Conversions from C to S Corporation
A frequently missed opportunity for appraisers
This article provides an overview of some of the complex rules relating to the built-in gains tax. It is intended only to acquaint business valuators with the structure of the tax and some of the key considerations which the business valuator must address.
In order to avoid double taxation, C corporationsâ€™ tax advisers frequently recommend that they elect to be taxed as an S corporation.Â When this option is being considered, it presents a situation that cries out for engaging a qualified business appraiser to perform a conclusion of value appraisal engagement.Â All too often however, the tax adviser does not strongly urge the client to have such an appraisal performed.Â It has been my experience, as a CPA specializing in taxes over the 55 years since the concept of S corporations came into existence that more often than not, the decision is made not to go forward with an appraisal at the time of conversion.Â Instead, the tax adviser and the client decide to wait and see what happens in the future, and therefore delay having an appraisal until events take place that could cause the imposition of a â€śbuilt-in gains tax.â€ťÂ Frequently, the issue of the cost of such an appraisal is cited as the reason for not going forward.Â Deciding not to have the appraisal up front, either just prior to the S corporation effective date or soon afterward, can be a costly mistake.Â As I will discuss later in this article, the tax consequences may not occur for up to as many as ten years later.Â This could result in the cost of a retroactive appraisal being significantly higher. Furthermore, it may not even be possible for the appraiser to perform an appraisal that would be acceptable to the IRS and state taxing authorities.
Business appraisers need to understand how the built-in tax works so that they can intelligently inform their tax adviser colleagues on the need for the upfront appraisal.Â Further, the appraiser needs to understand the applicable terminology in the Revenue Code so that he or she can properly perform the appraisal assignment.Â This short article is intended to be a useful primer for the business appraiser who is not also a tax specialist.
What is the â€śBuilt-in Gains Taxâ€ť?
Â Internal Revenue Code Section 1374, originally enacted in 1958 and amended several times up through 1997, defines what the tax is and how it works.Â Its workings are somewhat complex, but it is essentially a tax imposed at the S corporation level on the gain already existing (not yet recognized), but recognized on the later disposition (during the statutory recognition period) of assets, which were held as of the effective date of the election to be taxed as an S corporation.Â Each of the italicized words in the preceding, highly complex sentence must be understood by the appraiser when performing an appraisal to be used by the S corporationâ€™s tax preparer to determine the amount of built-in tax to be paid by the S corporation in years subsequent to the effective date of the S corporation election.
Words That the Appraiser and Tax Preparer Must Be Careful to Deal with Properly
Tax Imposed at the S Corporation Level: The built-in gains tax is imposed on the corporation itself at the highest rate currently applicable to C corporations.Â It must be understood that the built-in gains tax is in addition, and not in lieu of, the tax on the individual shareholders on the gain recognized.Â However, the gain allocated to the shareholders is reduced by the corporate level tax.
Gain Existing (but not yet recognized): This is the realized, but not yet recognized (for tax purposes), gain on each asset held by the corporation as of the effective date of the S election.Â It is the difference between the fair market value of each asset on that date and the net tax book value of the asset (i.e., its original cost minus the accumulated tax depreciation) as of the effective date of the S election.Â The amount of the gain is computed by the corporation or its tax preparer, but the appraiser needs to ascertain the fair market value of the â€śnet assetsâ€ť, which is computed and reported on by the appraiser.Â More on this later.
Disposition of assets: Taxes on the built-in gain are triggered at the time of disposition.Â â€śDispositionâ€ť includes not only the sale of individual assets, but also the sale or liquidation of all the assets.Â Keep in mind that a liquidation is deemed to occur at the time of conversion to a partnership or a single-owner disregarded entity.
