If you own a C corporation, you’re effectively taxed twice—once when the company earns taxable income and again when those earnings are paid to you as dividends. To avoid this double tax whammy, you might want to switch to the S corporation form of ownership.
Strategy: Watch out for the “built-in gains” (BIG) tax. This little-noticed tax can blindside someone converting from a C corp to an S corp.
However, with some careful planning, you can minimize the impact of the BIG tax.
Here’s the whole story: Currently, a corporation may owe income tax at a 35% rate on a net recognized built-in gain occurring within 10 years following a conversion to S corp status. For example, if you convert your C corp to an S corp on July 1, 2013, the tax applies to gains realized through June 30, 2023. (For purposes of computing the BIG tax, a five-year recognition period is extended through 2013 by ATRA. Thus, if a corporation converted to S corp status in 2007, in 2013 it can sell assets acquired before 2007 without paying the tax.)
The amount of the tax is based on the difference between the fair market value of property sold or otherwise disposed of and the basis of the property at the time of the conversion.
The net recognized built-in gain for the tax year doesn’t exceed the net unrealized 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 corporate tax rate (35% in 2013) to the S corp’s built-in gain for the year. “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, or (2) the S corp’s taxable income.
Also, note that an S corp using cash accounting may have to pay the BIG tax on part of its uncollected accounts receivables. But the situation may not be as dire as it appears.
Here are three possibilities:
- Any net operating loss (NOL) carryforward in a year in which the corporation was a C corp may be deducted against the net recognized built-in gain of the S corp.
- Your firm may use capital losses carried forward from prior years to offset the BIG tax.
- Excess business credits carried over from prior years may reduce the tax liability on built-in gains.
Tip: Consider all the implications, including the BIG tax, in a switch to S corp status and consult your tax advisor before pulling the trigger.