been an S corporation or the assets were not acquired until after the beginning of the transferee corporation's first tax year as an S corporation.

The proposed regulations specify that a separate determination of tax is to be made with respect to the assets the S corporation acquired in one Sec. 1374(d)(8) transaction from the assets the S corporation acquired in another Sec. 1374(d)(8) transaction and from the assets the corporation held on the first day of the recognition period. Thus, the loss carryforwards acquired in one Sec. 1374(d)(8) transaction can offset only the net recognized built-in gain attributable to assets acquired in the same transaction.(45)

In Ann. 86-128,(46) the Service stated that the regulations would apply a similar rule to property received by S corporations not subject to the Sec. 1374 tax from an S corporation subject to the tax. However, the proposed regulations make no mention of this rule. Presumably, the IRS intends to issue some additional guidance on this subject. Assets subject to the built-in gains tax in the hands of a transferor S corporation will continue to be subject to the tax in the hands of a transferee S corporation for the balance of the recognition period. However, assets not subject to the tax while held by the transferor should not become subject to it simply because they are transferred in a reorganization.

The transferred basis rule can have two effects on the S corporation's basic 10-year recognition period. First, this rule can extend the recognition period to include more than the first 10 years of the S corporation election period. If such an extension does occur, the extended period of time applies only to transferred basis properties that were acquired after the first day of the S corporation election period.

Second, an S corporation can be subject to the Sec. 1374 tax for more than one 10-year recognition period during its existence should it receive property from a second C corporation at a date subsequent to the beginning of the first recognition period. Similarly, the second recognition period applies only to the transferred basis property acquired from the second C corporation.

Under Sec. 1374(d)(6), the unrealized built-in gain taint carries over to any replacement property received in a like-kind exchange or an involuntary conversion. The recognition period for the replacement asset is the remainder of the 10-year recognition period that applied to the transferred assets. Both like-kind exchanges and involuntary conversions can result in the partial recognition of the S corporation's realized gain (e.g., when boot property is received). The proposed regulations do not specifically address the tax treatment for transactions when part of the S corporation's realized gain is recognized. One could guess that the portion of the built-in gain that must be recognized by the S corporation under Sec. 1031 or 1033 will be taxed under Sec. 1374 and then will act to reduce the built-in gain that is carried over to the replacement property. However, the proposed regulations do not address this issue.

It is still possible to use Sec. 1031 to achieve a tax-free transfer of built-in gain property for other like-kind property if the replacement property is held for the remainder of the 10-year recognition period. This holding period may even be reduced if the exchange is between brother-sister corporations. As long as the second corporation holds the original property for at least two years, it appears that the corporation may then dispose of the property without triggering the built-in gains tax on the first corporation.

Contributions of Built-in Loss Property

The Sec. 1374 tax is limited to the net unrealized built-in gain when the S election takes effect. An obvious way to reduce that built-in gain would be to contribute assets with built-in losses before the effective date of the S election. The corporation would receive a substituted basis in the assets and the built-in losses would reduce the net unrealized built-in gain. The proposed regulations prevent such tax-motivated transactions by providing "anti-stuffing" rules. If a corporation acquires an asset before or during the recognition period with a "principal purpose" of avoiding the Sec. 1374 tax, any loss relating to it will be disallowed.(47)

The proposed regulations were expected to include rules similar to those in Sec. 336(d)(2),(48) which would have provided that the loss inherent in property contributed to a corporation within two years before the earlier of (1) the effective date of the S election or (2) the filing of its election would not reduce built-in gains unless the taxpayer demonstrated "a clear and substantial relationship" between the contributed property and the conduct of the corporation's business. However, the proposed regulations contain no mention of a specific time period.

