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.

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Jacob M. Oksman
 
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