To avoid the hefty corporate and shareholder federal tax on distributions, many corporations decide to switch from C to S corporation status. However, if a corporation originally formed as a C corporation elects to switch to S status, the S corporation will be subject to the built-in capital gains (“BIG”) tax at the highest corporate rate (presently 35%) on all appreciation on its assets at the date of conversion if there is a triggering event—usually a sale—during the "recognition period."
Good news for corporations: the Protecting Americans From Tax Hikes Act (PATH) of 2015 cut the recognition period in half—from ten to five years. I advised a music publishing client whose C corporation held publishing assets with over $3,000,000 in built-in gain to elect S status in 2014. Accordingly, beginning in 2019, this S corporation could dispose of such assets without fear of a double-tax whammy!
While a C corporation is subject to federal income tax, an S corporation is generally not. Rather, an S corporation is treated as a pass-through entity, meaning its taxable income flows through to its shareholders on a pro-rata basis in accordance with share ownership. Conversely, a C corporation is treated as a separate entity, so its taxable income is taxed at the corporate level, and if distributions are made to the shareholders (dividends), a second level of tax is imposed on the shareholders. The combined corporation and shareholder level tax on a C corporation can exceed 60%! For this reason, many corporate owners elect S status. However, switching from C to S status followed by a sale within the recognition period can be a trap for the unwary.
Fortunately, as part of the PATH Act, the recognition period was reduced to five years, beginning with the first day of the first tax year a corporation switched from C to S status. The shortening of the recognition period applies retroactively to January 1, 2015. To illustrate how the BIG tax works, if a C corporation held assets that had appreciated by $5,000,000, at the effective date of the S election, and disposed of those assets during the recognition period, the $5,000,000 of built-in gain would be taxed at 35% ($1,750,000). The gain would then get taxed again to the individual shareholders (at their tax rates). The combined corporate and shareholder taxes are downright confiscatory.
Because the PATH Act reduced the recognition period to five (5) years, the business owner of a C corporation with appreciated assets should seriously consider converting to S status if disposition of assets with significant built-in gains is reasonably likely to occur, but can be deferred for more than five (5) years.