As a general rule, S corporations do not pay taxes, but rather their income is reported and taxed on the individual tax returns of their shareholders. However, a corporation that was originally formed as a C corporation is subject to a built-in gains tax on any appreciation in the value of its assets that arose prior to its conversion to an S corporation. This pre-conversion appreciation is called “built-in gain.”
An S Corporation that sells a built-in gain asset within 10 years of the first day of the first year it became an S corporation must pay tax on the gain at the highest corporate rate (currently 35%) and the shareholders will be taxed at the individual level when the proceeds are distributed to them.
New reduced built-in gain holding period
The American Recovery and Reinvestment Act of 2009 has reduced the built-in gain holding period from 10 to 7 years for tax years 2009 and 2010. Consequently, the built-in gain holding (or recognition) period has already expired for converted S corporations that made their S elections before the 2002 tax year. These S corporations will not be subject to the built-in gains tax.
For S corporations that made elections in 2002 or 2003, the built in gain holding period will end at the beginning of the 2009 or 2010 tax year, respectively. For S corporations that made their S elections after 2003, the 10 year recognition period will continue to apply.
Tax planning tip
A corporation that converted to an S corporation prior to 2004 should consider selling its pre-conversion appreciated assets in 2009 or 2010, as the case may be, in order to take advantage of the reduced built-in gain holding period. If it doesn’t sell its built-in gain assets in 2009 or 2010, it must – assuming Congress doesn’t extend the new provision – wait the full 10 years before it can sell without incurring the built-in gain tax.
You should consult with a tax CPA or tax attorney before deciding whether, when and to what extent you should sell your built-in gain assets.
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