The New Five-Year Built-In Gain Recognition Period

On Jan. 2, 2013, the American Taxpayer Relief Act of 20121 (ATRA) enacted another change to the 10-year recognition period during which the Sec. 1374 built-in gains (BIG) tax applies to C corporations that elect S status. Under the ATRA amendment, for 2012 and 2013, the built-in gain recognition period was reduced to five years.

This new provision differs from the earlier temporary provisions that were enacted for 2009 and 2010 that provided that the built-in gain recognized more than seven years after the S election was not subject to the tax. This seven-year reference was reduced to five years for 2011. The ATRA provision eliminates the built-in gain carryover that would otherwise apply if the new five-year temporary provision is not extended. (It also eliminates a technical error in the 2009 and 2010 built-in gain rules for calculating the recognition period.)

Background

S corporations that were once C corporations are potentially subject to the BIG tax.2 The BIG tax was added to the Code in 1986 by the Tax Reform Act (TRA) of 19863 as part of the repeal of the General Utilities4 doctrine that had allowed corporations to distribute appreciated assets to their shareholders or sell appreciated assets without recognizing gain. Under the General Utilities doctrine, it was possible for C corporations to avoid double taxation when they liquidated.5 Sec. 1374 was included in the TRA of 1986 to prevent a corporation from circumventing the repeal of General Utilities by converting to S corporation status before distributing appreciated assets to its shareholders or selling appreciated assets.

The BIG tax prevents the “leakage” of income tax. Under the tax, an S corporation may be subject to tax on gains from the sale of assets held at the time it converted to S corporation status if it sells the assets within a specified period of time after making its S election (the recognition period).6 The maximum amount of gain on which an S corporation can be taxed under the BIG tax is based on the corporation’s net unrealized built-in gain, which is determined on the effective date of the S election.7 An S corporation’s net unrealized built-in gain is the amount (if any) by which the fair market value of its assets as of the beginning of the first year of its S election exceeds the aggregate adjusted bases of the assets.

When an S corporation disposes of an asset that it held at the time it made its S election, it generally will have a recognized built-in gain or loss on the disposal of the asset. The corporation’s recognized gains or losses for a year are used to determine its net recognized built-in gain. Net recognized built-in gain is, with respect to any tax year in the recognition period, the lesser of the amount that would be the taxable income of the S corporation for that tax year if only recognized built-in gains and losses were taken into account, or the corporation’s taxable income for that tax year.8 When an S corporation has a net recognized built-in gain,9 the BIG tax is imposed on that gain (subject to limitations) at the highest C corporation tax rate (currently 35%),10 regardless of the character of the gain.

An S corporation’s net recognized built-in gain and payment of the BIG tax is limited by the S corporation’s taxable income, determined as if the corporation were a C corporation.11 The excess of a corporation’s net recognized built-in gain in excess of its taxable income is treated as recognized built-in gain in the succeeding tax year12 subject to that succeeding year’s limitations. If the succeeding year is a year after the recognition period has expired, the gain escapes the BIG tax. And, finally, the total amount of recognized built-in gain on which the BIG tax is paid cannot exceed the amount of net unrealized built-in gain determined on the effective date of the S election.13

Note: The examples in this article assume that the S corporation has not recognized all its net unrealized built-in gain within the recognition period.

Earlier Provisions

A seven-year provision applied to years beginning in 2009 and 2010. For either year, if the seventh tax year in the recognition period had ended before that year, no tax was imposed on the net recognized built-in gain of the S corporation for that year.14 Although this provision was often described as a shorter built-in gains period, it did not have that effect on carryovers. Although the BIG tax was suspended for the eighth, ninth, and 10th years of the 10-year recognition period15 (the BIG tax rate was zero), once the recognition period reverted to the 10-year rule that applied permanently, the corporation needed to track its recognized but untaxed built-in gains during this suspension and calculate the effects on net unrealized built-in gain and built-in gain carryforwards.

