Recognizing transactions that trigger built-in gains or losses

Generally, any recognized built-in gain or recognized built-in loss on the disposition by an S corporation of any asset that would have taken place during the five-year recognition period is considered a sale or exchange for built-in gains tax purposes (Regs. Sec. 1.1374-4(a)(1)).

Generally, any item of income properly taken into account during the recognition period is recognized built-in gain if the item would have been included in gross income before the beginning of the recognition period by a taxpayer using an accrual method (as principally described under Secs. 446 and 451) (Regs. Sec. 1.1374-4(b)). Under this rule, zero-basis or low-basis assets (cash-basis receivables, inventories, installment notes, etc.) are subject to the built-in gains tax when income is recognized due to their collection, sale, or other disposition.

Disposition of assets that were on hand when the S election became effective

If the corporation is subject to the built-in gains tax, the tax generally is assessed when an S corporation recognizes built-in gain on the disposition of an asset that was on hand on the date the S election became effective. An asset not on hand when the S election became effective (such as assets subsequently purchased or contributed to the corporation) will not be subject to the tax unless it is transferred-basis property (Sec. 1374(d)(3)).

Disposing of natural resources

The following discussion relates to built-in gains from the disposition of natural resources.

Standing timber: Rev. Rul. 2001-50 exempts standing timber from the built-in gains tax. Under the ruling, built-in gain is not recognized when an S corporation holds timber property on the date it converts from C status to S status (or acquires transferred-basis timber property from a C corporation or S corporation subject to the built-in gains tax) and, during the recognition period, the corporation:

• Cuts the timber and sells the resulting wood products (e.g., logs);
• Recognizes gain or loss on cutting the timber under a Sec. 631(a) election; or
• Recognizes gain or loss on the disposal of timber under a Sec. 631(b) contract.

Sec. 631(a) provides an election under which the cutting of timber by a taxpayer who owns, or has a contract right to cut, timber is treated as a sale or exchange of the timber in the year the timber is cut, provided the timber or the contract right to cut the timber is held for more than one year, regardless of whether the timber or timber products are sold during the year. Under Sec. 631(b), the owner may contract to dispose of certain timber while retaining an economic interest in the property. The gain or loss on the disposition of timber may be treated as if the property had been sold, resulting in capital gain or loss on the transaction. Sec. 631(c) provides similar treatment for certain coal or domestic iron ore dispositions.

Timber cut before S election becomes effective: If timber is cut before the corporation’s S election becomes effective and the logs produced from the cut timber are held as inventory on the day the S election becomes effective, any income derived by the S corporation on the sale of such logs during the recognition period will constitute recognized built-in gain (IRS Letter Rulings 9430026 and 9519024).

Oil and gas: The built-in gains tax regulations provide that the sale of oil produced from an oil and gas working interest held on the effective date of the corporation’s S election is not subject to the built-in gains tax if the oil was extracted after that date. Such income is not built-in gain because, at the S election’s effective date, the corporation holds only a working interest in the oil and gas property and has no interest in the oil itself (Regs. Sec. 1.1374-4(a)(3), Example 1). However, sale of a royalty interest in an oil and gas property (as distinguished from the royalty received on the production of oil) is subject to the built-in gains tax (see Regs. Sec. 1. 1374-4(a)(3), Example 2).

Coal or domestic iron ore property: Under Rev. Rul. 2001-50, no built-in gain results when an S corporation holds coal or domestic iron ore property on the date it converts from C status to S status (or acquires transferred-basis coal or domestic iron ore property from a C corporation or S corporation subject to the built-in gains tax) and, during the recognition period, recognizes gain or loss on the disposal of the coal or iron ore under a Sec. 631(c) contract.

The ruling on timber and coal or domestic iron ore and the regulations on oil and gas are consistent in holding that income from the production of a natural resource property held on the first day of the corporation’s first year as an S corporation is not subject to the built-in gains tax. However, income from the sale of severed or extracted natural resources held on the effective date of the corporation’s S election is subject to tax.

Built-in gains or losses resulting from Sec. 481 adjustments

Any Sec. 481(a) adjustment (relating to changes in accounting method) during the recognition period is recognized built-in gain or loss to the extent the adjustment relates to items attributable to periods before the S election became effective (Regs. Sec. 1.1374-4(d); Argo Sales Co., 105 T.C. 86 (1995); Rondy, Inc., T.C. Memo. 1995-372, aff ’d, 117 F. 3d 1421 (6th Cir. 1997); and MMC Corp., T.C. Memo. 2007-354, aff ’d, 551 F. 3d 1218 (10th Cir. 2009)).

Example 1. Applying the built-in gains tax to a positive Sec. 481 adjustment: J, a calendar-year C corporation, changes a method of accounting. The change results in a positive Sec. 481(a) adjustment of $120,000 that will be included in J’s income at the rate of $30,000 per year for four years beginning in 2021. On Jan. 1, 2023, J elects S status and reports $30,000 of Sec. 481(a) adjustment income in years 2023 and 2024. The adjustment amounts taken into income after the S election is effective are recognized built-in gains. If the corporation has no other built-in gains or losses and no limitations apply, it will pay builtin gains tax of $6,300 ($30,000 × 21%) in 2023 and 2024.

Example 2. Applying the built-in gains rules to a negative Sec. 481 adjustment: K, a C corporation, has been improperly capitalizing repair costs and recovering them through depreciation deductions. On Jan. 1, 2020, K elects S status. In 2023, K properly changes its accounting method to deduct repair costs as they are incurred. At that time, $21,000 of repair costs had been capitalized and not depreciated. The basis of the related assets is reduced by $21,000 to remove the erroneous repair costs, and K has a negative Sec. 481(a) adjustment of $21,000. The adjustment will be taken as a deduction in 2023. The negative Sec. 481(a) adjustment is a recognized built-in loss because all of the $21,000 in undepreciated repair costs were attributable to the period before the S election became effective (Regs. Sec. 1.1374-4(d), Example 1).

Built-in gains or losses resulting from cancellation-of-debt income and bad debt deductions

Income from cancellation of debt under Sec. 61(a)(11) may be recognized built-in gain. However, it is built-in gain only if the income arises from a debt owed by the S corporation at the beginning of the recognition period and the income is recognized during the first year of the recognition period. Also, a bad debt deduction under Sec. 166 is recognized built-in loss if it arises from a debt owed to the S corporation at the beginning of the recognition period and the deduction is taken during the first year of the recognition period (Regs. Sec. 1.1374-4(f)).

Applying the built-in gains rules to partnership interests

The regulations provide extensive rules for determining recognized built-in gain and loss when the S corporation owns an interest in a partnership (Regs. Sec. 1. 1374-4(i)). In general, the regulations look through an S corporation’s partnership interest to treat its distributive share of the partnership’s items as recognized built-in gain or loss to the extent they would have been treated as recognized built-in gain or loss if recognized directly by the S corporation. (These items are referred to in the regulations as “partnership 1374 items.”) However, the application of this rule generally is limited to the S corporation’s built-in gain or loss in its partnership interest, defined as the gain or loss that the S corporation would recognize if it sold the partnership interest for fair market value (FMV) on the first day of the recognition period (Regs. Secs. 1.1374-4(i)(2)(i) and (i)(4)). The regulations generally do not apply to corporations that elected S status prior to Dec. 27, 1994.

An S corporation determines net recognized built-in gain from its distributive share of partnership items using the following steps (Regs. Sec. 1. 1374-4(i)(1)):

Step 1: Apply the rules of Sec. 1374(d) to the distributive share of partnership items of income, gain, loss, or deduction (partnership Sec. 1374 items) under the rules of Subchapter K to determine the extent to which it would be treated as built-in gain or loss if the partnership items had been taken into account directly by the S corporation. The S corporation’s share of the basis and FMV of the partnership’s assets needs to be determined as of the beginning of the recognition period.

Step 2: Determine the S corporation’s net recognized built-in gain without the partnership Sec. 1374 items.

Step 3: Determine the S corporation’s net recognized built-in gain with the partnership Sec. 1374 items.

Step 4: If the amount computed under Step 3 exceeds the amount computed under Step 2, the excess is the S corporation’s partnership recognized built-in gain as limited by Regs. Sec. 1.1374-4(i)(2)(i), and the S corporation’s net recognized built-in gain is the sum of the amount computed under Step 2 plus the partnership recognized built-in gain. If the amount computed under Step 2 exceeds the amount computed under Step 3, the excess is the S corporation’s recognized built-in loss as limited by Regs. Sec. 1.1374-4(i)(2)(ii), and the S corporation’s net recognized built-in gain is the amount computed under Step 2 less the partnership recognized built-in loss.

The partnership recognized built-in gain for any tax year may not exceed the excess (if any) of the S corporation’s recognized built-in gain limit over its partnership recognized built-in gain for prior years. The recognized built-in gain limitation does not apply if a corporation uses a partnership with the principal purpose of avoiding the built-in gains tax (Regs. Sec. 1.1374-4(i)(2)(i)).

The partnership built-in loss for any tax year may not exceed the excess (if any) of the S corporation’s recognized built-in loss over its partnership recognized built-in loss for prior tax years (Regs. Sec. 1.1374-4(i)(2)(ii)).

If the corporation disposes of its partnership interest, the amount treated as recognized built-in gain may not exceed the excess of the S corporation’s recognized built-in gain limitation over its partnership recognized built-in gain during the recognition period. Also, the amount treated as recognized built-in loss may not exceed the S corporation’s recognized built-in loss limitation over its partnership recognized built-in loss during the recognition period (Regs. Sec. 1.1374-4(i)(3)).

If the partnership interest is sold, the S corporation’s recognized built-in gain or loss limit is computed as follows:

• The amount realized if, at the beginning of the first day of the recognition period, the corporation had remained a C corporation and had sold the partnership interest (and any assets the corporation contributed to the partnership during the recognition period) at FMV to an unrelated party;
• Minus the corporation’s adjusted basis in the partnership interest (and any assets the corporation contributed to the partnership during the recognition period) at the time of the sale; and
• Plus or minus the corporation’s allocable share of the partnership’s Sec. 481(a) adjustments at the time of the sale.

If the result is positive, the S corporation has a recognized built-in gain limit equal to that amount. If the result is negative, the S corporation has a recognized built-in loss limit equal to that amount.

The lookthrough rules do not apply in any year in which the FMV of the S corporation’s partnership interest is less than $100,000 and represents less than 10% of the partnership capital and profits at all times during the year (Regs. Sec. 1.1374-4(i)(5)). Thus, if this de minimis exception applies, partnership items will not cause the S corporation to recognize built-in gains.

For purposes of the de minimis exception, if the corporation contributes assets to the partnership during the recognition period, the FMV of the S corporation’s partnership interest is determined as if the assets were contributed before the recognition period, using the FMV of each contributed asset as of the beginning of the recognition period. The contribution does not affect whether the de minimis exception applies for tax years in the recognition period before the tax year the contribution is made (Regs. Sec. 1. 1374-4(i)(5)(ii)).

The de minimis exception does not apply if the corporation uses a partnership with the principal purpose of avoiding the built-in gains tax (Regs. Sec. 1.1374-4(i)(5)(iii)).

An S corporation’s Sec. 704(c) gain or loss with respect to any asset is not reduced during the recognition period for built-in gains tax purposes, except for amounts treated as recognized built-in gain or loss with respect to that asset (Regs. Sec. 1.1374-4(i)(6)).

If an S corporation holds a partnership interest that holds an asset on the first day of the recognition period and, during the recognition period, the partnership distributes the asset to an S corporation that then disposes of the asset, the asset is treated as being held by the S corporation on the first day of the recognition period and as having the FMV and adjusted basis in the hands of the S corporation that it had in the hands of the partnership on that day (Regs. Sec. 1.1374-4(i)(7)).

Contributor

Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s S Corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2024 (800-431-9025; tax.thomsonreuters.com).