Editor: Mary Van Leuven, J.D., LL.M.
On February 17, 2009, the American Recovery and Reinvestment Act of 2009, P.L. 111-5 (ARRA), was enacted. ARRA contains numerous tax breaks for individual and corporate taxpayers. Of particular relevance to S corporations is an amendment to Sec. 1374(d) that provides a temporary exemption from the application of Sec. 1374 to sales of assets in 2009 and 2010, but only for S corporations that meet certain requirements. This item discusses the limited opportunity with regard to those S corporations and some of the nuances in its applicability.
Sec. 1374 Generally
An S corporation generally is not subject to federal tax on the income generated by its operations. Instead, that income is allocated among the S corporation’s shareholders in accordance with their stock ownership. Each shareholder then includes its allocable share of the S corporation’s income on its own federal income tax return and pays tax on that income accordingly. In certain situations, however, the Code provides that an S corporation is subject to a corporate-level income tax under Sec. 1374.
In the Tax Reform Act of 1986, P.L. 99-514, Congress repealed the General Utilities doctrine, which had allowed a C corporation to make a tax-free liquidating distribution to its shareholders prior to the sale of the company (General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935)). As a result, when a C corporation with individual shareholders distributes appreciated assets or sells them in the course of a complete liquidation, there are generally two levels of tax, a corporate level and a shareholder level.
Sec. 1374 generally is designed to prevent a C corporation from circumventing the repeal of the General Utilities doctrine by converting to S corporation status before distributing appreciated assets to its shareholders or before selling appreciated assets and distributing the sale proceeds to its shareholders as part of a complete liquidation. To do so, Sec. 1374 generally provides that an S corporation is subject to tax at the highest corporate rate on any net recognized built-in gains (RBIGs) of the corporation recognized during the recognition period, which is generally defined in Sec. 1374(d)(7) as the 10-year period beginning with the first day of the tax year for which the corporation was an S corporation.
Example 1: X, a calendar-year C corporation, elected S status effective on January 1, 2009. X’s recognition period begins on January 1, 2009, and ends at the close of the day on December 31, 2018.
Although a full analysis of RBIG is beyond the scope of this item, the Sec. 1374 tax generally will apply to any gain recognized on the disposition of assets by the corporation during the recognition period, except to the extent the corporation establishes that either: (1) the asset was not held at the time of the S election; or (2) the gain exceeds the built-in gain inherent in the asset at the time of the S election. Further, RBIG includes any item of income properly taken into account during the recognition period if that item would have been included in the gross income of an accrual-method taxpayer before the effective date of the S election.
The total amount subject to tax under Sec. 1374 is limited to the S corporation’s net unrealized built-in gain (NUBIG). An S corporation’s NUBIG generally is the amount of gain the S corporation would recognize on the conversion date if it had sold all of its assets at fair market value to an unrelated party that also assumed all its liabilities on that date.
Sec. 1374(d)(8) Transactions
Sec. 1374(d)(8) extends the application of Sec. 1374 by imposing a tax on an S corporation’s net RBIG recognized during the recognition period and attributable to assets that it acquired in a carryover basis transaction from a C corporation (a Sec. 1374(d)(8) transaction). Each acquisition of assets from a C corporation is subject to a separate determination of NUBIG and a separate 10-year recognition period beginning the day the assets are acquired.
Example 2: Assume the same facts as in Example 1, except that X also acquires the assets of Y, a C corporation, in a carryover basis transaction on January 1, 2010. X’s recognition period with respect to the assets X held when it made its S election on January 1, 2009, is unaffected. However, the recognition period with regard to the assets acquired from Y in the January 1, 2010, transaction begins on the date of the acquisition and ends at the close of the day on December 31, 2019.
Because a qualified subchapter S subsidiary (QSub) election results in a deemed liquidation of a wholly owned corporate subsidiary of an S corporation, it is common for an S corporation to acquire assets in a Sec. 1374(d)(8) transaction as a result of a QSub election. Further, because a QSub election may be filed at any time during the S corporation’s tax year, this may result in a 10-year recognition period with respect to the QSub’s assets that affects 11 tax years of the parent S corporation.