Broad Use of Carryforwards Allowed

The regulations allow the use of NOL and capital loss carryforwards from C years as deductions against net recognized built-in gain unless the losses are limited under Sec. 382, 383 or 384.(49) However, any other carryforwards, such as charitable contributions carryforwards, are not allowed as deductions against net recognized built-in gain.(50)

The amount of recognized built-in gain subject to tax under Sec. 1374 may not be reduced by NOL carryovers from other S corporation years, but may be reduced by NOL carryovers from C corporation years.(51) For purposes of determining the amount of an NOL that can be carried forward to later tax years, the amount of net recognized built-in gain is treated as taxable income.(52) Presumably, to the extent capital loss carryforwards are used to offset that part of the net recognized built-in gain consisting of capital gains, the amount of the net recognized built-in gain will be reduced by the offset in determining the amount of an NOL that can be carried forward to a later tax year.

Note that an NOL from a C corporation tax year is not carried over in determining an S corporation's taxable income. Once taxable income is determined and the amount of the net recognized built-in gain is determined, the NOL carryforward can be used to offset the net recognized built-in gain.

The only tax credits that can reduce the built-in gains tax are Sec. 39 business credits carried forward from C corporation years of the corporation; Sec. 53 minimum tax credits to the extent attributable to tax years for which the corporation was a C corporation; and Sec. 34 gasoline and special fuels credits.(53) Tax credit carryforwards from C corporations that merge into S corporations subject to the built-in gains tax can offset the tax on built-in gains from the acquiring corporation's disposition of its built-in gain assets, but cannot be used against other built-in gains.(54)

Effective Date

The regulations generally are effective for tax years ending on or after the date the regulations are finalized, but only when the return for the tax year is filed under an S election made on or after that date.(55)

Comments Requested

in the preamble, the IRS and the Treasury specifically request comments on the following issues relating to the uses of safe harbors: the usefulness of safe harbor rules for determining recognized built-in gain from inventory; the actual safe harbor rules described in the preamble for computing the built-in gain from a corporation's inventory, including what the designated percentage should be and how the rules would apply to LIFO taxpayers; any alternative safe harbor rule that is relatively simple to administer and consistent with the rule for valuing inventory provided in the proposed regulations.

Suggestions for Improving Final Regulations

Although the proposed regulations attempt to deal with most of the primary issues under Sec. 1374, many questions remain. The statute gives the S corporation the burden of establishing the amount of built-in gain, yet is silent regarding acceptable means to establish asset values. Although the proposed regulations address inventory valuation, valuation of other assets is not addressed. For example, the valuation of intangible assets raises numerous issues. Some intangible assets appearing on a corporation's balance sheet may have little or no economic value to the enterprise, while other intangible assets not appearing on its balance sheet may have enormous value. In either case, the FMV of intangible assets is always difficult to compute. Final regulations should offer additional guidance on the valuation of intangible assets in the absence of an offer to purchase the entire business. The importance of making a going-concern valuation of the business on the last day of its C corporation existence cannot be overstated. The valuation issue is discussed further in the appendix on pages 605-607.

A related question is whether a corporation's tax attributes, such as any NOL carryforward, capital loss carryforward or business credit carryforward, are "assets" with economic value, which must be properly reflected in computing a corporation's net unrealized built-in gain at the time of its election.

The computation of built-in income by cash-method taxpayers should be limited to the receivables' sale or exchange value, rather than face value. Built-in deductions should not be held to the 8 1/2-month rule for economic performance, but should be permitted as a deduction in the year the built-in income is recognized, provided they are paid by the last day of that tax year. If paid in a year prior to the year the built-in income is recognized, a built-in deduction carryforward should be allowed. Also, guidance should be given on how to establish built-in income and deduction values. Must a cash-basis taxpayer prepare an accrual-basis balance sheet, or will a list of accrued income and deduction items be sufficient? Must accrued deductions be approved by the board of directors and included in the corporate minutes, or does the accountant preparing the built-in gain computation have the discretion to determine appropriate year-end accruals?

The valuation of inventory issue should be addressed in greater detail in the final regulations, and examples of acceptable and unacceptable valuation methods should be given. Any safe harbor inventory value should be based on a replacement cost value adjusted for the costs associated with selling the inventory to one purchaser and permitting a deduction equal to the opportunity cost of holding the inventory for one inventory turnover cycle.

