Basically there are two types of relatively large corporations that exist in the American corporate system. C corporations were first introduced and they are a type of business that exists as a separate entity from its owners and is taxed as such. This is done so that the owners can deflect certain types of liability from themselves to the corporation itself. The owners are the shareholders of the corporation, and as such they do are not taxed on many aspects of the corporation, but the corporation itself has to pay the tax on assets to federal and state governments. This does set the company up for a form of double taxation though since although the owners are separate from the corporation as far as personal assets (such as homes, land, etc.), they still receive dividends from the shares of stock that they own. These dividends are taxed at the personal rate level to which the individual belongs. The other type is an S corporation. This is actually a more of a tax incentive than an actual corporate entity in that it was brought about by "Subchapters of Chapter 1 of the Internal Revenue Code of the IRS" (Diffen, 2012). This allows a small company to only realize single taxation in that the corporation is not taxed at the corporate rate, the shareholders are taxed for their personal gains realized from the dividends from their stock holdings.
Because of the tax advantages, C corporations that meet the requirements to become an S corporation often transition to an S corporation. However, this is not as much of a tax shelter as it may sound. Because the IRS realized that businesses would do this, and they also realized that there could be taxable assets lost to taxation if this occurred, they implemented a built-in gains tax and subsequent rules if a corporation moved from C. To S. status. Since the primary goal of the switch is to avoid double taxation and the net unrealized gains could be relatively large and greatly increase the burden to the corporation and its shareholders, there are methods that can be used to manage these built-in gains charges from the IRS. This paper looks at the difference between C. And S corporations, what the benefits of an S corporation are, what built-in gains are and finally how built-in gains taxation can be managed.
S Corporation vs. C Corporation
It may seem that these are two different types of corporate entities, and they are, but they are actually in completely different classifications all together. Most large corporations in the United States are C corporations because of the restrictions placed on the by definition. There are limits to what can be considered as an S corporation, but there are few limits for a C corporation. The reason that a C corporations encompass most of the largest is because there is no limit as to the number of shareholders that can hold shares of stock, there qualification on the type of stock carried, and it does not matter whether the shareholders are foreign or domestic (Diffen, 2012).
Of course, restrictions do apply to an S corporation because it is more of a tax shelter than a specific type of corporation. For an S corporation to be formed it;
Must be an eligible entity (a domestic corporation or a limited liability company)
Must have only one class of stock
Must not have more than 100 shareholders: spouses are automatically treated as a single shareholder, and all shareholders must be U.S. citizens or residents and must be physical entities.
Profits and losses must be allocated to shareholders proportionately to each one's interest in the business (Diffen, 2012).
These are placed on the formation of an S corporation because it is a means for U.S.-run companies to avoid gross U.S. federal taxes. This is a legal shelter for U.S. companies and is meant to drive business.
S Corporation Benefits
The reason why the government produced a special tax code for smaller companies to be able to form S corporations rather than be confined to C corporation status is that there is always a desire to ensure that small businesses thrive and that more people are getting involved in business. Research has shown that the formation of the S corporation status has done exactly that. S corporations, sometimes called "small business corporations" (Clark, 2011), are the same as a C corporation under an individual states laws, but they have the protection of a partnership when for federal income tax purposes. This means that although a C corporation receives double taxation (as a corporation and then the gains of individual shareholders), in an S corporation only the shareholders are taxed. Thus, the person who owns stock in the company is just taxed based on their yearly gains from the company, and the corporation does not incur any federal taxes. This is positive for small businesses, that may not have the income level to absorb the double taxation and helps the smaller company use more of its revenue.
Many people have issues with S corporations, especially those that believe that they are bad for the overall economy. Actually, these people do not believe that the corporations themselves are bad for the economy, they believe that tax breaks given to companies, such as that for built-in gains, could potentially be harmful to the economy. And this is a cumulative issue, meaning that the breadth of breaks could be an issue for the economy, not just one particular type of break (Aquilino & Jeffers, 2011).
To understand why a company would want a break from built-in gains, they must first be explained. Many S corporations are formed originally as S corporations because the company meets the standards and realizes that this is a better tax deal than they would get if they incorporated under the laws governing a C corporation. However, there are also many companies that are first classified as C corporations and wish to move to S corporation status for various reasons, but primarily because of the tax breaks associated with the switch. When a corporation makes this switch it is like they are cheating the government out of monies that would have been paid, so the government devised a way that they would continue to receive corporate tax from this type of company for ten years. AC corporation that becomes an S corporation must pay built-in gains taxes for ten years (in certain circumstances) following the switch. In an article for The Journal of Accountancy, Allistair Nevius (2012) explains the reasoning by saying;
"If a C corporation converts its tax status to a partnership or a disregarded entity, the resulting actual or deemed liquidation, in most cases, would be a taxable transaction for both the corporation and its shareholders. In contrast, if a C corporation elects S corporation status, these immediate tax consequences are avoided. If a corporate-level built-in gains tax were not imposed, a C corporation could make an election to be taxed as an S corporation (assuming it is otherwise eligible to do so) and sell all or part of its assets with a single level of tax. The built-in gains tax is imposed to prevent an S corporation election from being used to circumvent the effects of a taxable liquidation."
Thus, the fear from the government is that the executives making the switch are possibly seeking to legally circumvent the tax code by hiding a portion of the assets that would have otherwise been taxed if the company were still a C corporation. So, the idea of built-in gains was implemented. There are several caveats to the rule also which are important to note.
The firs is going to happen to almost every C corporation that files as an S corporation. Most of the time there will be gains from appreciation, property that the C corporation owned or other types of gains that would not be taxed appropriately after the move to an S corporation was made. Therefore, the IRS determined that built-in gains taxes could be paid for up to ten years if there is a net unrealized built-in gain (NUBIG). According to Harris and Kugler (2009);
An S corporation's NUBIG generally is the amount of gain the S corporation would recognize on the conversion date if it had sold all of its assets at fair market value to an unrelated party that also assumed all its liabilities on that date.
These gains can be from any item, tangible or intangible, that could be a source of gain that originated from the c corporation. As Harris and Kugler relate, it there is a net gain, then it is taxed. If, however, there is a net loss in the conversion, then the shareholders incur none of that.
The other issue is that an S corporation, whether it was a C corporation or was originally conceived as an S corporation, that receives…