Normally, a corporation can use the cash method of accounting if services (rather than merchandise) are provided to clients or customers. However, the corporation may have to use the accrual method (at least to account for purchases and sales) if it is required to maintain inventory records because the production, purchase, or sale of merchandise is a material income-producing factor (Regs. Secs. 1.446-1(c)(2), 1.471-1).C Corporations
Even if a C corporation otherwise qualifies to use the cash method (because it provides only services), it must convert to the accrual method when its annual gross receipts reach $5 million, unless it is in the trade or business of farming, or is a qualified personal service corporation. Under Sec. 448(b), a C corporation using the cash receipts and disbursements method of accounting must abandon that method and adopt the accrual method, unless the corporation meets the definition of one of the following three classes of exempt corporations:
- Corporations in the trade or business of farming;
- Qualified personal service corporations; or
- Corporations with gross receipts of not more than $5 million.
A qualified personal service corporation is defined as one performing services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and substantially all of the stock by value is held by current or past employees who perform such services (Sec. 448(d)).
Certain taxpayers can use the cash method if their average annual gross receipts are more than $1 million but not more than $10 million. This exception to the accrual-method requirement does not apply to C corporations with gross receipts of more than $5 million.S Corporations
An S corporation that qualifies to use the cash method (because it provides only services) is not required to convert from the cash method if it fails one of the three statutory exceptions (Sec. 448(a)(1)). However, two specific hazards must be considered: the built-in gains tax and the accrual requirement for tax shelters.Electing S Status to Avoid Switching to the Accrual Method
As discussed in Example 1, a C corporation may be able to avoid the mandatory change to the accrual method by electing S status. However, this can cause the S corporation to be subject to the built-in gains tax.
Built-In Gains (BIG) Tax
A corporate-level tax is imposed on certain "built-in" gains of an S corporation if the gains arose before conversion from C status to S status. The BIG tax generally does not apply to an S corporation that has never been a C corporation.
It is important to note here that an S corporation's items of income or expense generally are treated as recognized built-in gain or loss if the item would have been taken into account before the start of the five-year recognition period under the accrual method of accounting (Sec. 1374(d)(7)(A)).
Example 1: C Corp. is a calendar-year regular C corporation that conducts a trucking and freight storage business. Growth has been rapid, with gross receipts reaching $4 million for 2014 and $6 million for 2015. For 2016, the company expects to exceed $10 million of gross receipts. The corporation will likely be required to convert to the accrual method of accounting in 2017, and the shareholders are considering having the corporation make an S election. The corporation projects that its accounts receivable balance at Dec. 31, 2016, will be $350,000 and that its accounts payable will be about $50,000. Can C elect S status to avoid conversion to the accrual method?
If C elects S status for its 2017 tax year, it will not be required to convert from the cash method of accounting. Only regular C corporations are forced to accrual status when they fail one of the three statutory exceptions listed previously (i.e., farming corporations, qualified personal service corporations, or corporations with gross receipts of not more than $5 million) (Sec. 448(a)(1)).
C will be subject to the BIG tax as it collects the receivables that were on hand when S status was elected. Assuming C has a net built-in gain of $300,000 at the point of electing S status (accounts receivable of $350,000 less accounts payable of $50,000), it will incur regular corporate tax as it collects these receivables at the top rate authorized by Sec. 11(b) (35% for 2016). Assuming all of these accounts are collected (and no other built-in gains transactions occur) in the first year of S status, C will incur and pay $105,000 of corporate tax.
The planner would look for methods of eliminating or minimizing the BIG tax. The planner would also consider the other ramifications of electing S status, such as the passthrough of all corporate taxable income to the shareholders and the corporate cash flow available for distribution to shareholders. Assuming the other advantages and disadvantages of electing S status or retaining C status are neutral, C faces a difficult choice:
- Retention of C status forces a change to accrual accounting, causing acceleration of tax over four years on the net accrual balance as of Jan. 1, 2017. Assuming C reports its $300,000 accounting method adjustment at the top corporate rate of 35% over the four-year period, it would incur an additional $105,000 of corporate tax that otherwise would have been deferred indefinitely.
- Election of S status causes the Jan. 1, 2017, cash-method net accounts receivable to be subject to the BIG tax. Unless the tax can be reduced or eliminated, these receivables will be taxed at the 35% top corporate rate when collected. This effectively causes double taxation on the receivables by first subjecting them to the 35% corporate rate, followed by taxation to the S corporation shareholders on the corporate net income, which also includes the receivable collections. However, the BIG tax is passed through as a loss. This "loss" retains the character of the built-in gain (or gains) that generates the tax (Sec. 1366(f)(2)).
Given the incentive to avoid the accrual accounting method, as well as the advantage to the shareholders of receiving an annual basis increase in their stock, and avoiding the current and long-term costs of C corporation double taxation, C should file an S election. However, the planner has pointed out that cash-method corporations with accounts receivable are particularly vulnerable to the BIG tax when electing S status.
Certain S Corporations With Inventories Must Use the Accrual Method
Example 2: C Corp. is a calendar-year C corporation that operates a chain of grocery stores. Growth has been rapid, with gross receipts reaching $4 million for 2014 and $6 million for 2015. For 2016, the company expects to exceed $10 million of gross receipts. (These are the same facts as in Example 1, except C Corp. conducted a freight and storage business in that example.) C Corp. now falls under the general rule that taxpayers, including S corporations, must use the accrual method (at least to account for purchases and sales) if the taxpayer is required to maintain inventory records because the production, purchase, or sale of merchandise is a material income-producing factor (Regs. Secs. 1.446-1(c)(2), 1.471-1).
The small taxpayer exception, however, allows taxpayers (even those that have inventory) to use the cash method of accounting if the taxpayer's average annual gross receipts are no more than $1 million. This exception does not apply to C, however, because of the corporation's income level. Furthermore, certain taxpayers can use the cash method if their average annual gross receipts are more than
$1 million but no more than $10 million. This exception to the accrual-method requirement does not apply to taxpayers engaged in retail trade, so it would not protect C Corp. from the accrual-method requirement.
Because C's gross income exceeds $1 million and the corporation is engaged in retail trade, it must use the accrual method (at least to account for purchases and sales) regardless of whether it retains its C status or elects S status.
Tax Shelters Cannot Avoid Accrual Requirement
Under Sec. 448(a)(3), any "tax shelter" is required to convert to the accrual method. This rule applies whether or not a corporation is in the business of farming, is a qualified personal service corporation, or has gross receipts of $5 million or less. Furthermore, it applies to any form of organization, including an S corporation, partnership, or proprietorship. (Tax shelters do not qualify for the small taxpayer exception of Sec. 448(c).) Accordingly, the S election would not be an effective escape from the accrual requirement if the corporation were a tax shelter.
The tax shelter definition includes not only entities or arrangements for the avoidance or evasion of federal income tax, but also partnerships or other entities when more than 35% of the losses are allocable to limited partners and limited entrepreneurs (defined as those not actively participating in the management of the enterprise) (Sec. 448(d)(3), referring to Sec. 461(i)(3)). Under these definitions, an S corporation whose shareholders do not actively participate in management will be a tax shelter and, accordingly, must use the accrual method under Sec. 448.
This case study has been adapted from PPC's Tax Planning Guide: S Corporations, 30th edition (March 2016), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).
|Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.