If a corporation that was previously a C-corporation files its S election after December 31, 1986 it is subject to the built-in gains tax under the Tax Reform Act of 1986. As enacted, the tax was imposed on any built-in gain resulting from the sale of any assets owned at the time of the S election during the 10 year period following the election. The 2009 Recovery Act reduced the 10 year period to 7 years for 2009 and 2010 tax years. The 2010 Small Business act further reduced the 10 year period to 5 years for 2011. The 2012 Taxpayer Relief Act (the “Act”) provides that for 2012 and 2013, the recognition period remains at 5 years.
The Act further provides that where assets are sold using the installment sale, the tax treatment is determined by the year of sale. Accordingly, if the sale occurs and the S corporation qualifies for the 5 year period, there is no built-in gains tax on the proceeds received after the sale even if received after 2013, when the recognition period may revert to 10 years.
Recognized built-in gains cannot exceed taxable income for any year. If taxable income is less than the built-in gains, the excess built-in gains are carried over through the recognition period. Built-in gains not recognized for eligible corporations in 2012 or 2013 because of the taxable income limitation will not be carried over into later years even if the recognition period reverts to 10 years.
If an S corporation has a built-in gain carryover and qualifies for the 5 years recognition period, it should attempt to keep taxable income to zero in 2012 or 2013, as the case may be, so the built-in gain will “disappear” and not be carried forward.
If an S corporation that qualifies for the 5 year period has built-in gain that it expects will be subject to recognition after 2013 if the 10 year recognition period is reinstated, consideration should be given to “forcing” recognition of the gain during 2013. This could be done, for example, by the corporation distributing the asset to its shareholders, who would receive a step-up in basis equal to fair market value on the distribution date. There would be gain on the distribution equal to the difference between the asset’s basis and fair market value (but no built-in gains tax), but there would not be gain on the resale of the asset by the shareholders if the fair market value of the assets did not increase. Another option would be to merge the S corporation with a limited liability company in 2013. This will trigger the gain in 2013 (but not the built-in gains tax), but there would again not be gain on the sale of the assets by the limited liability company after 2013 except to the extent the assets appreciated after the merger.