Reduction of Pass-Thru Items, S Corporation

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Reduction of Pass-Thru Items

If the corporation is subject to the capital gains tax, the tax on built-in gains, or the tax on excess net passive income, discussed later, the related items are reduced in the following ways:

1. The amount of the corporation’s long-term capital gain is reduced by any capital gains tax the corporation has to pay. If the amount of that tax exceeds the long-term capital gains, the excess is used to reduce the gain on the sale or exchange of §1231 property. For this purpose, “long-term capital gain,” does not count with any gain from the sale or exchange of any §1231 property.

2. The amount of each recognized built-in gain is reduced by its proportionate share of the tax the corporation has to pay on these gains.

3. The amount of each item of passive investment income is reduced by a portion of the tax on excess net passive income the corporation has to pay. Each item is reduced by an amount that has the same ratio to the tax on excess net passive income as each item of passive investment income has to the total passive investment income for the tax year.

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Built-In Gain – §1374

If a taxable corporation converts into an S corporation, the conversion is not a taxable event. However, following such a conversion, an S corporation must hold its assets for a specific recognition period to avoid taxation on any built-in profits that existed at the time of the conversion (§1374). The recognition period has been the ten-year period beginning with the first day of the first tax year for which one of the corporations is an S corporation (§1374(d)(7)(A)).

Note: If an S corporation has a net recognized built-in gain for any taxed year beginning in the recognition period, a tax is imposed on the income of the S corporation for that tax year (§1374(d)(7)).

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However, because of several tax acts, this 10-year recognition period has varied, over time, from 7 to 5 years for various tax years. Thus, for 2009 and 2010, it was seven years. From 2011 through 2014, the “recognition period” was a five-year period beginning with No1 day of the first taxable period which the corporation was an S corporation.

Note: The 5-year period refers to 5 calendar years from the No.1 day of the No1 taxable year for which the corporation was an S corporation. Comment: In the case of built-in gain attributable to an asset received by an S corporation from a C corporation in a basic carryover transaction, no tax was imposed under §1374 if such gain was recognized after the date that was seven years following the date on which such asset was acquired. Shareholders continued to take into account all items of gain and loss under §1366.

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For 2015, the five-year recognition period was scheduled to expire and revert to ten years. However, the PATH Act reinstated the five-year recognition period and made it permanent. The tax applies only to a corporation that converted from a regular corporation to an S corporation after 1986. It does not apply to any corporation if an election to be an S corporation was in effect for each of its tax years. An S corporation and any predecessor corporation are treated as one corporation for this purpose. X Corp. was a C corporation for several years until it made an S election. Its only asset at the beginning of its first S corporation year was the Black acre. The value of Black acre was $100,000, but its basis was only $2,000. Two years later, Quoted from INTUIT

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Example

Corp. sold Black acre for $160,000. Because there was a built-in net gain at the time X’s S, the election went into effect; it is liable for the tax under §1374. It will be subject to corporate income tax on $98,000 of its gain. The remaining $60,000 of its gain is not subject to corporate tax. The entire $158,000 gain is taxed to the shareholders (but it is reduced by the amount of tax that X Corp. had to pay on the gain) (§1366(f)(2),1374). Quoted from INTUIT how do I calculate recognized built-in gain for 1st year as an s corp?

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Net Recognized Built-In Gain

The term “net recognized built-in gain” for any tax year in the recognition period is the lesser of:

(1) The total amount that would be taxable income of an S corporation for the tax year if only recognized built-in gains and recognized built-in losses were taken into account, or

(2) The total amount that would be taxable income of the corporation if it were not an S corporation.

Note: Taxable income is the gross income of the corporation minus most deductions, including the amortization deduction for corporate organization costs allowed a corporation. But it does not include the net operating loss deduction or other special deductions for corporations, such as the dividend received deductions. Quote  S Corporation The State of UTAH

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If the amount in item (1) is more than the amount in item (2), the excess is treated as recognized built-in profit in the following tax year. The carryover provision does not apply to corporations that elected to be S corporations before March 31, 1988.

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Recognized Built-In Gains

The term “recognized built-in gain” is any gain recognized when an asset is disposed of during the recognition time, except to the extent the S corporation shows that:

(a) The asset was not held by the S corporation at the beginning of its first tax year as an S corporation, or

property (b) The gain is more than the fair market value of the p at the beginning of the first tax year minus the adjusted basis of the property at the beginning of that year.

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A recognized built-in gain also includes any item of income properly taken into account during the recognition period, but which is from periods before the first tax year the corporation was an S corporation. Therefore, disposing of an asset includes not only sales and exchanges, but also other

income recognition events that give up a right to claim or receive income.

Note: The first tax year a corporation is treated as an S corporation is deter Mined by its most recent election to be an S corporation.

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For example, the collection of accounts receivable by a cash method S corporation and the completion of a long-term contract performed by a taxpayer using the completed contract method of accounting are treated as dispositions of an asset.