Many small corporations elect subchapter “S” status because of the many tax benefits it offers. It can work well for corporations that make this election soon after their formation, but a corporation that begins its existence as a “C” corporation faces a distinct challenge, in the form of the “built-in gains tax.” 26 U.S.C. § 1374. This tax specifically applies to S corporations that used to be C corporations, and it taxes certain transactions at the highest possible corporate rate, which is currently 35 percent. Id. at §§ 11(b)(1)(D), 1374(b)(1). It only applies, however, for a specified period of time, known as the “recognition period,” after a corporation switches from C to S status. After several amendments shortening the recognition period, which was originally 10 years, Congress permanently shortened it to five years in the Protecting Americans From Tax Hikes (PATH) Act of 2015, Pub. L. 114-113, Div. Q (Dec. 18, 2015).
The laws governing corporate taxation are found in Subtitle A, Chapter 1, Subchapter C of the Internal Revenue Code (IRC), 26 U.S.C. § 301 et seq. In general, corporations pay income tax on profits, and shareholders pay taxes on dividends. Since this is essentially the same money subject to income tax twice, once in a corporate tax return and again in an individual shareholder’s return, it is often known as “double taxation.”
A corporation can avoid double taxation by electing S status, named for Subchapter S of the same chapter of the IRC, 26 U.S.C. § 1361 et seq. This subchapter uses “pass-thru” taxation, by which corporate profits are taxed directly to shareholders on a pro rata basis. Id. at § 1366. Not all corporations are eligible for S status, however. It is only available to “small business corporations” with only one class of stock, and with 100 or fewer shareholders, none of whom are nonresident aliens or business entities. Id. at § 1361(b)(1).
Congress created the built-in gains tax in the Tax Reform Act of 1986, 100 Stat. 2085 (Oct. 22, 1986). It imposes a tax on an S corporation’s “net recognized built-in gains” for each tax year, unless the corporation has elected S status “for each of its taxable years.” 26 U.S.C. §§ 1374(a), (c)(1). The tax applies to the appreciated value of assets owned by the corporation on the date it converts from C to S status, which it sells within the defined recognition period. The tax rate, as mentioned earlier, is the highest corporate tax rate allowed by law.
The recognition period for the built-in gains tax was originally 10 years. 26 U.S.C. § 1374(d)(7)(A). Congress reduced the period to seven years for taxable years starting in 2009 and 2010, 123 Stat. 342, (Feb. 17, 2009); and to five years for those starting in 2011, 124 Stat. 2556 (Sep. 27, 2010). A law passed in 2013 extended the five-year recognition period to taxable years beginning in 2012 and 2013. 126 Stat. 2334 (Jan. 2, 2013). The PATH Act makes the five-year recognition period permanent. Pub. L. 114-113, Div. Q, § 127.
Tax law attorney Samuel C. Berger represents business owners, businesses, and entrepreneurs in the New York City and Northern New Jersey areas. We offer fixed-fee legal-service packages that address a wide range of legal matters and client needs. To schedule a confidential consultation with a knowledgeable and skilled business advocate, contact us today online, at (201) 587-1500, or at (212) 380-8117.
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