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Converting to an S corp? Cut the BIG tax down to size

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in Small Business Tax,Small Business Tax Deduction Strategies

Are you tired of paying tax twice on income as a C corporation owner? First, income is taxed to the corporation as it is earned and then again to you personally when it is paid out as dividends. To avoid the double tax whammy, consider a switch to S corporation status.

Strategy: Watch out for the built-in gains (BIG) tax. This appropriately named tax can blindside entrepreneurs who convert from a C corp to an S corp. In some cases, the conversion may not even be worth the price of admission.

Nevertheless, with some planning, you can minimize the impact of the BIG tax or, at the very least, estimate the damages.

Here’s the whole story: A corporation may owe income tax at regular income tax rates on a net recognized built-in gain occurring within the 10 years following a conversion to S corp status (see box below). For example, if you convert from a C corp to an S corp on July 1, 2010, the tax applies to gains recognized through June 30, 2020.

The tax is based on the difference between the fair market value of property sold or otherwise disposed of (including cash-basis receivables that are collected) and the basis of the property at conversion. The tax rules in this area are extremely complex, but here’s the skinny:

An S corp may be liable for the BIG tax if the following conditions are met:

  • It was a C corp prior to the S corp election.
  • It has a recognized built-in gain within the 10-year recognition period.
  • The net recognized built-in gain for the tax year doesn’t exceed the net unrealized built-in gain minus the net recognized built-in gain for prior years in the recognition period (to the extent such gains were subject to tax).

The BIG tax is computed by applying the highest average corporate tax rate to the S corp’s built-in gain for the year. Currently, the top tax rate is 35%. “Net recognized built-in gain” is defined as the lesser of (1) the amount that would constitute taxable income of the S corp if only recognized built-in gains and losses were taken into account and (2) the S corp’s taxable income. 

There are other complexities. For example, an S corp that uses the cash method of accounting includes unrealized accounts receivable and unrealized accounts payable in its BIG tax calculations. So your firm might have to pay BIG tax on part of its uncollected accounts receivable.

But the situation may not be as dire as it appears. For starters, any net operating loss (NOL) carried forward from a year in which the corporation was a C corp may be deducted against the net recognized built-in gain of the S corp. Also, your firm may use capital losses carried forward from prior years to offset the BIG tax. Finally, excess business credits carried over from prior years may reduce the tax liability on built-in gains.

Tip: Don’t attempt this on your own. Consult with a tax pro.

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