By: Amanda Wilson
An S corporation is a popular tax vehicle for family owned businesses, as it allows for a single layer of tax instead of the double layer of tax imposed on regular corporations. Instead of the S corporation paying tax, the taxable income of the S corporation passes through to the shareholders and is reported on the shareholders’ personal tax returns. The S corporation can generally then distribute the accompanying profits to the shareholders free of federal tax.
To avoid corporations converting to S corporations and then selling their assets (thereby taking advantage of the single level of tax imposed on S corproations), the Internal Revenue Code imposes a 10 year built-in gains tax on S corporations. If an S corporation sells assets within this 10-year period, it pays the normal corporate level tax to the extent any of the gain on the sale was already built-into the asset at the time it made the S election. For example, assume a corporation has an asset with a fair market value of $10 at the time it converts to an S corporation. If the corporation later sells the asset for $12 within the 10 year built-in gain period, the S corporation would pay corporate level tax to the extent that it had gain attributable to the first $10 of the sales price.
A recent proposal in the House of Representatives would permanently reduce this 10-year period to 5 years. This change is proposed to be retroactive to January 1, 2015. This change, if it makes its way into law, would be great news for S corporations as well as real estate investment trusts (which are subject to a comparable built-in gains tax). Stay tuned!