United States: How S Corporations Can Minimize The Built-In Gains Tax

An S corporation that was previously taxed as a C corporation, or that received assets from a C corporation in a carryover-basis transaction, can be subject to the built-in gains tax. Fortunately, there are several planning techniques for minimizing or entirely avoiding the built-in gains tax. Some of these techniques received a significant boost from the Protecting Americans from Tax Hikes Act (the "PATH Act"), enacted on Dec. 18, 2015.

Overview of Entity Taxation

Different types of entities are subject to different tax rules. Income earned by C corporations is subject to two levels of tax, at the entity level (when the income is earned) and at the shareholder level (when the earnings are distributed to the shareholders). By contrast, income earned by pass-through entities, including S corporations, partnerships and disregarded entities, is generally not subject to tax at the entity level. (Limited liability companies can choose to be taxed as C corporations or as pass-through entities.) Instead, a pass-through entity's items of income and loss pass through to its owners.

Shareholders of a C corporation that want to change it to a pass-through entity generally have two alternatives: (1) convert the C corporation to a limited liability company taxed as a partnership (or a disregarded entity in the case of a single owner), or (2) elect to treat the C corporation as an S corporation (assuming the requirements for S corporation treatment, discussed below, are satisfied). The first alternative would result in entity-level taxable gain, generally in the amount of the fair market value of the assets of the C corporation, reduced by the assets' aggregate tax bases. By contrast, the second alternative can avoid the entity-level taxable gain unless the built-in gains tax applies.

Overview of S Corporation Taxation

A corporation can be taxed as an S corporation if it satisfies certain requirements. First, an S corporation cannot have more than 100 shareholders. Second, an S corporation cannot have more than one class of stock, provided, however, that it can have stock with differing voting rights. Third, the only permitted shareholders are (1) individuals that are U.S. citizens or tax residents, and (2) certain trusts and estates.

An eligible entity can elect to be taxed as an S corporation since its formation. Alternatively, an eligible C corporation may generally elect to be taxed as an S corporation in any year after its formation. If an S election is terminated, the corporation and any successor corporation could not elect to be taxed as an S corporation for five years, without the consent of taxing authorities.

An S corporation is generally not subject to entity-level tax. Instead, items of income and loss pass through to the S corporation's shareholders, based on their respective ownership interests. Whether an item of income or loss is capital in nature is determined at the corporate level. Shareholders of an S corporation increase the basis of their stock by the amount of income and reduce the basis of their stock (not below zero) by the amount of loss passed through to them.

An S corporation may be subject to the built-in gains tax at the entity level, as discussed below. An S corporation may also be subject to entity-level tax on its excess net passive income, if (1) the S corporation inherited any earnings and profits from a C corporation, and (2) more than 25 percent of its gross receipts consist of passive investment income.

S corporation shareholders who sell S corporation stock can elect (generally, with the purchaser's consent) to treat the sale of stock as a sale of assets for federal income tax purposes. In that case, for federal income tax purposes, the S corporation would be treated as if it (1) sold all of its assets to a new corporation, and (2) made a liquidating distribution of the consideration to its shareholders.

The Built-In Gains Tax

The built-in gains tax is an entity-level tax on an S corporation that (1) was formerly a C corporation or received assets from a C corporation in a carryover basis transaction (for example, a tax-free reorganization or corporate separation), and (2) disposes of the assets that had built-in gain in the hands of the C corporation in a taxable sale or exchange during the recognition period. The recognition period is a five-year period that begins when a C corporation converts to an S corporation, or when an S corporation receives assets from a C corporation in a carryover-basis transaction.

The built-in gains tax is imposed at the highest corporate rate, currently 35 percent. It generally applies to built-in gains in the hands of the C corporation that are recognized during the recognition period. The amount subject to the built-in gains tax is generally reduced by any loss recognized on a disposition of an asset held by the C corporation, to the extent the C corporation had a built-in loss in the asset. Net operating losses inherited from a C corporation can generally also be used to reduce the amount subject to the built-in gains tax. In addition, other items of deduction and loss can generally shelter the recognized built-in gains that would be subject to the built-in gains tax. However, in that case the recognized built-in gain would carry over into the subsequent year and could be subject to the built-in gains tax in that year, if it is within the recognition period. (Recognized built-in losses, corporate net operating losses, and other items of deduction and loss generally could be used to shelter such carryover recognized built-in gain.)

