The tax provisions contained in the recently enacted American Recovery and Reinvestment Act of 2009 (“ARRA”) provide a number of tax benefits for individuals and small businesses. One interesting provision provides a welcome benefit for certain S corporations that have “built-in gains” from years prior to their S corporation election.
An S corporation isn't taxed at the corporate level with limited exceptions. Instead, its items of income, loss, deduction and credit are passed through to, and taken into account by, its shareholders in computing their individual tax liabilities.
One major exception applies to a corporation that was once a C corporation and elects to become an S corporation (or to an S corporation that receives property from a C corporation in a nontaxable carryover basis transfer). In that case, the S corporation is taxed at the highest corporate rate (currently 35% at the Federal level) on all gains that were built-in at the time of the election (or transfer from the C corporation), if the corporation recognizes the gains during a specified “recognition period.” In general, the recognition period is the first ten tax years after the effective date of the S election (or during the ten-year-period after the asset transfer from the C corporation).
Example. A C corporation elects to become an S corporation on January 1, 2001, when its assets have a fair market value of $1,000 and an adjusted tax basis of $400. The difference, $600, is “built-in gain.” If the S corporation sells some or all of those assets before January 1, 2011, the S corporation itself will be liable for tax on the amount of the built-in gain recognized.
ARRA shortens the recognition period for built-in gains from ten tax years to seven tax years for built-in gains recognized in 2009 or 2010. This change provides a new opportunity for former C corporations that elected S corporation status after 1999 and before 2004 (or acquired assets from a C corporation in a carryover basis transaction during that period), because the shortened recognition period could permit a disposition of built-in gain assets at a greatly reduced Federal income tax cost.
Example. Under the ARRA amendment, in the example above, if the S corporation sells built-in gain assets in 2009 or 2010, the S corporation will not be liable for the built-in gain tax on the amount of gain recognized, because the recognition period ended at the end of 2008.