Academic journal article Journal of Accountancy

Finally, Guidance on the Built-In Gain Tax

Academic journal article Journal of Accountancy

Finally, Guidance on the Built-In Gain Tax

Article excerpt

Following the Tax Reform Act of 1986, many corporations found it beneficial to be taxed as S corporations. But if a corporation elected S status after December 31, 1986, it may be subject to the built-in gain tax. The tax generally does not apply to corporations that always have been S corporations (a special transition rule applies to corporations that made the election before 1989) and is a major exception to the general rule that S corporations are not taxed on their earnings, which instead flow through to shareholders and are reported on their individual tax returns.

Internal Revenue Code section 1374 imposes a corporate-level tax on S corporations' income or gain recognition to the extent it reflects unrealized appreciation in a corporation on the date it switched from C to S status. Any gain recognized and taxed to such corporations is passed through and taxed to shareholders, resulting in a double tax. Corporations treat the tax as a loss, which also is passed through to shareholders. Section 1374 requires corporations to calculate this unrealized appreciation on assets at the time they convert to S status, which involves valuing assets. Valuing inventories has been particularly troublesome, since it was unclear which valuation method should be used.

Before the Internal Revenue Service issued the proposed regulations, little guidance was available regarding elements of the built-in gain computation, including the treatment of

* Sales or exchanges.

* Items of income or deduction.

* Discharge of indebtedness.

* Bad debts.

* Long-term contracts.

* Installment sales.

* Partnership interests.

* Deduction and credit carryforwards.

* Inventory.

The proposed regulations provide muchneeded general guidance as well as specific guidance on a number of items. This article focuses on these rules.


The built-in gain tax is computed by applying the highest corporate tax rate (currently 35%) to the net recognized built-in gain for any taxable year beginning in the recognition period--the 10-year period beginning on the date of conversion to S status. The net recognized built-in gain and the tax are reduced by certain carryover items, as discussed below. It is unclear whether the 10-year period is defined in terms of months or tax years. What happens when the recognition period ends at a time other than the end of a taxable year also is unclear. One hopes the final regulations will provide further guidance.

The net recognized built-in gain on which the tax is computed is the least of

* The prelimitation amount (taxable income, which is determined using the C corporation rules and considering only recognized built-in gains, recognized built-in losses and recognized built-in gain carryovers).

* The taxable income limitation (overall taxable income, which is determined using the C corporation rules and considering not only the items above but als5 other items that normally enter into the taxable income computation: net operating loss and certain other corporate deductions are not taken into account).

* The net unrealized built-in gain limitation (the amount by which net unrealized built-in gains exceed net recognized built-in gains for all prior taxable years).

If either the taxable income or the net unrealized built-in gain limitation applies for any taxable year, S corporations' net recognized built-in gain consists of a ratable portion of each item of income, gain, loss and deduction included in the prelimitation amount. Also, if the taxable income limitation applies for any taxable year to S corporations whose elections were made after March 30, 1988, the amount by which the prelimitation amount exceeds the taxable income limitation (recognized built-in gain carryover) is included in the prelimitation amount for the succeeding taxable year. …

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