Tucked away in the Small Business Jobs Act of 2010 enacted by Congress in September, 2010 was a golden gift for owners of businesses who converted from “C” Corp status to “S” Corp status within the past 10 years.
If you are the owner or shareholder of an “S” Corp who switched from “C” Corp status within the past 10 years, you may know something about built-in gains (“BIG”). IRS regulations stipulate if you sell the assets of an “S” Corp within 10 years of converting from a “C” Corp, the BIG is taxed at the highest corporate tax rate, which would be 39% for BIG taxes versus 15% for capital gains, a whopping 24% difference.
Specifically, what is the BIG? According to Christopher F. Beaulieu, CPA:
If a prior C corporation makes an S election, the company needs to measure the fair market value at the effective date of the S election as compared to the tax basis. The amount of unrecognized gain is determined for each asset. The net of unrecognized built-in gains and built-in losses is the company’s unrecognized built-in gain. This amount is reported on page two of Form 1120S (S Corporation Tax Return).
Owners of “S” corps which had converted from “C” within 10 years were faced with two choices when considering a sale of their businesses: a)Sell the stock of the company, which for many closely held, private concerns is not very practical…or desirable for acquirers, or; b)Sell the assets and pay Uncle Sam a fairly hefty sum.
However, thanks to the aforementioned gift from Congress, those with BIG issues have been given a temporary reprieve. The Small Business Jobs Act of 2010 (Section 2014 to be specific)* stipulates the following as it pertains to BIG:
Under the Small Business Jobs Act, if the fifth year of an S Corporation’s recognition period ends before their 2011 taxable year begins, then no tax is imposed on the net recognized built-in gain for the 2011 tax year.
In other words, if you are the owner/shareholder of a “S” corp which switched from a “C” corp between more than five years ago but less than 10 years ago, you are not subject to the confiscatory taxes on the BIG if you sell the assets of your business in 2011.
For example, if, when you switched from “C” to “S” status your CPA determined the BIG was $4,000,000 at the time of the conversion, the BIG tax on the sale of those assets would be $1,560,000. However, if you are able to take advantage of this gift from Congress, and you sell your business in 2011, Federal capital gains taxes on $4 million would be $600,000, a savings of $960,000 (versus taxes on the BIG).
While this may only benefit or pertain to a select few companies around the nation, it isn’t very often Congress hands out gifts to business owners. If you are the owner or shareholder in a business which converted from “C” to “S” more than five years ago, AND you are thinking of exiting your business in the future, you might want to consider stepping up your plans to take advantage of what may be a one-time tax savings for you. Of course, you could always wait for the 10-year clock to run out as well. But, there is no guarantee Federal capital gains tax rates will remain at 15% in the future, either.
*Note: To be fair, unknown to many, in 2009, Congress reduced the hold-period for conversions from 10 years to seven years, for businesses sold in 2009 and 2010. However, the additional reduction to five years, for 2011 only, is an opportunity we may not see again in the future.
Posted by Jim Zipursky