Article: Built-In Gains - Advantageous Tax Opportunity Available for Asset Sales Completed by 2011 Year End

By Andy Lipscomb

Additional tax liability generally results for S corporation shareholders when appreciated assets are sold within 10 years of a C corporation’s S election or some types of acquisitions. Commonly referred to as the “built-in gains tax,” gains realized during the 10 year holding period are subject to tax at a rate of 35%, instead of the 15% capital gains tax rate. In addition, the gains are subject to two levels of taxation, a result not normally encountered in an S corporation.

For the remainder of 2011, the normal 10-year holding period is reduced to 5 years, creating an opportunity for S corporations to divest appreciated assets held for at least 5 years with more favorable tax consequences.

In general, when an S corporation sells assets, the gain or loss passes through to the shareholders and is taxed at capital gain rates (currently 15%) if the asset was a capital asset to the corporation. However, there is an exception: §1374 of the Internal Revenue Code imposes a tax commonly called the built-in gains tax. The following is a basic summary of how this tax works:

1. A potential built-in gain tax liability can be created in two ways. The more common occurs when a corporation elects Subchapter S status, having previously operated as a C corporation. The other arises when an S corporation acquires an asset from a C corporation and carries over the C corporation’s basis (for example, in a merger). In the former case, the “starting date” is the date of the S election; in the latter, the date on which the assets were acquired.
2. At the starting date, a maximum liability for each asset is established as the amount of gain that would result from selling that asset at its fair market value on that date. In addition, an overall maximum is established as the net gain across all assets (including those for which a fair-market-value sale would be at a loss). Note that goodwill (which, for tax purposes, includes all intangible assets that are not explicitly treated separately) is an asset (a capital asset) for this purpose, even if it has not been recorded on the books. Therefore, it is critical to determine values of all assets—tangible and intangible—at the time the S election or acquisition is made.
3. If such an asset is sold within a certain period of time, normally 10 years, after the starting date, there is a taxable gain equal to the lowest of three amounts: the potential gain on that asset, the remaining amount of the overall maximum gain, and the gain actually realized. This gain is taxed at 35%. (If there is additional gain beyond that amount, that part of the gain is passed through to the shareholders under the normal S-corporation rules.) In addition to the tax paid at the corporate level, the gain (net of the tax) is passed through to the shareholders where they again pay tax on the gain.

Recently, the “certain period of time,” referred to above, has been changing. For most S corporations (those that report on a calendar-year basis)--in 2011 only--the period is five years, measured to the day from the starting date. Thus, assets whose built-in gain period began between 2003 and 2006 (inclusive), or in 2002 after the start of the year, may be sold without built-in gains tax, provided the sale is made in 2011. At the start of 2012, the period reverts to its usual length of 10 years, so those assets will again be subject to the built-in gains tax.

The situation is slightly more complex for S corporations using a fiscal year:    

• The “window” for the five-year rule does not open until the corporation begins a fiscal year in 2011. In the 2010 fiscal year, the period is seven years, measured as taxable years. Thus, to avoid the tax on a sale before the start of the 2011–2012 fiscal year, the S election had to be made in 2003 or before, or the asset had to have been acquired before the start of fiscal 2004–2005.
• Similarly, the window does not close until a fiscal year begins in 2012. Thus, even assets acquired in early 2007 may be eligible, if sold between the five-year anniversary date and the end of the 2011–2012 fiscal year.

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