The Recognition Period

Prior to the PATH Act, taxpayers have faced significant uncertainty for several years with respect to the duration of the recognition period. From the time when the built-in gains tax was first enacted in 1986 until 2009, the recognition period was 10 years; however, in response to the 2008 financial crisis, beginning in 2009 through 2014 Congress temporarily shortened the recognition period several times.

On Feb. 17, 2009, the recognition period was reduced to seven years for tax years beginning in 2009 and 2010 by the American Recovery and Reinvestment Act of 2009. For tax years beginning in 2011, the Creating Small Business Jobs Act of 2010, enacted on Sept. 27, 2010, reduced the recognition period to five years. For tax years beginning in 2012 and 2013, the American Taxpayer Relief Act of 2012 extended the reduced five-year recognition period. However, that legislation was enacted on Jan. 2, 2013, and thus the planning environment for S corporations with built-in gains was fraught with uncertainty for the 2012 tax year. The Tax Increase Prevention Act of 2014, enacted on Dec. 19, 2014, extended the five-year reduced recognition period to tax years beginning in 2014. However, once again, because the law was enacted at the end of 2014, S corporations with built-in gains endured an uncertain planning environment for nearly all of 2014.

The PATH Act made permanent the five-year recognition period for tax years beginning in 2015. Thus, changing the five-year duration of the recognition period in the future would require congressional action.

Planning Opportunities

There are several planning opportunities that can minimize or eliminate the built-in gains tax.

An S corporation could wait until after the recognition period to dispose of the assets that would trigger the built-in gains tax. The PATH Act provides a more predictable planning environment than the one that existed in recent years because the duration of the recognition period has been shortened and made permanent.

An S corporation could dispose of built-in loss assets in the same year as when it disposes of built-in gain assets in order to minimize the built-in gain subject to the built-in gains tax.

Toward the end of the recognition period, an S corporation could accelerate items of deduction and loss (other than built-in loss) in order to shelter the recognized built-in gains from the built-in gains tax. The PATH Act has made this strategy substantially more viable, because (1) the sheltered built-in gain carries over into subsequent years, and (2) the shortened recognition period makes it easier to implement. However, not all items of deduction and loss may be appropriate. For example, paying substantial bonuses to reduce the S corporation's income is not always appropriate, especially if it is done in more than one year.

If the shareholders wish to dispose of the S corporation, they could sell the stock without electing the deemed asset sale treatment. The purchasers may object, however, because they would not get the benefit of tax-basis step-up in the corporation's assets. For example, in the case of consideration allocable to goodwill, which is generally amortizable over 15 years, the purchasers would miss out on the benefit of amortization deductions equal to one-fifteenth of the consideration per year for 15 years.

Shareholders could get an appraisal to establish the amounts of built-in gain and loss on the date when a C corporation converts to an S corporation, or when an S corporation receives assets from a C corporation in a carryover-basis transaction. That could help in connection with any subsequent dispute with the taxing authorities over the amount of built-in gains that are subject to the built-in gains tax.

If an S corporation disposes of a built-in gain asset in a nonrecognition transaction, the disposition would not trigger the built-in gains tax. Thus, where applicable, an S corporation could dispose of unwanted built-in gain assets in a tax-free exchange.

Originally published by Law 360

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Jacob M. Oksman
Similar Articles
Relevancy Powered by MondaqAI
Lowndes, Drosdick, Doster, Kantor & Reed, P.A.
Lowndes, Drosdick, Doster, Kantor & Reed, P.A.
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Lowndes, Drosdick, Doster, Kantor & Reed, P.A.
Lowndes, Drosdick, Doster, Kantor & Reed, P.A.
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions