In the previous post, we discussed the advantages of making an S election five years prior to a corporation selling its assets. A corporation that makes the S election typically avoids the two levels of tax (corporate level and shareholder level). However, a corporation that makes an S election and sells its assets within five years can be subject to a corporate-level tax called the “built-in gains tax.” Nevertheless, an S election may make sense even if the corporation makes such a sale.
There are some issues that arise after making an S election that a corporation must manage. This is true even if the corporation sells its business five years after the election.
- Selling Business within Five Years of an S Election.
The built-in gains tax does not apply to corporations that have always been S corporations. For other corporations, the built-in gains tax applies when an S corporation sells its assets within five years of becoming an S corporation. The tax applies to the lesser of (1) the gain that existed at the time of the S election, (2) the gain that the corporation realized on the sale or (3) the S corporation’s taxable income for the year (which includes the gain).
Appreciation in asset value after the S election is not subject to the built-in gains tax. However, for sales within the five year post-election period the tax regulations presume that the gain is attributable to pre-election appreciation. Thus, all of the gain realized on a sale is subject to the built-in gains tax.
The S corporation can rebut this presumption. The corporation needs to have support for claiming a lower value for the assets at the time of the S election. Obviously, the best support would be a contemporaneous appraisal. While the corporation could get an appraisal in the event of an IRS challenge, the IRS and the courts may be more likely to view such an appraisal as an after the fact justification of the corporation’s position.
The S corporation must weigh the cost of an appraisal against the tax benefits of avoiding tax on post- election appreciation. Avoiding the gain can be of great advantage when the corporation’s assets are appreciating.
- Managing the Post-Election Years.
If an existing corporation makes an S election, it must manage its operations to avoid triggering the built-in gain or delaying the tax to the latest possible time. The corporation especially wants to avoid having its normal operations trigger the built-in gain tax.
An S corporation triggers built-in gain when it disposes of an appreciated asset. The tax law defines the term “disposition” very broadly. As a result, dispositions include transactions that someone may not normally think of as such. For example, collecting accounts receivable is an asset disposition. For a corporation that reports on the cash method, this can create a problem.
Assume a corporation is on the cash basis of accounting for tax purposes and has accounts receivable with no tax basis when it makes an S election. When the S corporation collects the accounts receivables, it will realize built-in gain that is subject to the built-in gains tax.
In some cases, the S corporation may reduce or eliminate the impact of the built-in gain tax. One technique would be for the corporation to offset the built-in gain with (1) accruable but unpaid expenses that existed as of the S election or (2) losses on the disposition of assets.
Example: As of the first day of its tax year, X Corporation has $500,000 of accounts receivable (with no basis) and $400,000 of accounts payable. If X Corporation makes an S election, it will have $100,000 of built-in gain ($500,000 accounts receivable minus $400,000 accounts payable) that will be potentially subject to the built-in gains. X Corporation may accrue a $100,000 bonus to its shareholder-employees prior to its first S corporation year. If the corporation declares a bonus prior to its first S corporation year, it could use the accrued bonus to eliminate the built-in gain. (Of course, the bonus would need to be a reasonable amount and meet the other requirements for deductible compensation.)
The S corporation also could avoid disposing of appreciated property during the five years after the S election. Instead of a disposition, the corporation could enter into an alternative transaction, such as a lease of the asset with an option that permits the lessee to acquire the property after five years.
Another possibility is for the S corporation to eliminate taxable income in the year when it realizes built-in gain. Since the built-in gain tax applies to the lesser of the built-in gain or taxable income for the year, the S corporation can eliminate the built-in gain tax in this manner for at least one year. Any realized built-in gain carries over to the next year in the five year post- election period and is taxed if the corporation has income. Any built-in gain left at the end of the five year period disappears. To eliminate taxable income, the S corporation could pay salaries and bonuses to its shareholders.
Prior to the S election, the S corporation shareholders might also consider contributing to the corporation assets that have depreciated in value. The S corporation could utilize the losses on disposition of the contributed assets to offset the overall built-in gain.
The tax regulations warn that this technique will not work unless there is a non-tax business purpose for contributing the assets to the corporation. Thus, the shareholders must show a business reason for the contribution.