Considering converting your C corporation to an S corporation? It is important for you to understand the effects of a built‐in gains tax that may apply when appreciated assets held by the corporation at the time of the conversion are subsequently disposed of and what we can do to minimize its impact.
Although an S corporation is normally not subject to tax, when a C corporation converts to S corporation status, the tax law imposes a tax at the highest corporate rate (currently 35%) on the net built‐in gains of the corporation. The idea is to prevent the use of an S election to escape tax at the corporate level on the appreciation that occurred while the corporation was a C corporation. This tax is imposed when the built‐in gains are recognized (i.e., the appreciated assets are sold or otherwise disposed of) during the five‐year period after the S election takes effect (referred to as the “recognition period”).
Assets that have not appreciated, accounts payable, unpaid bonuses, and some other liabilities may carry built‐in losses that can be used to offset built‐in gains. From a planning perspective, it is important to establish these amounts before the S election becomes effective so that all potential offsets to built‐in gains can be utilized.
The tax may apply even if the S corporation does not make any unusual asset dispositions. For instance, a cash method corporation that collects an account receivable that accrued during the C corporation period, or an accrual method corporation that disposes of inventory that was acquired during the C corporation period, may be subject to the built‐in gains tax.
The recognized built‐in gain is passed through to the shareholders as income, in addition to being taxed at the highest corporate level. This unfortunate result is mitigated somewhat by treating the tax as a corporate loss that passes through to the shareholders.
You can see how important it is to plan for the impact of the built‐in gains tax since, at a minimum, it is necessary to establish the amount of built‐in gains (and losses) at the time of the conversion to an S corporation. After the conversion, we can plan by timing the sale of assets, matching gains and losses, and so on. Right now, the important thing is to value the corporation’s assets and have appraisals, where feasible, of the assets including inventory as of the date the S corporation election will take effect in order to ensure that the appreciation which takes place after that date will not be subject to the built‐in gains tax.
We can assist you in getting the necessary appraisals, as well as in identifying any built‐in losses that could reduce the effect of the built‐in gain tax.