The “permanent” recognition period is the 10-year period beginning with the first day of the first tax year for which the corporation was an S corporation.16 Under the regulations, a “10-year period” is 120 months;17 short tax years do not reduce the 10-year recognition period. Because the provision that permitted a seven-year recognition period referred to a “taxable year,” those seven tax years may have resulted in fewer than 84 months. Later changes to the statute eliminated this error.

The first five-year provision applied to tax years beginning in 2011. In the case of any tax year beginning in 2011, if the fifth year in the recognition period preceded the current year, no BIG tax was imposed.18 Because this provision used the term “year,” it required 60 months to elapse since the S election became effective for the corporation to avoid the imposition of the BIG tax.

The original version of the five-year provision also had the effect of reducing the BIG tax rate to zero for years during the suspension but having it apply again once the permanent 10-year rule reappeared. Sec. 1374(d)(2)(B), which limits the recognition of built-in gains to the taxable income of the corporation (determined as if it were a C corporation), remained in effect to create a carryover to the succeeding year. The expiration of the five-year provision, which restored the 10-year recognition period, would have had the effect of causing some post-60 month built-in gains to “spring back to life” as carryovers into one of the years of the 10-year recognition period.

As mentioned above, the effect of the 2009 through 2011 temporary provisions was to reduce the BIG tax rate to zero. The net unrealized built-in gain and taxable income limitation computations were not changed.

Example 1: Corporation X elected S status effective Jan. 1, 2006, at which time its assets were appraised and its net unrealized built-in gain (NUBIG) was determined to be $1 million, all attributable to land.19 Its fifth year as an S corporation ended Dec. 31, 2010. The land was sold in 2011, generating a $1.5 million gain.

The realized built-in gain is the lesser of the actual gain on the sale of the land or the built-in gain (determined at the election date) of $1 million. If the corporation’s taxable income (determined as if it were a C corporation) was in excess of $1 million, the entire built-in gain would be recognized, and the BIG tax would have been due. Corporation X would have owed a BIG tax of $350,000, but under the temporary five-year provision, the BIG tax is suspended and the tax is zero. There is no carryover of unrecognized built-in gain to 2012 because the recognition of gain was not limited by taxable income.

If, however, the corporation’s taxable income was only $200,000, then $800,000 ($1 million – $200,000) of the recognized built-in gain would not be included in net recognized built-in gain because of the taxable income limitation. Under Sec. 1374(d)(2)(B), it would be carried forward and treated as recognized built-in gain in the following year. But for the change in law for 2012 and 2013 (as discussed below), Corporation X would have been exposed to BIG tax on this recognized built-in gain carryforward unless its taxable income had been zero throughout the 10-year recognition period, which would have applied after the expiration at the end of 2011 of the five-year recognition period.

Under the 2009 through 2011 temporary provisions, built-in gains realized during the suspension period (i.e., the sixth through ninth years after its S election for 2010 and 2011), but not recognized (i.e., not subject to the BIG tax) because of the taxable income limitation, carried over to the next succeeding year. If that next succeeding year was within the recognition period and after the temporary five-year recognition period expired, the BIG tax would apply to the carried over recognized built-in gain, subject to the taxable income limitation. Thus, under the 2009 to 2011 provisions, it was important to compute the amount of recognized built-in gain to determine if a carryover existed, even though the corporation would not have been subject to tax on the recognized built-in gain because it was in the suspension period in the year during which the gain was recognized.

The ATRA Five-Year Provision

The earlier temporary provisions had the effect of changing the BIG tax for built-in gains recognized after the seventh tax year (2009 and 2010) or fifth year (2011), to zero, but did not actually change the 10-year recognition period of Sec. 1374(d)(7)(A). ATRA did not continue this approach, but instead, added a new subparagraph, Sec. 1374(d)(7)(C), specifically for 2012 and 2013, which modified the Sec. 1374(d)(7)(A) recognition period. To determine the net recognized built-in gain for tax years beginning in 2012 or 2013, the recognition period is changed to five years from 10 years.20 Using the same method the regulations use to define a 10-year period, this will change the recognition period to 60 months, and a short tax year will not reduce the five-year recognition period.

