Managing built-in gains tax when converting to S corporation status

¶ … Tax

Managing the S Corporation Built-in Gains Tax

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.

Managing the Built-In Gains Tax

The highest current corporate tax rate is 35% and that is the level at which built-in gains are taxed. So it behooves the C corporation to do one of two things. Either the assets can be drawn down to a level of zero prior to the switch to S corporation status (which would result in the maximum amount of tax being paid on those assets), or they can allow these assets to be a part of the switch, but they can manage them in such a way that the tax penalty is minimized. Burilovich and McCombs (2003) in a foundational study regarding this issue concluded that;

"C corporations considering an S corporation election need to evaluate the potential impact of the built-in gains tax provisions of Section 1374. The S corporation election could conceivably con ceive

v. con ceived, con ceiv ing, con ceives

v.tr.

1. To become pregnant with (offspring).

2. create a higher tax burden than the corporation and its shareholders would have as a C corporation. However, careful planning can avoid or minimize the built-in gains tax"

Thus, there has to be a critical evaluation of the pros and cons of all situations that could occur. But, these built-in gains can be managed if the group decides to switch to an S corporation after the examination has taken place. Frist, the company must make a calculation regarding the gains to be expected.

According to Nevius (2012), this calculation depends on the gains that would have been "realized if the corporation had remained a C corporation and sold all of its assets at fair market value on the date of the S. election to an unrelated party who assumed all of its liabilities." The company may also have to do more calculations to determine the actual net unrealized built-in gains. This is important because that is the amount that the company will have to pay tax on.

Of course, ensuring that the calculations are accurate is very important because they can determine the advisability of changing status to that of an S corporation, but it also gives the managers a look at the gains and losses that the company can expect and determine an efficient method for managing the gains. One method of managing the built-in gains uses this concept of net gains and losses to the company's advantage. Tw terms are important -- realized built in gains (RBIG) and realized built in losses (RBIL). These are both carry overs from the time when the company was a C corporation. If the RBIG number is larger than the RBIL number, then the company has to pay taxes. However, it the opposite is true, then the company does not have to pay taxes. It must be remembered that these built in gains are for appreciations, but there are losses such as depreciation of certain items. Anderson (2012) provides the example that of inventory that a company possessed as a C corporation that is still there when the switch is made. Inventory has to be accounted for because when it is sold it can become a gain. This is true, obviously, because the sale price will be a gain from the purchase price. However, there can be inventory that either does not give the company a gain and instead causes a loss. If, for some reason, the company bought the goods for more than they can sell them for, then they will realize a net loss from the merchandise. Thus, the company does not have to pay the built-in gain.

One way that a corporation can also use net operating losses to its advantage is by using the carry forward rules that apply. According to Burilovich and McCombs (2003);

"The presence of built-in gains provides an S corporation with the opportunity to benefit from unused net operating loss carry forwards Net operating loss carryforwards

Application of losses to offset earnings in future years., capital loss carry forwards Loss Carryforward

An accounting technique with which a company applies net operating losses of the current year to future year's profits in order to reduce tax liability.

Notes:, unused business tax credits and minimum tax credit carry-forwards from the C corporation years. These losses and credits are carried over and applied in the same manner as if the corporation had continued to be a C corporation."

What this means is that a company that has switched its status to an S corporation still has the advantage of those losses that it can carry forward in its books. The carry forward period is a maximum of 20 years from the time of the loss, so this gives the new S corporation a big advantage. The traditional period for an S corporation has to calculate the built in gains and pay taxes on them is ten years. If the accumulated losses are great enough, then the corporation may be able to apply them over the period and negate any tax penalty they would incur from the realized built in gains. This may be the primary way that the built in gains can be managed.

A company can manage the built in gains prior to the switch by paying tax on the gains as a C corporation rather than after it is an S corporation. Besides managing the losses as described above, a company may pay a lower corporate tax rate as a C corporation than it would as an S corporation. The accepted tax rate for the built in gains for an S corporation, as explained above, is the maximum rate or 35%. However, a C corporation may not be taxed at the highest rate, so it makes sense that any gains that it will be taxed on and can be taxed prior to the transfer to S corporation status would lower the burden placed on the corporation (Clark, 2011). So, a company wants to maximize its losses, if possible, and minimize the amount of built in gains that are carried over.

The very definition of built in gains can be used to the advantage of the new S corporation shareholders. It says that if the property were sold at fair market value at the time of the S corporation election then that would be a gain. However, if it is possible for the company to hold on to those assets until the ten-year period expires before it sells them, then they do not have to pay the built in gains taxes (Burilovich and McCombs, 2003). This may also be a way for the company to reduce the tax even if they are not able to completely stave off the sale of all of the assets.

However, the government may have offered the best means for minimizing he gains that have to be taxed over the ten-year period. One of the main issues is that the tax can be very egregious because the S corporation is taxed at the highest corporate level for the entire ten years. Because of the poor economy since 2008, the government has lowered the amount of time that a company has to pay this gain twice. First it was agreed that any company that was in the midst of its ten-year period as of 2009 would only have to pay a cumulative seven years after that time (Harris & Kugler, 2009). This means that if a company began it ten-year period in 2003, its period would have been reduced to the seven-year period in 2009 and they would only have had one year left. Law was recently enacted that lowered this requirement to five years. These temporary revisions are also a boon to companies because instead of having to wait to sell assets until after the ten years, they now only have to wait for five. This means, at least according to the government, that the S corporation will be able to realize this revenue sooner and also boost the economy that much sooner.

Conclusion

It may seem like corporate cheating in some ways (Aquilino & Jeffers, 2011), but the government has made these programs available to companies to encourage the growth of small businesses and hopefully encourage them to remain in the United States. Of course there are those who use the generosity of these programs for their benefit, several individuals were recently penalized heavily for their misuse of the S corporation program (Schnee, 2010), but, in general, the program is beneficial to small businesses. This is especially true if the business takes full advantage of the program and determines methods for limiting the impact of built in gains with wise decisions both before and after the S corporation election is finalized.