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Finally, guidance on the built-in gain tax.

Following the Tax Reform Act of 1986, many corporations found it beneficial to be taxed as S corporations. But if a corporation elected S status after December 31, 1986, it may be subject to the built-in gain tax. The tax generally does not apply to corporations that always have been S corporations (a special transition rule applies to corporations that made the election before 1989) and is a major exception to the general rule that S corporations are not taxed on their earnings, which instead flow through to shareholders and are reported on their individual tax returns.

Internal Revenue Code section 1374 imposes a corporate-level tax on S corporations' income or gain recognition to the extent it reflects unrealized appreciation in a corporation on the date it switched from C to S status. Any gain recognized and taxed to such corporations is passed through and taxed to shareholders, resulting in a double tax. Corporations treat the tax as a loss, which also is passed through to shareholders. Section 1374 requires corporations to calculate this unrealized appreciation on assets at the time they convert to S status, which involves valuing assets. Valuing inventories has been particularly troublesome, since it was unclear which valuation method should be used.

Before the Internal Revenue Service issued the proposed regulations, little guidance was available regarding elements of the built-in gain computation, including the treatment of

* Sales or exchanges.

* Items of income or deduction.

* Discharge of indebtedness.

* Bad debts.

* Long-term contracts.

* Installment sales.

* Partnership interests.

* Deduction and credit carryforwards.

* Inventory.

The proposed regulations provide muchneeded general guidance as well as specific guidance on a number of items. This article focuses on these rules.

NET RECOGNIZED BUILT-IN GAIN

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-year period beginning on the date of conversion to S status. The net recognized built-in gain and the tax are reduced by certain carryover items, as discussed below. It is unclear whether the 10-year period is defined in terms of months or tax years. What happens when the recognition period ends at a time other than the end of a taxable year also is unclear. One hopes the final regulations will provide further guidance.

The net recognized built-in gain on which the tax is computed is the least of

* The prelimitation amount (taxable income, which is determined using the C corporation rules and considering only recognized built-in gains, recognized built-in losses and recognized built-in gain carryovers).

* The taxable income limitation (overall taxable income, which is determined using the C corporation rules and considering not only the items above but als5 other items that normally enter into the taxable income computation: net operating loss and certain other corporate deductions are not taken into account).

* The net unrealized built-in gain limitation (the amount by which net unrealized built-in gains exceed net recognized built-in gains for all prior taxable years).

If either the taxable income or the net unrealized built-in gain limitation applies for any taxable year, S corporations' net recognized built-in gain consists of a ratable portion of each item of income, gain, loss and deduction included in the prelimitation amount. Also, if the taxable income limitation applies for any taxable year to S corporations whose elections were made after March 30, 1988, the amount by which the prelimitation amount exceeds the taxable income limitation (recognized built-in gain carryover) is included in the prelimitation amount for the succeeding taxable year. Thus, the built-in gain tax generally cannot be avoided completely by incurring non-built-in losses or deductions in 1 or several years of the 10-year recognition period. Nevertheless, reducing taxable income by paying compensation or other means is a common planning technique to limit the tax in a particular year.

In using the C corporation rules to determine income, it appears cash-basis S corporations may have to recalculate their incomes on an accrual basis if they would be required to use that method as C corporations. The American Institute of CPAs tax division asked the IRS to specify in the final regulations that S corporations should apply C corporation rules using their current accounting and election methods.

NET UNREALIZED BUILT-IN GAIN

Congress defined net unrealized built-in gain for purposes of the limitation on the built-in gain tax as the fair market value of S corporations' assets at the time of conversion to S status minus their aggregate adjusted cost bases. The IRS clarified the definition in the proposed regulations, saying the net unrealized built-in gain is the total of the following as of the first day of the recognition period:

1. The amount that would be realized if the corporation sold all of its assets at fair market value to an unrelated party that assumed all liabilities. Thus, valuation in a liquidation setting has been rejected. This amount is

* Decreased by any liability included in the amount realized (but only if the corporation would be allowed a deduction on payment of the liability).

* Decreased by the aggregate adjusted bases of the corporation's assets.

* Increased or decreased by the corporation's IRC section 481 adjustments-- items of income or deduction to be reported in the future due to a past accounting method change. Such adjustments are considered recognized built-in gains or losses when taken into account during the recognition period.

2. Any recognized built-in losses that are not allowed under the trafficking limitations of IRC sections 382, 383 and 384 due to ownership changes.

According to the example in the proposed regulations, goodwill must be considered and valued when making this computation (see exhibit 1, at left).

SALES OR EXCHANGES

Recognized built-in gain includes any gain recognized during the recognition period on the sale or exchange of an asset except to the extent an S corporation establishes either that

* The gain exceeds the excess of the asset's fair market value at the time of conversion over its adjusted basis at that time.

* The asset was not held by it at the time of conversion.

The regulations do not address how S corporations should establish such values; however, it may be advisable to have major assets appraised as well as entire businesses (for purposes of the net unrealized built-in gain limitation).

