By Lisa Starczewski, Esq.
Buchanan, Ingersoll & Rooney PC, Washington, DC
Under §1374 of the Internal Revenue Code (the "Code"), S corporations are subject to a tax on appreciated assets held on the day a C corporation converts to S status, referred to as the built-in gains tax. The tax can be fairly onerous because if an appreciated asset is disposed of during the defined "recognition period," the S corporation recognizes gain at the entity level (to the extent that the income or gain realized from the subsequent sale or exchange of those assets reflects unrealized appreciation in the corporation as of the conversion date) and that gain is immediately passed through and taxed to the S corporation shareholders. In addition, the built-in gains tax is imposed at the highest corporate tax rate.
The "recognition period" is generally 10 years. However, as a business "incentive," the American Recovery and Reinvestment Act of 2009 provides that the recognition period is reduced to seven years for 2009 and 2010. Thus, in the case of any taxable year beginning in 2009 or 2010, no tax is imposed on the net recognized built-in gain of an S corporation if the seventh taxable year in the recognition period preceded such taxable year.1
So – how does the built-in gains tax work in the context of an installment sale? S corporations can sell assets and use the installment method to defer gain. Essentially, under the regulations, if a converted S corporation sells an asset either before or during the recognition period and recognizes income (either during or after the recognition period) from the sale under the installment method, the income is subject to the built-in gains tax.2 If a corporation sells an asset before the recognition period, the income from the sale that is not reported before the recognition period is treated as having been reported in the first year of the recognition period.3
With respect to the new provision regarding the 2009 and 2010 taxable years, what happens if a corporation disposes of an asset during 2009 or 2010, and receives payments after those years but still within a ten-year recognition period? In other words, if 2008 was year seven of a 10-year recognition period for a corporation and 2009 and 2010 are years eight and nine (and are exempt from the built-in gains tax), what happens when the corporation receives a payment in 2011 (year 10 of the 10-year period)? Is the built-in gains tax re-triggered? The answer is not entirely clear. The Committee Report makes the statement that "no tax will be imposed under [§1374] if such gain is recognized after the date that is seven years following the date on which such asset was acquired." However, this doesn't necessarily answer this question because this statement is clarifying the effect of the amendment, relative to tax years 2009 and 2010. Query whether use of the term "after" means at any time after if the disposition occurs in 2009 or 2010 and the seven-year period is over? The answer is probably.
In addition, there is some question about what happens if a corporation disposes of an asset within a 10-year recognition period but before 2009 or 2010 and receives payment under an installment sale during those years. If year seven precedes 2009 or 2010, does the built-in gain tax apply to the disposition? Most likely – but again, there is no definitive answer.
Hopefully, the IRS will provide some clarification of these issues. In the meantime, practitioners will need to form reasonable opinions and advise their clients accordingly.
For more information, in the Tax Management Portfolios, see Starczewski, 565 T.M., Installment Sales, and in Tax Practice Series, see ¶3550, Installment Sales.
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