Built-in Gains Tax Planning Opportunity Expires on 12/31/13

If you are a former C corporation with an S election older than five calendar years (i.e., your business has been an S corporation since 1/1/2008) and are currently subject to built-in-gains (BIG) tax implications, there might be immediate relief in 2013 to permanently avoid BIG tax ramifications without IRS scrutiny.

General background information:  The BIG tax regime is an S corporation, entity level tax calculated at the highest C corporation federal income tax rate (currently 35%) by some states (i.e., depending on the state taxing jurisdiction) and is imposed on the taxable recognition of net unrealized built-in gains (NUBIG) within the S corporation recognition period, which, unless modified by law, generally stands for the first 10 taxable years (full calendar years) of an electing S corporation. The calculated BIG tax is limited each reporting year within the S corporation recognition period to the calculated taxable income of the electing S corporation as a C corporation. Realized but unrecognized former NUBIG becomes a carried over tax item and is accounted as incurred for purposes of the BIG tax calculation in the subsequent year of the S corporation recognition period.

The NUBIG is comprised of all the C corporation deferred income tax items that include the taxable disposition of appreciated assets as further explained below within the S corporation prescribed recognition period.  Depending on the state tax ramifications beyond the scope of this blog, the double taxation regime (i.e., combined S corporation and stockholder level tax on the same pass-through taxable income) could be as much as 70% in some cases.  The NUBIG is measured at the S election conversion date and generally stems from either:

• The application use of friendly tax accounting methods (e.g., cash basis, completed contract for long-term contracts, installment sales reporting, and accelerated and bonus depreciation)  creating deferred income taxes including unrecognized accounting method change cumulative balance  (i.e., Sec 481(a) adjustment); or
• The net gain recognition (i.e., limited to the appreciation measured at the S election conversion date) attributable to tangible and intangible self- created assets (e.g., intellectual property, contract rights, customer list, goodwill, etc.) disposed within the prescribed S Corporation recognition period.

Note: The NUBIG items described above do not comprise an all-inclusive list.    

The good news is that thanks to Congress, the recognition period has been temporarily reduced from ten to five calendar years for 2013. Therefore, it is strongly recommended that any S corporation with an S election conversion, the effective date of on or before January 1, 2008, should consider accelerating taxable income into 2013 and taking full advantage of the five-year reduced recognition period. 

In the context of contemplated Sec 338(h) (10) or Sec 336(e) sales transactions involving a target S corporation with a BIG tax profile, you will need to run the numbers to get the full picture, but it might make sense to induce the seller party to accelerate the contemplated transaction into 2013 by reducing the asking price (i.e., sharing the tax savings).

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