A significant benefit afforded to an S corporation and its shareholders is the general avoidance of entity-level federal income tax on the corporation's earnings because of its passthrough status. However, in accordance with Sec. 1374, a qualifying C corporation that converts into an S corporation in an attempt to obtain a single layer of tax may incur an entity-level tax when the entity recognizes built-in gain. The new entity may be liable for built-in-gain (BIG) tax if the corporation's assets at the time of conversion are sold during the ensuing statutory recognition period (Sec. 1374(a)). The tax may also apply if the S corporation acquires assets with a basis determined by reference to the basis of the asset in the hands of a C corporation (Sec. 1374(d)(8)).
The entity-level tax is imposed at the highest corporate tax rate in effect under Sec. 11(b), currently 35%, on the lesser of the corporation's net recognized built-in gain for the tax year or the remaining net unrealized built-in gain not previously subjected to the tax (Sec. 1374(b)(1)). It should be noted that a regulated investment company (RIC) or real estate investment trust (REIT) may also be subject to an entity-level tax using the principles of Sec. 1374 if the property at issue had been owned by a C corporation that converted to RIC or REIT status absent a deemed sale election (Regs. Sec. 1.337(d)-7).
PATH Act
On Dec. 18, 2015, S corporations with net unrealized built-in gain (NUBIG) received an early Christmas present when Congress passed the Protecting Americans From Tax Hikes (PATH) Act of 2015, part of the Consolidated Appropriations Act, 2016, P.L. 114-113. Section 127(a) of the PATH Act permanently limited the recognition period for the imposition of the BIG tax to five years (Sec. 1374(d)(7), as amended by the PATH Act). The enactment of this provision at last provided certainty to S corporations operating in the shadow of the BIG tax, given the numerous changes in the length of the recognition period and the manner in which it has been applied in recent history. The lingering potential effect of the BIG tax is often a significant consideration during pending acquisitions involving an S corporation.
History of the Sec. 1374 BIG Recognition Period
When the Tax Reform Act of 1986, P.L. 99-514, repealed the General Utilities doctrine (see General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935)), the current version of the BIG tax was added to the Code to prevent taxpayers from escaping two levels of tax on unrealized gains upon conversion to S corporation status and created a 10-year recognition period. Under the original provision, net recognized built-in gain (NRBIG) recognized upon the sale of BIG assets previously held by the entity in C corporation form was subject to corporate-level tax if the recognition occurred within 10 years after the year of conversion. NRBIG is defined as the lesser of the amount that would be the taxable income of the S corporation for the tax year if only recognized built-in gains and recognized built-in losses were taken into account, or the corporation's taxable income for the tax year (determined as provided in Sec. 1375(b)(1)(B)) (Sec. 1374(d)(2)(A)).
In an effort to provide economic stimulus, for tax years beginning in 2009 and 2010, Congress temporarily changed the law so that, effectively, no tax would be imposed under Sec. 1374 on recognized built-in gain attributable to BIG assets after the seventh tax year after conversion to S corporation status (see the American Recovery and Reinvestment Act of 2009, P.L. 111-5, §1251). Congress extended this provision to include 2011 and further provided that no tax was imposed if the corporation's fifth year preceded the tax year that began in 2011 (see Small Business Jobs Act of 2010, P.L. 111-240, §2014). Subsequent legislation reduced the recognition period from 10 years to five years for tax years beginning in 2012 or 2013 and inserted a provision subjecting payments received on the sale of an asset by an S corporation reporting the sale under the installment method to the rules of Sec. 1374 in accordance with the rules applicable in the year of the sale (see the American Taxpayer Relief Act of 2012, P.L. 112-240, §326). Then, as part of the Tax Increase Prevention Act of 2014, the five-year recognition period was extended to tax years beginning in 2014 (P.L. 113-295, Division A, §138). Therefore, for those tax years, an S corporation whose S status had been in effect for at least five years before the built-in gain was recognized would not be subject to BIG tax.
With the enactment of the PATH Act, Sec. 1374(d)(7)(A) permanently reduces the BIG recognition period to five years.
Example: B Corp., a former C corporation with a tax year ending Dec. 31, properly elected S corporation status on Feb. 1, 2013. At the time of conversion, a valuation was conducted, resulting in adjusted basis and fair market value, respectively, as follows: land: $100,000 and $200,000; building: $200,000 and $300,000; other equipment: $10,000 and $20,000. On B's first S corporation tax return (Form 1120S, U.S. Income Tax Return for an S Corporation), the company reports NUBIG of $210,000, which represents the sum of the built-in gain for each asset owned, net of built-in losses (if any). In 2015, B sells the building for $350,000. Since the building was subject to $100,000 of NUBIG at the time of conversion, and the sale occurred within the five-year recognition period, the S corporation is subject to an entity-level tax of $35,000 ($100,000 × 35%), assuming its taxable income for the year is at least $100,000. Additionally, the company's remaining NUBIG is reduced to $110,000 ($210,000 NUBIG ‒ $100,000 NRBIG). This adjusted balance would be reflected on B's 2016 Form 1120S.
If no other built-in gain is recognized during the five-year recognition period ending on Dec. 31, 2017—the period began on the first day of the first tax year in which B Corp. elected S corporation status—a subsequent sale of the corporation's assets will not be subject to tax under Sec. 1374.
Ultimately, the now-permanent statutory provision should give S corporation shareholders a greater degree of comfort in knowing that the shortened period is intended to remain in effect for the foreseeable future.
EditorNotes
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.