Conclusion

While the proposals are effective only after the final regulations are issued, some S corporations may be entitled to a built-in gains tax refund if they feel they overstated the value of their inventories based on the principles set out in the proposals. Also, corporate clients that were reluctant to elect S status in the absence of more specific guidance on the built-in gains tax may now be willing to make the election, taking into account other considerations, such as the increase in the top marginal rate for individuals.

Appendix: Valuing Assets at the Date of Conversion from C to S

When a C corporation elects S status, it is imperative that the FMV of all assets (both tangible and intangible) and liabilities be determined. This should be done, ideally, by a competent appraiser. In the absence of a professional appraisal, the taxpayer should estimate the FMV of each asset, set out the method used to arrive at each value, and make a complete list of all corporate liabilities, including all unpaid bills (essential, even if the corporation uses the cash method of accounting).

Hindsight, that is, waiting until the assets are sold to determine their value, will likely expose the taxpayer to the risk that all their appreciation will be subject to the built-in gains tax. The taxpayer has the burden of proof in refuting this presumption. Also, some assets may have been acquired after the conversion date and not be subject to the built-in gains tax. Without documentation, however, this may be difficult to prove, especially in the case of intangible assets.

When all the assets of a business are sold in a single sale, a problem arises in allocating the lump-sum purchase price among the various assets. The IRS now requires both the purchaser and seller to attach to the tax return Form 8594, Asset Acquisition Statement Under Section 1060, indicating the allocation of the purchase price among the various assets. If the total purchase price exceeds the sum of the FMVs of the tangible assets, the net or residual amount is allocated to goodwill, or other comparable intangible assets.

In the absence of a sale, such as at the date of conversion from C corporation to S corporation, some other method of valuing intangibles may be used. According to Rev. Rul. 59-60, 1959-1 CB 237, goodwill can be based on the expected future earning capacity of the firm. The presence of goodwill and its value rests on the excess of the net earnings over and above a fair return on the net tangible assets. While Rev. Rul. 59-60 indicates numerous methods for valuing goodwill, one method, the capitalization of historical average earnings, is fairly easy to compute, although it can yield a wide range of values, depending on the discount rates used.

The starting point for this method is the average earnings for a period of time (for example, five years). From this amount, an estimated return on the tangible assets (for example, 10%) is deducted. The excess net earnings, presumably attributable to the intangibles, is capitalized (for example, at 20%) to arrive at the estimated value of goodwill.

Example: The average annual earnings for X Corp. for the period 1988-1992 are $635,850. The average net tangible assets for the same time period are $5,889,128. The appropriate discount rate is 10% for the tangible assets, and 20% for the intangible assets.

The goodwill is valued at $234,685, computed as follows:

Average net earnings $635,850

Return on tangible assets

($5,889,128 X 10%) -588,913

Net earnings on

intangible assets 46,937

Capitalization rate,

  @ 20%                        X      5
                               $234,685

While there are several problems with this valuation method--e.g., historical earnings may not be representative of future earnings; the appropriate discount rates for tangible and intangible assets are unknown; or the "goodwill" may have a limited life, especially if it is attributable to an intangible, such as a trade name or a customer list--it at least offers a starting point. The presence of goodwill cannot be ignored when computing the corporation's built-in gain, and in the absence of a competent, professional appraisal, the taxpayer may have to rely on this method to approximate goodwill.

Comprehensive Example

The following example illustrates the problems facing a C corporation in computing its built-in gain in the absence of a professional appraisal of the assets on the last day of the C corporation tax year.

* Scenario

ABC Corp. is a successful distributor of plumbing supplies to contractors. The corporation was formed on Feb. 1, 1983 by C, who is the sole shareholder. ABC's taxable income averages $30,000 per year, which is net of a $750,000 salary payment to C. Should the corporation's tax return be audited by the IRS, it is likely that $500,000 of the salary could be deemed excessive. To avoid the excessive salary issue, ABC elected S status, effective with the 1992 calendar year.

