The built-in gains tax

A corporate liquidation generally is treated as a sale of the corporation’s assets at fair market value (FMV), and gain or loss is recognized at the corporate level. C corporation liquidation gain is effectively taxed twice — once at the corporate level and again at the shareholder level as payment for stock surrendered. This makes S corporation status attractive because gain recognized upon liquidation generally will be taxed only once (at the shareholder level) due to the increase in stock basis that results from passthrough treatment. To discourage a C corporation from electing S corporation status just before a liquidation to avoid double taxation, a tax on “built-in gains” was imposed.

Overview of built-in gains tax

The built-in gains (BIG) tax generally applies to C corporations that make an S corporation election, and it can be assessed during the five-year period beginning with the first day of the first tax year for which the S election is effective. The BIG tax is imposed at the highest corporate rate as specified in Sec. 11(b) (Sec. 1374(b)(1)), which is 21%, and is triggered by the disposition of any asset that was on hand at the time the S election became effective. The term “disposition,” however, is broadly defined for built-in gains purposes and includes certain routine transactions, such as the collection of cash-method zero-basis accounts receivable.

An asset not on hand when the S election became effective, such as equipment acquired after the corporation elected S status, ordinarily would not be subject to the tax. However, certain property may be subject to the tax if it is acquired from another corporation in a transferred (substituted) basis transaction. The BIG tax rate applies to recognized built-in gain, regardless of whether the gain is ordinary or capital.

S corporations that are not subject to the BIG tax

An S corporation is not subject to the BIG tax if any of the following situations apply:

• It was never a C corporation (Sec. 1374(c)(1));
• It had no net unrealized built-in gain (i.e., the aggregate basis of its assets exceeded their cumulative FMV) on the date the S election became effective;
• It has previously recognized built-in gains equal to the net unrealized built-in gain on the date the S election became effective; or
• The recognition period beginning with the date the S election was effective has expired, and there are no outstanding payments from installment sales that originated before or during the five-year period beginning with the date the S election became effective (Sec. 1374(d)(7)).

Caution: Even if an S corporation meets one or more of the preceding exceptions to the BIG tax rules, it can be subject to the BIG tax if the corporation received transferred basis property from a C corporation or an S corporation subject to the BIG tax rules (Sec. 1374(d)(8)).

Strategies to avoid or reduce the BIG tax

Tax planning strategies to avoid or reduce the BIG tax generally revolve around:

Recognizing built–in losses in years when built–in gains are recognized, to utilize the current recognition limit: The built-in gain that can be recognized during the year is subject to the current recognition limit, which is the amount that would be the corporation’s taxable income for the tax year if only recognized built-in gains and recognized built-in losses were taken into account. The strategy for using the current recognition limit is to recognize built-in losses in the year there are built-in gains.

Reducing taxable income to utilize the taxable income limit: Built-in gain subject to tax in any year is limited to the taxable income of the corporation computed as if it were a C corporation. Thus, if the S corporation shows a loss (computed under the C corporation rules), no BIG tax is imposed for that year. The loss under the C corporation rules is calculated without taking into account a net operating loss (NOL) or the special deductions allowed by Part VIII of Subchapter B (Secs. 241-248), other than the Sec. 248 deduction for the amortization of corporate organization expenditures.

However, any built-in gain not recognized because of the taxable income limitation carries forward during the remainder of the recognition period and is recognized in a later year to the extent there is taxable income (Sec. 1374(d)(2); Regs. Sec. 1.1374-2(c)). Even so, the taxable income limit can be a useful planning tool to avoid (or at least defer) the BIG tax.

Reducing net unrealized built–in gain (e.g., by increasing built–in losses) to utilize the overall limit: The maximum built-in gain an S corporation must recognize is the “net unrealized built-in gain” (the excess of the aggregate FMV over the aggregate adjusted basis of all assets on hand as of the first day the S election is effective).

Declaring bonuses before the S election becomes effective to increase built–in losses: One method of generating built-in loss is to have the C corporation declare or accrue reasonable bonuses to shareholder/employees and not pay them until after the S election becomes effective.

Using C corporation carryovers: NOLs, capital losses, minimum tax credits, and business tax credits that are carried over from C corporation tax years can be used to reduce the BIG tax.

Deferring property sales beyond the five–year recognition period: Dispositions of property that was on hand when the S election became effective are not subject to the BIG tax after the expiration of the recognition period.

Structuring a tax–deferred transaction, such as a like–kind exchange: A Sec. 1031 like-kind exchange can also be an effective device to avoid the recognition of built-in gains. A tax-deferred, like-kind exchange of an asset does not trigger the built-in gain inherent in that asset, except to the extent of boot received in the exchange. Rather, the unrecognized built-in gain and the unexpired portion of the recognition period transfers to the asset received in the exchange (Sec. 1374(d)(8); Regs. Sec. 1.1374-8). So, if no boot is received in the exchange and the new asset is retained until the expiration of the recognition period (beginning with the date the S election became effective), no built-in gain is recognized.

Selling accounts receivable before the S election becomes effective: Another tax strategy for reducing exposure to the BIG tax is to sell the receivables to the shareholders before the S election becomes effective. Under some circumstances, the shareholders may want to form a new S corporation rather than have the C corporation elect S status.

Leasing or licensing property rather than selling it: BIG tax and the onerous BIG tax installment sale rules can be avoided by leasing property rather than selling it. The S corporation must, however, ensure that the arrangement is a bona fide lease and not a disguised sale. The corporation could also consider licensing the rights to assets rather than selling the assets themselves. Again, the agreement must contain fair market terms so it will not be construed as a disguised sale by the IRS.

Making charitable contributions of appreciated property: The BIG tax applies when an asset that was on hand at the date the S election became effective is disposed of, but only if the transaction results in recognized income or gain (Sec. 1374(d)(3)). A charitable contribution of appreciated property does not result in recognized gain. Therefore, charitable contributions of property that appreciated before the S election became effective are not subject to the BIG tax. (See, e.g., IRS Letter Ruling 200004032.)

Selling stock instead of assets: If the S corporation is disposed of during the recognition period, the BIG tax can be avoided if the transaction is put in the form of a stock sale instead of an asset sale. The buyer, however, is likely to want an asset sale rather than a stock sale in order to get a stepped-up basis for the S corporation’s assets. One way out of this impasse would be for the parties to compromise on an asset sale, with an upward adjustment in the sales price to compensate the seller for the additional tax caused by putting the transaction in the form of an asset sale, thereby causing imposition of the BIG tax.

This case study has been adapted from PPC’s Tax Planning Guide: S Corporations, 34th edition (March 2020), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).