Recognition period: â€“ The â€śrecognition periodâ€ť in the original law was 10 years.Â F For the years beginning 2009 and 2010, the recognition period was seven years.Â Beginning in 2011, it was changed to five years and is now currently back to a 10-year timespan.Â
Corporations That Have Always Been S Corporations
With some exceptions, a corporation that has always been an S corporation is not subject to the built-in gains tax.Â One occasionally overlooked exception applies to an S corporations, which has acquired assets from a C corporation in a tax-free transaction.Â In this case, such acquired assets are subject to the built-in gains tax regardless of the fact that the acquiring S corporation has always been an S corporation.
Tips for the Business Valuator
What does all of this mean for the business valuator?Â Here are some tips for the business appraiser who is taking on an engagement for a C corporation which is electing S corporation status:
- Remember that you are being engaged to give your opinion on the â€śnet assetsâ€ť of the corporation as of the effective date of its becoming an S corporation.Â You are not being engaged to value an ownership in the corporationâ€™s capital stock.Â Accordingly, because you are not valuing an interest in the stock, there should be no adjustments for control or lack thereof, nor should there be any discount for lack of liquidity or lack of marketability of the corporate stock interest.
- Do not overlook the fact that intangible assets, such as goodwill, are assets included in the term â€śnet assetsâ€ť.Â
- Be sure to consider, and very likely use, all three approaches to value income approach, market approach, and asset-based approach, just as you would do in other business valuation engagements.
- Be careful, however, when you use the Asset-Based Approach.Â If the corporation has real property and/or machinery and equipment, you must either be a qualified real estate and/or machinery appraiser, or you must have the client provide you with an appraisal performed by a qualified appraiser in these other disciplines.Â As I have observed, failure to insist in getting such appraisals is a common shortcoming of many business appraisals performed for conversions to S corporation status!
- Be sure to provide to the client a detailed list of the fair market values of each of the items of real and/or personal property included in â€śnet assets.â€ť
- Urge the client and its tax adviser to have the appraisal of the net assets performed to support the fair market value of the assets possibly subject to the built-in gains tax done at, or very close to, the effective date of S corporation status.
This article does not attempt to cover all the complex rules relating to the built-in gains tax.Â It is intended only to acquaint business valuators with the structure of the tax and some of the key considerations with which the business valuator must address.Â Leave the fine points of the law to the clientâ€™s tax adviser.
The American Taxpayer Relief Act of 2012, signed into law January 2, 2013 provides in part, that the built-in gain (BIG) recognition period for S corporations is shortened to five years again for transactions taking place in tax years of the S corporation beginning in 2012 or 2013. While this gem of a provision will sunset after 2013, it was made retroactive to 2012.
As a result of the new legislation, the BIG tax liability one thought the client was exposed to in 2012 may be eliminated. Equally, if the S election became effective before 2009 and a sale of assets by the S corporation occurs in 2013 after the expiration of the new 60-month recognition period, one may avoid the 35 percent BIG tax, as well. Care of the timing of 2013 transactions is now very important, and techniques should be employed to defer the closing until the new recognition period has expired.
Therefore, despite the new tax lawâ€™s increase in tax rates for individuals (both the income tax and capital gains tax rates, as well as the imposition of the new 3.8 percent net investment income tax for shareholders who do not materially participate in the business of the S corporation), the S shareholder clients may experience a net decrease in taxes for 2013 transactions when compared to prior years because of the elimination of any liability for the 35 percent BIG tax.
Dick Thorsen is a CPA/ABV, ABAR, CVA,Â Â and CMEA.Â He has been an active CPA since 1954 and served as Chairman of the Minnesota State Board of Accountancy and President of the Minnesota Society of CPAs.Â Mr. Thorsen has been elected Vice President of the AICPA and been a member of its Board of Directors, along with 21 of its committees, and Chair of its Responsibilities in Tax Practice Committee. Â He is a member of the Institute of Business Appraisers (IBA) Board of Governors and its Professional Responsibility Board and one of its representatives on the NACVA/IBA Standards Unification Task Force. Â He is a member of NACVAâ€™s Standards Committee and Examination Grading Committee. Â Dick can be reached at firstname.lastname@example.org.