In September 2010, President Barack Obama signed into law several temporary tax incentives in the Small Business Jobs Act of 2010, P.L. 111-240 (SBJA), which includes an additional temporary reduction of the recognition period for built-in gains (BIG) tax under Sec. 1374. Under the provision, the recognition period will be five years for sale (or deemed sale) transactions occurring in tax years that begin in 2011. The American Recovery and Reinvestment Act of 2009, P.L. 111-5 (ARRA), previously had temporarily reduced the recognition period from ten years to seven years for sale (or deemed sale) transactions occurring in tax years beginning in 2009 and 2010. Absent further legislation, the recognition period reverts back to 10 years for sale (or deemed sale) transactions occurring in tax years beginning in 2012.
The BIG tax is an entity-level tax imposed at the highest corporate rate on net built-in gains recognized by an S corporation during the recognition period. It applies to a corporation that makes an S corporation election or an S corporation that acquires appreciated assets from a C corporation (or former C corporation) in a Sec. 1374(d)(8) transaction (such as a qualified subchapter S subsidiary election). The general rule under Sec. 1374 and Regs. Sec. 1.1374-1(d) is that the BIG recognition period is the 120-month period beginning on the date of the C to S conversion or the date of the Sec. 1374(d)(8) transaction.
Recent Statutory Changes
The ARRA provided for a temporary change by modifying Sec. 1374(d)(7)(B) so that the BIG tax does not apply for any tax year beginning in 2009 or 2010 if the seventh tax year in the recognition period preceded the tax year of the transaction that results in BIG.
The BIG tax often discourages taxpayers from pursuing a sale of assets. The 2009 and 2010 revisions to Sec. 1374 give more taxpayers the ability to divest some assets and business lines in order to raise cash without incurring the BIG tax. The changes also give S corporation shareholders greater flexibility to consider sales of their S corporation stock with a Sec. 338(h)(10) election to treat the sales as asset sales for tax purposes, thereby making them more attractive to certain buyers. That flexibility is crucial to taxpayers in implementing strategies to survive a rough economic climate.
The SBJA reduces the recognition period to five years for 2011 transactions only. The BIG tax does not apply to sale (or deemed sale) transactions for any tax year beginning in 2011 if the fifth year in the recognition period preceded the 2011 tax year. The language in the SBJA (as well as the legislative history and related footnotes) makes it clear that five 12-month periods (calendar years) must have elapsed prior to January 1, 2011, for an S corporation to avail itself of the five-year recognition period provision. This amendment is consistent with the permanent rule under Sec. 1374(d)(7)(A).
The SBJA did not change the language in Sec. 1374(d)(7) for tax years beginning in 2009 or 2010 (that is, seven tax years must elapse prior to 2009 or 2010 for a taxpayer to avail itself of the reduced recognition period in 2009 or 2010). When considering a transaction that may qualify under these provisions, taxpayers should pay close attention to the nuance in the language and confirm that the appropriate number of tax years (seven tax years for 2010) or calendar years (five calendar years for 2011) has passed before concluding that the transaction is not subject to BIG tax.
The following examples help explain the application of the various rules to different time periods.
Example 1: Entity A elects to become an S corporation on October 1, 2003, with a calendar year end. The BIG recognition period ends on September 30, 2013 (120 months from the date of election). If a sale transaction occurs on January 1, 2010, A will have seven tax years preceding the year of the sale transaction. The 2003 short period from October 1, 2003, to December 31, 2003, will be considered a tax year, and the 2010 sale transaction will not result in BIG tax.
Example 2: Entity B elects to become an S corporation on October 1, 2006, with a calendar year end. The BIG recognition period ends on September 30, 2016 (120 months from the date of election). If a sale transaction occurs on January 1, 2011, the S corporation will have only four calendar years preceding the year of the sale transaction (years ending December 31 of 2007, 2008, 2009, and 2010). Therefore, the 2011 sale transaction will result in BIG tax.
Example 3: The shareholders of C, a C corporation, elect to treat the company as an S corporation on January 1, 2011. The BIG recognition period is 120 months beginning on that date.
Application to REITs and RICs
Although the legislation and the legislative history do not expressly mention real estate investment trusts (REITs) and regulated investment companies (RICs), this change would likely apply to them as well. Regs. Sec. 1.337(d)-7 indicates that when property of a C corporation becomes property of either an REIT or a RIC, Sec. 1374 will apply (unless the C corporation elects deemed sale treatment with respect to the conversion transaction as provided in Regs. Sec. 1.337(d)-7(c)). Thus, any legislative changes to Sec. 1374 should be equally applicable to REITs and RICs subject to BIG tax.
Practitioners with S corporation, REIT, or RIC clients should pay close attention to the possible relief from the BIG tax offered by the SBJA. A full analysis of the facts and dates—especially for those taxpayers that are outside the five-year recognition period in 2011—must be performed to determine whether the relief applies, but the provisions could afford those clients extra help in their strategies to deal with continued economic uncertainty.
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, DC.
For additional information about these items, contact Mr. Almeras at (202) 758-1437 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.