Example 3: Assume the same facts as in Example 2, except that on July 1, 2009, X elects to treat Z, its wholly owned C corporation subsidiary, as a QSub. As a result of the election, Z is deemed to distribute all of its assets to X in liquidation at the close of the day on June 30, 2009. X’s recognition period for its other assets remains unchanged. However, X’s recognition period for the assets deemed distributed to X in the liquidation of Z begins on July 1, 2009, and ends on June 30, 2019. Thus, the 10-year recognition period for the QSub’s assets begins in X’s 2009 tax year and continues until X’s 2019 tax year, thus affecting a total of 11 of the S corporation’s tax years.
The New Legislation and Its Effect on S Corporations
ARRA revises the definition of the term “recognition period” for purposes of applying Sec. 1374. The revised legislation retains the general definition of recognition period—the 10-year period beginning with the first day of the tax year for which the corporation was an S corporation. New Sec. 1374(d)(7)(B), however, creates an exception to the general rule. For any tax year of an S corporation beginning in 2009 or 2010, no tax will be imposed on the net RBIG of an S corporation if the seventh tax year in the recognition period preceded that tax year (the Sec. 1374 exception). This exception is applied separately for any asset acquired in a Sec. 1374(d)(8) transaction.
The Sec. 1374 exception is intended to provide S corporations that are well into their 10-year recognition period with a reprieve from application of Sec. 1374. The effect on S corporations in particular situations is best illustrated by examples. In each of the following, X is a calendar-year taxpayer and a former C corporation that held built-in gain assets on the date of its S election (S election assets). Y is also a C corporation, the assets of which are acquired by X in a Sec. 1374(d)(8) transaction (the acquired assets).
Example 4: X elected S status effective on January 1, 2001. Thus, by the beginning of 2009, eight tax years of X’s recognition period had elapsed. The Sec. 1374 exception applies to sales of the S election assets by X during 2009 and 2010. Because X’s recognition period for the S election assets ends on December 31, 2010, as of January 1, 2009, X will no longer be subject to Sec. 1374 for those assets. The same result would be reached if X had elected S status effective on January 1, 2000 (except that X would not need to rely on the Sec. 1374 exception for 2010 because its recognition period would have expired even under the general rule).
Example 5: X elected S status effective on January 1, 2002. Thus, by the beginning of 2009, seven tax years of X’s recognition period had elapsed. X acquired Y’s assets in a Sec. 1374(d)(8) transaction on December 31, 2002. The Sec. 1374 exception applies to sales of the S election assets by X during 2009 and 2010. However, beginning on January 1, 2011, X’s sale of the S election assets arguably will again be subject to Sec. 1374 until the December 31, 2011, expiration of the general 10-year recognition period. The Sec. 1374 exception does not apply to sales of the acquired assets in 2009 because seven years had not elapsed between December 31, 2002, the date of the Sec. 1374(d)(8) transaction, and January 1, 2009. However, the Sec. 1374 exception should apply to sales of the acquired assets in 2010. Beginning on January 1, 2011, however, sales of the acquired assets arguably would again be subject to Sec. 1374 until the December 30, 2012, expiration of the 10-year recognition period.
Example 6: X elected S status effective on January 1, 2003. By the beginning of 2009, only six tax years of X’s recognition period had elapsed. Thus, the Sec. 1374 exception will not apply to sales of X’s S election assets during 2009. However, by the beginning of 2010, seven years of X’s recognition period will have elapsed. Thus, the Sec. 1374 exception will apply to sales of X’s S election assets during the 2010 calendar year. Beginning on January 1, 2011, X arguably will again be subject to Sec. 1374 on sales of its S election assets until the December 31, 2012, expiration of the general 10-year recognition period.
Note that the previous examples assume that the application of Sec. 1374 resumes in 2011. This is based on a literal interpretation of Sec. 1374(d)(7)(B) (“In the case of any taxable year beginning in 2009 or 2010, no tax shall be imposed on the net recognized built-in gain of an S corporation if the 7th taxable year in the recognition period preceded such taxable year”). However, this may not have been Congress’s intent in drafting the statute. The conference report for ARRA provides that
no tax is imposed on an S corporation under section 1374 if the seventh taxable year in the corporation’s recognition period preceded such taxable year. Thus, with respect to gain that arose prior to the conversion of a C corporation to an S corporation, no tax will be imposed under section 1374 after the seventh taxable year the S corporation election is in effect. [H.R. Conf. Rep’t No. 111-16, 111th Cong., 1st Sess. 570–571 (2009)]
One could argue that this language indicates that Congress intended to draft a statute under which Sec. 1374 might never again apply to an S corporation’s S election assets if seven tax years had elapsed prior to the first tax year beginning on or after January 1, 2009 (or 2010, as appropriate). If this was indeed Congress’s intent, it is not apparent from the statutory language, and thus guidance from the government would be helpful.