Net unrealized built-in gain should be computed carefully at the time of conversion to S status: The resulting amount must be disclosed on page 2 of Form 1120S, U.S. Income Tax Return for an S Corporation, in the conversion year. In addition, all subsequent tax returns must disclose any remaining net unrealized built-in gain in excess of net recognized built-in gain from prior years. Therefore, S corporations should prepare detailed permanent tax work papers identifying each built-in gain item and its amount at the time of conversion. The work papers should be updated annually to reflect any changes in the disposition of assets, the recognition of built-in gain, etc.

Any realized but unrecognized gains on like-kind exchanges are not subject to the built-in gain tax, which provides a planning opportunity. If S corporations have a choice, an asset with a lower built-in gain than that of an asset of similar value should be sold to generate needed funds. And, assets with built-in losses can be sold to offset built-in gains in the same year.

ITEMS OF INCOME OR DEDUCTION

Other income or deduction items (besides sales or exchanges) taken into account during the recognition period are recognized built-in gains or losses if they are attributable to periods before conversion to S status.

Under the proposed rules, 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 by taxpayers using the accrual method before the conversion to S status. The amounts of these items for recognized built-in gain or loss purposes are the same as their proper accrual amounts as of the last C corporation year; for assets sold or exchanged, the fair market value at the time of conversion is relevant, as discussed above. While the IRS thought valuing such income or deduction items would be unduly burdensome, such items must be valued anyway in computing net unrealized built-in gain. For purposes of this rule, deduction items are taken into account under the accrual method without regard to the portion of the economic performance rules requiring payment for worker's compensation and tort liabilities.

According to the examples in the regulations, cash-basis taxpayers' accounts receivable held on the first day of the recognition period on which any payments are received during the recognition period are recognized built-in gain; the examples also clarify the treatment of mineral interests (see exhibit 2, page 81). Contingent liabilities at the time of S conversion, such as the possible settlement from a pending lawsuit that would not have been allowed as a deduction before the recognition period under the accrual method, do not give rise to built-in losses when paid. On the other hand, deferred payment obligations under a worker's compensation act or a tort that are not deductible at the time of the conversion under the economic performance rules requiring payment, such as obligations to pay fixed amounts of damages pursuant to a completed lawsuit, give rise to built-in losses when paid. Finally, prepayments of income received before the conversion for services that are properly reportable under revenue procedure 71-21 during the recognition period are not recognized built-in gain.

As a result of these rules, cash- or accrual-basis C corporations planning S elections should take appropriate action (such as board resolutions, book entries or documentation in the minutes) to establish that intended items of built-in loss are deductible under the accrual method before the election. An example is accrued compensation to owner-employees payable after the election becomes effective.

Finally, certain IRC provisions effectively put accrual-method taxpayers on the cash basis with respect to certain items such as expenses payable to related parties or deferred compensation (the accrued compensation discussed above) not paid within two-and-one-half months after yearend. It appears such items incurred before the recognition period nevertheless may not be recognized built-in losses when paid. The AICPA tax division suggested that the final regulations say these deduction limitations should not apply.

DISCHARGE OF INDEBTEDNESS AND BAD DEBTS

If discharge-of-indebtedness income or bad-debt deductions are taken into account properly during the first year of the recognition period and such items arise from debts owed by or to S corporations before conversion to S status, they are recognized built-in gains or losses. Thus, if these items are taken into account after the first year of the recognition period, they will not be recognized built-in gains or losses. Therefore, planning opportunities exist to defer discharge-of-indebtedness income beyond the first year or to accelerate bad-debt deductions into the first year.

LONG-TERM CONTRACTS

Any income item that was taken into account properly during the recognition period under the completed-contract method is recognized as built-in gain to the extent it would have been included in gross income under the percentage-of-completion method before the first day of the recognition period. Under a similar rule, deduction items are treated as built-in losses.

INSTALLMENT SALES

If corporations sell assets before or during the recognition period and report income under the installment method during or after that period, the built-in gain tax is imposed on the income when reported to the extent it would have been subject to the tax if the entire amount had been reported in the year of sale and the built-in gain provisions applied at the time. The regulations provide several examples illustrating this rule. The rule makes it possible to defer but difficult to avoid the tax completely using the installment method.

PARTNERSHIP INTERESTS

If at the beginning of the 10-year recognition period an S corporation holds a partnership interest, it must include its distributable share of partnership items when determining net recognized built-in gain or loss (in accordance with the lookthrough rules). S corporations include such partnership items as if each item originated in and was accounted for directly by the S corporation.

Application of the lookthrough rules generally is limited to S corporations' built-in gains or losses in a partnership interest. Therefore, the value of each partnership interest and each partnership item should be documented at the beginning of the recognition period. In addition, partnerships should track partnership items so any subsequent dispositions can be reported to S corporation partners, as appropriate. Any amount recognized as a built-in gain or loss as a result of the disposition of such partnership interest during the recognition period will be adjusted by a previously recognized built-in gain or loss under the lookthrough rules.

These rules also apply to transfers of property to partnerships during the recognition period. However, they do not apply to any year in the recognition period if a partnership interest's fair market value is less than $100,000 and represents less than 10% of partnership capital and profits at all times during the year.

