Academic journal article Journal of Accountancy

Surprise Built-In Gains Taxes

Academic journal article Journal of Accountancy

Surprise Built-In Gains Taxes

Article excerpt

Small businesses that change their status from C to S corporations can be subject to "surprise" built-in gains taxes. According to Internal Revenue Code section 1374, a built-in gains tax is applied to die appreciation of assets due to a corporate status change if the appreciation is disposed of within 10 years.

In a recent court case, a company that elected S status before the adoption of the final regulations (1.1374-7(a)) had to pay taxes against work-in-process inventory. The case involved a business that manufactured metal containers and tanks. The final regulations said work-in-process was valued at the price an arm's-length buyer would pay, which resulted in a lower-than-retail value and subjected the S corporation to the built-in gains tax. The company argued that the value should be based on the replacement value of the products, producing no built-in gain.

The Tax Court said the value of the work-in-process inventory should be measured by the amount received in a bulk sale to a buyer. Because the taxpayer could not document the value of the unfinished inventory in a bulk sale, the court used the Internal Revenue Service valuation. …

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