In addition to temporarily changing the built-in gain recognition period, ATRA changed how the BIG tax applies to installment sales. The treatment of all gain recognized under the installment method for BIG tax purposes is governed by the BIG tax provisions in effect for the year of sale.21 For example, if the S election was effective on Jan. 1, 2008, or earlier, all gains under a 2013 installment sale escape the BIG tax, even if the 10-year recognition period springs into effect for 2014 and later years. (Other nuances of the installment sale provision are beyond the scope of this article.)

Effect on Built-In Gain Carryovers

The recognition period has been changed for tax years beginning in 2012 and 2013 to five years.22 For a calendar-year S corporation, an S election effective Jan. 1, 2007, and earlier is outside the 60-month recognition period for 2012. If that corporation had a carryover of built-in gain under Sec. 1374(d)(2)(B) into 2012,23 the gain escapes Sec. 1374 because the recognition period expired at the end of the 60th month following the S election. The same principle applies to 2013 for S elections effective Jan. 1, 2008, and earlier.

The benefit of the ATRA language lies in the application of the carryover rules after the temporary provision expires. Assume that Sec. 1374(d)(7)(C) is not extended by subsequent legislation and the 10-year recognition provision springs back to life. An S corporation whose election was effective on Jan. 1, 2007, is within the 10-year recognition period through Dec. 31, 2016. Built-in gains realized in 2014 through 2016 are subject to the BIG tax. Unless the corporation’s taxable income is zero in each of the remaining years of the recognition period, it will be subject to the BIG tax and liable for the 35% tax on its recognized built-in gains.24 However, an S corporation whose election was effective Jan. 1, 2008, or earlier will not have a carryover of recognized built-in gain into 2014 because it is outside the five-year recognition period in 2013. As discussed below, it cannot have a carryover.

The recognized built-in gain for a year that is not subject to BIG tax because of the taxable income limitation (i.e., net recognized built-in gain for the year less taxable income) is “treated as a recognized built-in gain in the succeeding taxable year.”25 If the S election was effective Jan. 1, 2008, the 2012 calendar year was within the five-year recognition period. If, for example, the taxable income of the S corporation (computed as if it were a C corporation) was zero, no recognized built-in gain is subject to the BIG tax.26

The succeeding tax year is 2013, a year outside the (temporary) five-year recognition period. However, there is no net recognized built-in gain in a year outside the recognition period.27 Thus, there is no built-in gain unrecognized due to the taxable income limitation in 2013 to carry over to its succeeding tax year (i.e., 2014).28 The five-year provision has the effect of “cleansing” the corporation of any built-in gain carryovers. The provision provides for a carryover only to the succeeding tax year, not all succeeding tax years.

To have a carryover of recognized built-in gain, the recognized built-in gain must have been subject to the BIG tax in a year within the recognition period but for the taxable income limitation.29 If the corporation was not within the recognition period in 2013, this provision ensures that there is no carryover of built-in gain to 2014.

Example 2: X Corp.’s S election was effective Jan. 1, 2008. X has no built-in gains in 2012 other than a $1 million carryover from the recognition of built-in gains in earlier years that were not taxed due to the taxable income limitation. Assume its 2012 taxable income is also zero. Year 2013 is the succeeding tax year, but that year is outside the recognition period; the BIG tax therefore does not apply, even to gains from earlier years not yet taxed for BIG tax purposes because of the taxable income limitation. As a result, only built-in gains recognized in 2014 will be subject to the BIG tax in 2014, when the temporary five-year recognition period expires and the 10-year recognition period springs back to life.

Conclusion

The temporary30 five-year recognition period for built-in gains added by ATRA effectively eliminates the carryover of built-in gain to a later year if that year is after the five-year recognition period. If the recognition period is later lengthened (e.g., because of the expiration of a temporary shorter period), the change to the recognition period will not change that result. An S corporation whose election was effective no later than Jan. 1, 2008, has no carryover of unrecognized built-in gains into 2014 from years beginning before 2014.31

Footnotes

Author’s note: The author gratefully expresses appreciation to Kenneth Orbach, Ph.D., professor of taxation, Florida Atlantic University in Boca Raton, Fla., for his insights into the nuances of Sec. 1374(d). Any errors or omissions remain the author’s own.