DEDUCTION AND CREDIT CARRYFORWARDS

Only net operating loss and capital loss carryforwards from C corporation years are allowed as deductions from S corporations' net recognized built-in gains. Business credit carryforwards and minimum tax credits from C corporation years are allowed as reductions to the built-in gain tax. Because the minimum tax credit for C corporations cannot reduce regular tax below the tentative minimum tax, the proposed regulations require a hypothetical tentative minimum tax calculation when computing the credit.

A detailed example of this computation is included in the proposed regulations. Special fuel tax credits also reduce the tax. Any limitations on the use of a C corporation's carryforwards on the first day of the recognition period also limit their use against an S corporation's net recognized built-in gain and resulting tax. In addition, if corporations acquire assets to avoid net recognized built-in gains and the resulting tax, the asset and any loss, deduction or carryforward will be disregarded.

INVENTORY

For purposes of computing built-in gains or losses, the proposed rules say S corporations' inventory should be valued on the first day of the recognition period in an amount equal to the amount a willing buyer would pay a willing seller for it if the buyer purchased all the S corporation's assets on that day (the bulk sale rule). Valuing inventory on a bulk sale basis rather than on a retail sale basis generally results in lower values. Thus, the related built-in gain realized (the difference between this value and the inventory's cost) should be substantially less.

Before the regulations were proposed, it was unclear which method should be used to value inventory. The AICPA tax division suggested the final regulations use the term bulk sale and add an example illustrating how this valuation method could result in a lower inventory value than the retail method. It believes the approach taken in the proposed rules still requires engaging a professional to appraise inventory and does not adopt the replacement- or reproduction-costing method. Many S corporations use valuation methods (such as those based on retail values) that result in higher built-in gains. Such corporations may want to reevaluate their methods in light of the proposed rules.

S corporations determine whether the inventory disposed of during the recognition period is the inventory held on the first day of that period using the same method of accounting for inventory for tax purposes (first-in first-out, last-in firstout, etc.). For example, under the Lifo method, inventory disposed of is not considered held on the first day of the recognition period until the Lifo layers in existence on that day have been invaded. The Treasury Department and the IRS are considering whether previous guidance (including case law) for valuing inventory purchased for a lump sum should be modified and what, if any, safe-harbor rules for determining built-in gains from inventory should be implemented. (A suggested safe-harbor rule would allow recognized built-in gain to be computed as an amount equal to the gross profit from one inventory turn after the first day of the recognition period, multiplied by a designated percentage.)

EFFECTIVE DATES

The new rules will be effective for taxable years ending on or after the date final regulations are published in the Federal Register, but only when a return for the taxable year is filed pursuant to an S corporation election made on or after that date. Previous announcements and notices continue to apply to S corporations to which these new rules do not apply. In areas where there is no previous guidance, some commentators suggest existing S corporations consider adopting these proposed rules. Any C corporation currently considering conversion to S status may want to elect S status before the regulations are final to avoid potentially unfavorable provisions.

TABULAR DATA OMITTED

EXECUTIVE SUMMARY

* LONG-AWAITED IRS regulations on the S corporation built-in gain tax provide guidance on computing the tax, including specific items, valuing assets on an overall basis and valuing specific built-in gain or loss items.

* NET RECOGNIZED BUILT-IN gain, on which the tax is computed, is an S corporation's taxable income for the taxable year determined as if it was a C corporation with only recognized built-in gain and loss taken into account. The gain is limited to the lesser of a corporation's taxable income (determined as if it was a C corporation with all items taken into account) or its net unrealized built-in gain limitation.

* NET UNREALIZED BUILT-IN gain includes the amount that would be realized if a corporation sold all its assets at fair market value to an unrelated party that assumed all its liabilities.

* ITEMS OF INCOME OR deduction, properly taken into account during the 10-year recognition period in which the tax can apply, are treated as recognized built-in gains or losses if they would have been taken into account using the accrual method before the switch to S corporation status.

* DISTRIBUTABLE SHARES OF partnership items must be taken into account in determining S corporations' net recognized built-in gains.

* INVENTORY IS VALUED on the first day of the recognition period as equal to the amount a willing buyer would pay a willing seller for it if the buyer purchased all of the S corporation's assets.

* THE NEW RULES ARE effective for taxable years ending on or after the date final regulations are issued but apply only to S corporation elections made on or after that date.

SCOTT E. GRIMES, CPA, JD, is a partner in the Dublin, Ohio, office of Norman, Jones, Enlow & Co. He is a past member of the estate planning committee of the American Institute of CPAs tax division and currently serves on the tax practice committee of the Ohio Society of CPAs and the business tax committee of the Columbus, Ohio, Bar Association. MARILYN

K. WIGGAM, CPA, is a tax ,manager with Norman, Jones, Enlow & Co. in Dublin and dean of accounting and business operations at the DeVry Institute of Technology, Columbus. An AICPA and Indiana Society of CPAs member, she is the editor of the personal financial planning department of the Ohio CPA Journal.
COPYRIGHT 1994 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1994, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Wiggam, Marilyn K.
Publication:Journal of Accountancy
Date:Feb 1, 1994
Words:3181
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