1. S Corporation Built-in Gains Tax Rules Summary and Illustrations

2. The built-in gains tax generally applies to C corporations that make an S corporation election,

3. And can be assessed during the 10-year period beginning with the first day of the first tax year for which the S election is effective

4. The built-in gains tax is imposed at the highest corporate rate (currently 35%),

5. And is triggered by the disposition of an asset that was on hand at the time the S election became effective.

6. (a) the actual recognized gain,

7. Or (b) the amount that the asset's fair market value exceeded its basis at the date the S election became effective.

8. 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.

9. 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.

10. However, certain property may be subject to the tax if it is acquired from another corporation in a transferred (substituted) basis transaction.

11. it can be subject to the built- in gains tax if the corporation received transferred basis property from a C corporation or an S corporation subject to the built-in gains tax rules.

12. An S corporation can offset built-in gains with built-in losses
An S corporation can offset built-in gains with built-in losses. Losses are built-in if an asset's basis exceeded its FMV on the S election's effective date.

13. Built-in losses also occur when an amount is allowable as a deduction during the 10- year recognition period if the expense is attributable to the C period,

14. Such as accounts payable on the date an S election is effective [IRC Sec (d)(5)(B); Regs (a)(1), , and (b)(2)].

15. Built-in losses are also beneficial because they reduce net unrealized built-in gain; the overall limit on the amount of built-in gain that can be taxed [IRC Sec (d)(5)(C)].

16. Net Unrealized Built- in Gain

17. The corporation's total built- in gain is normally limited to

18. The net unrealized built-in gain (i. e
The net unrealized built-in gain (i.e., the excess of the aggregate FMV over the aggregate adjusted basis of all assets on hand as of the date the S election was effective, reduced by any previously recognized built-in gains).

19. However, in the case of transferred basis property received from a C corporation or another S corporation subject to the built-in gains tax,

20. The asset subject to the tax may have been acquired after the date the S election became effective.

21. Net Recognized Built-in Gain

22. The amount of gain subject to the built-in gains tax in any tax year is referred to as net recognized built-in gain [IRC Sec. 1374(d)(2); Reg (a)].

23. The net recognized built-in gain subject to the tax is limited to the smallest of:

24. a. The current recognition limit, i. e
a. The current recognition limit, i.e., the amount that would be taxable income if only recognized built-in gains and recognized built-in losses were taken into account;

25. b. The taxable income limit, i. e
b. The taxable income limit, i.e., the corporation's taxable income for the year, computed as if it were a C corporation; or

26. c. The overall limit, i.e., net unrealized built-in gain

27. If net recognized built-in gain is limited by the taxable income limit (item b. in the preceding paragraph), the gain in excess of the taxable income limit carries over to the next year.

28. Recognizing Build-in Gains

29. When an asset subject to the built-in gains tax is disposed of at a gain, the built-in gain is limited to the lesser of [IRC Sec. 1374(d)(3)]:

30. a. The gain actually recognized, or

31. b. The amount by which the fair market value of the asset exceeded its adjusted basis on the date the S election became effective.

32. If an asset subject to the built-in gains tax is disposed of at a loss, the loss is limited to the lesser of:

33. a. The loss actually recognized, or

34. b. The amount by which the adjusted basis of the asset exceeded its fair market value on the date the S election became effective.

35. Example 1: Limiting built-in gain to pre-S status appreciation

36. Inncorp, a cash basis C corporation, elects S corporation status on January 1, the beginning of the corporation's current taxable year. The company holds the following assets on that date:

37. Switch to Excel Spreadsheet

38. The corporation has taxable income (calculated as if it were a C corporation) of $70,000 for the year.

39. During the current year, Inncorp sells Asset A for $70,000 and Asset B for $37,000.

40. Inncorp recognizes gain of $82,000 on the sales, as shown in the Excel spreadsheet:

41. The recognized built-in gain on the disposition of Asset A is limited to the asset's fair market value (FMV) in excess of its basis at the effective date of the S election or $60,000.

42. The recognized built in gain on the disposition of Asset B is the actual gain on the sale, $12,000.

43. Thus, the recognized built-in gain for the year is $72,000.

44. Example 2: Recognized Built-in Gains

45. Adam Corp. is a C corporation that reports on the cash basis and uses a calendar year.

46. The corporation's gross receipts average $900,000 annually.

47. Jack, the sole shareholder wants to have the corporation elect S corporation status effective January 1, 2012, to avoid double taxation.

48. On that date, the corporate assets are as follows:

49. Switch to Excel Spreadsheet

50. The corporation has no accounts payable.

51. Taxable income for the corporation's first S year will be approximately $60,000. (Taxable income would be the same if it were computed under the C corporation rules.)

52. In future years, the corporation will not receive any transferred or substituted basis property from another corporation.

53. Jack is in the 28% tax bracket. What will Adam Corp
Jack is in the 28% tax bracket. What will Adam Corp.'s built-in gains tax liability be if it elects S corporation status?

54. Potential built-in gain is determined on the date a C corporation becomes an S corporation.

55. If, on that date, an asset's FMV exceeds its adjusted basis, there is unrealized built-in gain attached to that asset.

56. The built-in gain is recognized if the asset is disposed of during the 10-year recognition period beginning with the first day of the first S corporation year [IRC Sec (d)(7); Reg (d)].

57. In this example, the recognition period expires on December 31, 2021.

58. A cash basis corporation with accounts receivable faces the built-in gains tax when the accounts receivable are collected, normally during the year the election is first effective.

59. Collection of an account receivable by a cash basis taxpayer is a disposition of an asset and will result in built- in gain recognition [IRC Sec (d)(5)(A); Reg (b)(1)].

60. In this case, $55,000 from such collections will be subject to built-in gains tax.

61. The tax (assessed at the highest corporate rate) will be 35% of $55,000, or $19,250.

62. The taxable income of $60,000 will be passed through to Jack, and the corporate tax will pass through to him as a loss [IRC Sec. 1366(f)(2)], resulting in a pass-through to Jack of $40,750 ($60,000 − $19,250) in net income.

63. Example 3: Applying built-in losses against built-in gains

64. Assume the same facts as in Example 2, except that the corporation also has $30,000 of accounts payable on the date the S election becomes effective.

65. All of the payables will be deducted by the S corporation when paid in 2012, so the $30,000 of payables represents a built-in loss.

66. This built-in loss reduces the net unrealized built-in gain at the date the S election is effective.

67. Thus, $25,000 ($55,000 − $30,000) is the maximum cumulative amount of built-in gains that Adam Corp. will be required to recognize.

68. Since the accounts receivable are received and the accounts payable are paid in 2012, the built-in gain recognized in that year will be $25,000 ($55,000 − $30,000).

69. Adam Corp. will no longer be subject to the built-in gains tax because the entire amount of net unrealized built-in gain has been recognized.