¹ American Taxpayer Relief Act of 2012, P.L. 112-240. Although the legislation was enacted in the beginning of January 2013, it is referred to as 2012 legislation.

² Sec. 1374(c)(1). Stated another way, if the S corporation has always been an S corporation, the built-in gains tax does not apply, except if a predecessor corporation exists or as noted in the regulations.

³ Tax Reform Act of 1986, P.L. 99-514.

⁴ General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935).

⁵ Double taxation resulting from corporate-level tax on the appreciation of assets plus shareholder-level tax on dividends or liquidation gain.

⁶ This article addresses situations where Sec. 1374 applies because a corporation that was taxed as a C corporation makes an election to be taxed as an S corporation. However, the BIG tax also applies to assets acquired by an S corporation that have a basis determined in whole or in part by reference to their basis to a C corporation. The recognition period and net unrealized built-in gain for these assets is based on the time the assets are acquired instead of the time the corporation makes its S election.

⁷ Secs. 1374(d)(1) and (7)(A).

⁸ Sec. 1374(d)(2).

⁹ For purposes of this article only, “net recognized built-in gain” refers to gain on which BIG tax will be paid in the current year, i.e., gain that doesn’t exceed the corporation’s taxable income limitation. Built-in gain carried over to the succeeding year, because of the taxable income limitation, will be referred to as built-in gain on which the BIG tax has not yet been paid, or some derivation thereof.

¹⁰ Sec. 1374(b)(1) by reference to Sec. 11(b).

¹¹ Sec. 1374(d)(2)(A)(ii) by reference to Sec. 1375(b)(1)(B) for the definition of “taxable income.”

¹² Sec. 1374(d)(2)(B).

¹³ Sec. 1374(c)(2).

¹⁴ Sec. 1374(d)(7)(B)(i).

¹⁵ For purposes of this article, the “suspension period” is that portion of the 10-year recognition period for which the BIG tax was suspended, i.e., for which no tax was imposed.

¹⁶ Sec. 1374(d)(2)(A).

¹⁷ Regs. Sec. 1.1374-1(d).

¹⁸ Sec. 1374(d)(7)(B)(ii).

¹⁹ Note that tangible and intangible assets must be valued to determine the net unrealized built-in gain of the corporation. Goodwill, although not recorded on the books, must be valued in case the assets of the trade or business of the corporation are sold and the trade or business contains intangible assets.

²⁰ Sec. 1374(d)(7)(C).

²¹ Sec. 1374(d)(7)(E).

²² Sec. 1374(d)(7)(C).

²³ For example, the built-in gain recognized in 2011 was not subject to tax because of the taxable income limitation, leaving the built-in gain not taxed as a carryover item to the succeeding tax year, i.e., 2012.

²⁴ Total recognized built-in gain cannot exceed the net unrealized built-in gain determined at the date of the S election.

²⁵ Sec. 1374(d)(2)(B).

²⁶ Sec. 1374(d)(2)(A)(ii).

²⁷ Sec. 1374(d)(2)(A).

²⁸ This result is made clear by the ATRA amendment to Sec. 1374(d)(2)(B). After ATRA, the subsection states, by reference to Sec. 1374(d)(2)(A), that carryover applies only to years within the recognition period. Before amendment, carryover applied in “any taxable year.”

²⁹ Sec. 1374(d)(2)(B), by reference to subparagraph (A).

³⁰ It is uncertain how “temporary” the five-year provision will end up being. Note that the permanent Sec. 179 amount is $25,000, a limitation that was supposed to be fully effective for years beginning in 2003, but legislation increased the amount for 2003 through 2005. Subsequent legislation has continued the increased deduction at various amounts.

³¹ The above analysis does not address the computation of built-in gains and carryovers for S elections made by fiscal-year C corporations after Jan. 1, 2007. Those computations are too complex to address here.