The balance sheet of the final C corporation year on Dec. 31, 1991 is:

Cash                                        $ 524,410
Accounts receivable                            21,500
Inventory                                     623,986
Other current assets                            9,542

Adjusted basis of depreciable assets

(accumulated depreciation, $704,075)           930,562
Total assets                                 2,110,000
Notes payable                                  540,000
Current liabilities                            676,224
Loans from stockholders                        375,000
Mortgages payable                               86,660
Capital stock                                   58,695
Retained earnings                              373,421
Total liabilities and capital               $2,110,000

No appraisal of the business was made on Dec. 31, 1991. The profitability of the business did not go unnoticed. A competitor offered to purchase the major assets of the company for a single cash payment on Feb. 1, 1993. The agreed on sales price, adjusted basis of the assets and realized gain are as follows:

Asset           Sales price   Adjusted basis   Realized gain
Inventory       $1,834,000      $1,189,091       $ 644,909

Depreciable assets 1,281,000 1,140,343 140,657

Favorable

lease             740,000                0         740,000
Customer list      70,000                0          70,000

Assembled 

work force        150,000                0         150,000
Trade name        110,000                0         110,000
Goodwill          615,000                0         615,000

Covenant not

to compete        850,000                0         850,000
Total          $5,650,000       $2,329,434      $3,320,566

C is faced with the task of proving that the entire realized gain of $3,320,566 is not subject to the Sec. 1374 built-in gains tax. There are three separate built-in gain issues: the gain on the inventory, the gain on the depreciable equipment and the gain on the intangible assets.

* Inventory gain

The sales price of the inventory was based on the bulk purchase value method as computed in Knapp King-Size. The sales price in the ordinary course of business was reduced by normal selling expenses and a return on the investment in the inventory. Since the Dec. 31, 1991 ending inventory is only 52% of the Feb. 1, 1993 ending inventory, only a portion of the gain, approximately $338,000, can be considered built-in gain in the inventory. Since ABC uses the FIFO method of inventory, any built-in gain in the inventory should be reported on the 1992 tax return. If this was not done, an amended 1992 S tax return to reflect the built-in gain in the inventory should be filed.

* Depreciable asset gain

ABC owned depreciable assets of $1,634,637 (before accumulated depreciation) on Dec. 31, 1991. By Feb. 1, 1993, this amount increased by $308,351 to $1,942,988. Since it appears that 16% of the depreciable assets were acquired after electing S status, the built-in gain should be limited to $120,000, 84% of the total gain. The fact that the realized gain on the sale of the depreciable assets is all Sec. 1245 (ordinary) gain does not preclude the imposition of the built-in gains tax. Also, C should have made an itemized list of each depreciable asset's current FMV and adjusted basis to possibly establish that a larger portion of the gain is attributable to assets acquired after electing S status and is therefore not subject to the built-in gains tax.

* Intangible asset gain

ABC has a realized capital gain on the sale of its intangible assets of $2,535,000. C can assert that the gain attributable to the covenant not to compete is not a built-in gain, since this asset was not in existence at the date of electing S status.

To compute the value of the intangible assets on the date of electing S status, the capitalization of historical earnings method can be used. However, in this case, actual average historical earnings should be increased by the excessive salary payments made to C. Under this method the intangible assets are valued on Dec. 31, 1991 at $1,595,000, computed as follows:

Average taxable income              $   30,000
Excessive salary                       500,000
Average annual earnings                530,000

Less: return on tangible assets

$2,110,000 x 10  )                     211,000
Net earnings on intangible assets      319,000
Capitalization rate  @ 20%)         X        5
Goodwill                            $1,595,000