Short Tax Years
It is interesting to note that application of the Sec. 1374 exception depends on whether seven tax years in the recognition period have elapsed. This raises an interesting issue for S corporations that, while C corporations, were on a fiscal year rather than a calendar year. A fiscal-year corporation generally must switch to the calendar year as a result of its S election. Thus, elections by fiscal-year corporations give rise to short first tax years as S corporations. By using the phrase “tax year” rather than “recognition year” or some other term in determining application of the Sec. 1374 exception, the legislation appears to reduce the amount of actual time that must elapse between certain S elections and January 1, 2009 (or 2010, as appropriate), for the Sec. 1374 exception to apply.
Example 7: X, a C corporation with a fiscal year ending on November 30, elected S status effective on December 1, 2002. Thus, X’s recognition period begins on December 1, 2002, and ends on November 30, 2012. As a result of its S election, X must use the calendar year as its tax year. So X’s first tax year as an S corporation is a short year beginning on December 1, 2002, and ending on December 31, 2002. Thus, as of January 1, 2009, seven tax years (one short year and six full years) have elapsed since the effective date of X’s S election.
Accordingly, the Sec. 1374 exception could apply to sales of X’s assets in 2009 and 2010, despite the fact that only six years and one month of X’s recognition period have passed as of January 1, 2009.
Interestingly, however, the same is apparently not true for Sec. 1374(d)(8) transactions. Although the statute itself appears to treat Sec. 1374(d)(8) transactions similarly (albeit separately), legislative history indicates another intent. The ARRA conference report provides that in the case of built-in gain attributable to an asset received by an S corporation in a Sec. 1374(d)(8) transaction, no tax will be imposed under Sec. 1374 “if such gain is recognized after the date that is seven years following the date on which such asset was acquired” (H.R. Conf. Rep’t No. 111-16, 111th Cong., 1st Sess. 571 (2009)). Thus, it appears Congress intended that seven full calendar years must elapse following a Sec. 1374(d)(8) transaction for the Sec. 1374 exception to apply.
Example 8: X elected S status on January 1, 2001. X elected QSub status for Z, its wholly owned subsidiary, effective on December 1, 2002. As discussed above, beginning on January 1, 2009, X will no longer be subject to Sec. 1374 for its S election assets. X’s recognition period with respect to the assets acquired from Z begins on December 1, 2002, and ends on November 30, 2012. By January 1, 2009, only six years and one month of the recognition period for the assets acquired from Z have elapsed. Thus, X arguably will be subject to Sec. 1374 for the assets acquired from Z if they are sold prior to November 30, 2009. However, the Sec. 1374 exception will apply to the assets acquired from Z sold between December 1, 2009, and December 31, 2010.
As Example 8 illustrates, the effect of the conference report’s explanation of the statute appears to shorten the period during which the Sec. 1374 exception applies to assets held by the S corporation when S status was elected in the short tax year situation described in Example 7, as compared to certain assets acquired in Sec. 1374(d)(8) transactions. There appears to be no readily apparent reason for doing so. Hopefully, the IRS and Treasury will provide guidance on these issues.
Conclusion
Although relief from taxes is always welcome, this relief unfortunately may be too late for certain taxpayers. Given the current economic situation, the fair market value of many assets—particularly real estate or marketable securities— owned by S corporations may be substantially lower than the fair market value of those assets one year ago. Depending on the type of asset involved, the fair market value today may be even lower than it was at the time the owner of that asset elected S corporation status (or acquired the asset in a Sec. 1374(d)(8) transaction). Because Sec. 1374 applies only to net RBIGs, the statute by definition does not apply when no gain is recognized. Thus, when the value of assets has dropped below the S corporation’s basis in those assets, Sec. 1374 will not apply anyway.
Further, a tax adviser should consider that it generally is economics, rather than the federal tax result, that motivates business decisions. The current economic environment may cause S corporations to “wait and see” whether their property recovers lost value. Thus, as a business matter, an S corporation may not be willing to sell property today—at a lower price than it might receive in the future—regardless of whether the law today provides a potentially better federal tax result. Tax advisers, however, should make clients aware of the potential impact of the new law so that they can consider it in making business decisions.
EditorNotes
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
This article represents the views of the author or authors only, and does not necessarily rep-resent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
© 2009 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or mvanleuven@kpmg.com.