In addition to the built-in gain in the inventory of over $300,000, and the built-in gain in the depreciable assets of $120,000, there is a built-in gain attributable to the intangible assets of over $1,500,000. Since no competent appraisal of the business was made when electing S status, it is likely the corporation will have a built-in gains tax liability of at least $680,000. (1) TD CO-80-87 (12/8/92). (2) Rev. Rul. 86-141, 1986-2 CB 151. (3) Ann. 86-128, IRB 1986-51, 22. (4) Notices 88-134, 1988-2 CB 559; and 90-27, 1990-1 CB 336. (5) Sec. 1374(d)(7). (6) Prop. Regs. Sec. 1.1374-2(c). (7) Prop. Regs. Sec. 1.1374-3(a). (8) Prop. Regs. Sec. 1.1374-2(b). (9) Adapted from the example in Prop. Regs. Sec. 1. 13 74-2(e). (10) Prop. Regs. Sec. 1.1374-4(a). (11) Prop. Regs. Sec. 1.1374-4(b). (12) Prop. Regs. Sec. 1.1374-4(b)(1). (13) Prop. Regs. Sec. 1.1374-4(b)(3), Example 1. (14) Prop. Regs. Sec. 1.1374-4(b)(3), Example 2. (15) Rev. Proc. 71-21, 1971-2 CB 549. (16) Prop. Regs. Sec. 1.1374-4(b)(3), Example 4. (17) Prop. Regs. Sec. 1.1374-4(f). (18) Prop. Regs. Sec. 1.1374-4(e). (19) Prop. Regs. Sec. 1.1374-4(d). (20) Prop. Regs. Sec. 1.1374-4(c). (21) Prop. Regs. Sec. 1.1374-4(b)(2). (22) Sec. 461(h)(2)(C). (23) Prop. Regs. Sec. 1.1374-4(b)(3), Example 5. (24) Prop. Regs. Sec. 1.1374-4(b)(3), Example 3. (25) Prop. Regs. Sec. 1.1374-4(g)(1). (26) Prop. Regs. Sec. 1.1374-4(g)(2), Example 1. (27) Prop. Regs. Sec. 1.1374-4(h)(5)( (28) Prop. Regs. Sec. 1.1374-4(h)(2). (29) Prop. Regs. Sec. 1.1374-4(h)(3). (30) Prop. Regs. Sec. 1.1374-4(h)(4). (31) Prop. Regs. Sec. 1.1374-4(h)(2)( (32) Prop. Regs. Sec. 1.1374-4(h)(5)( (33) Prop. Regs. Sec. 1.1374-4(h)(7). (34) Prop. Regs. Sec. 1.1374-4(h)(8). (35) Prop. Regs. Sec. 1.1374-7(a). (36) At the IRS hearings on the built-in gain regulations on Apr. 28, 1993, Eric Solomon, IRS Corporate, reiterated the IRS position that the term bulk sale should not be used in a distressed sale context, but rather in the context of selling the entire business. (37) See Tax Clinic, "S Corporation's Built-In Gains Tax," 20 The Tax Adviser 320 (May 1989); Schultz and Connors, "The S Corporation Built-In Gains Tax--Can It Be Avoided?" 20 The Tax Adviser 383 (June 1989). (38) For companies electing S status in 1987, 1988 and possibly 1989, the statute of limitations expired before the proposed regulations were issued. (39) Prop. Regs. Sec. 1.1374-10. (40) Rev. Proc. 77-12, 1977-1 CB 569. (41) Knapp King-Size Corp., 527 F2d 1392 (Ct. Cl. 1975)(37 AFTR2d 76-501, 76-1 USTC [paragraph] 9128). (42) Zeropack Co., TC Memo 1983-652. (43) Prop. Regs. Sec. 1.1374--7(b) (44) Id. (45) Prop. Regs. Sec. 1.1 (46) Ann. 86-128, note 3. (47) Prop. Regs. Sec. 1.1374-9. (48) Ann. 86-128, note 3. (49) Prop. Regs. Sec. 1.1374-2(d). (50) Prop. Regs. Sec. 1.1374-5(a). (51) Sec. 1374(b)(2). (52) Id. (53) Prop. Regs. Sec. 1.1374-6(a). (54) Prop. Regs. Sec. 1.1374-8(a (55) Prop. Regs. Sec. 1.1374-10.