The Built-in Gains Tax is a tax on S corporations that formerly were C corporations. While C corporation earnings are subject to double taxation, S corporations are flow-through entities with only one level of taxation at the shareholder level. An exception to this single taxation rule is the BIG Tax.
The BIG Tax was part of the Tax Reform Act of 1986. While S corporations and gains taxes have been around since 1958, the Tax Reform Act made electing S corporation status more attractive by lowering individual tax rates. Lawmakers wary of S corporation conversion abuse put an extended 10-year monitoring window and related BIG Tax on new S corporations.
So how does the BIG Tax work?
When a company converts from a C corporation to an S corporation, there is generally a difference between the cost of the assets and the fair market value of the assets. This difference can be a gain (appreciation on a building) or a loss (decline in value of company’s automobiles). The net gains and losses become the net “Unrealized Built-in Gain” of the company, which is subject to the 35 percent BIG tax when the underlying assets are sold.
The Built-in Gains Tax earns its acronym when comparing the tax rates on C corporation and S corporation income. The BIG Tax is imposed at the highest corporate rate of 35 percent. Had the tax been imposed when the company was a C corporation, the tax rate would have been between 15 and 35 percent, with an average of 34 percent. The BIG Tax is generally bigger than the C corporation tax would have been.
Relief from the BIG tax comes in the form of a limitation to the recognition and payment of the BIG Tax. This limit is called the “recognition period.” The recognition period historically was 10 calendar years from the S election date. Thereby, any sales of BIG assets after the 10-year window were exempt from the BIG Tax. The American Recovery and Reinvestment Act of 2009 shortened this recognition period to seven years for taxable years beginning in 2009 and 2010, and the Small Business Jobs Act of 2010 shortened the period to five years for taxable years beginning in 2011. The reduced recognition period creates an opportunity for companies to sell appreciated assets before the traditional 10-year window lapses. The reduction also creates some headaches.
The main concern about the reduction is that it is temporary. For example, a company that elected S status on Jan. 1, 2002, would be exempt from the BIG Tax during the 2009-11 tax years, but subject to the tax again in 2012. Therefore, the reduction in recognition period is merely a tax “holiday” rather than substantial change in tax law.
Under current rules, the BIG Tax (under the installment method) is calculated during an asset’s year of sale and collected as the company receives proceeds. If proceeds are received outside a 10-year recognition period, the BIG Tax applies since the original sale was subject to the tax. For example, if a company sells an asset in year 10, but collects proceeds in years 10-15, the BIG tax applies since it was in place when the item was sold - even though collections fall outside the recognition period.
So what happens if a company sells an asset during the BIG Tax holiday, but receives proceeds after the holiday has passed? The BIG Tax would be zero since it did not apply when the asset was sold. Therefore, if a company sells an asset in year seven and is exempt from the BIG Tax, but collects proceeds in years eight through 10, the BIG Tax would still be zero. The strange occurrence of no BIG Tax during a period when it would normally apply appears to be an unintended consequence of the 2009 Act and a great planning opportunity. Companies who would like to spread out collection of proceeds and related taxable income for their shareholders can avoid the BIG Tax by utilizing this tax holiday.
Whether Congress intends to make the reduced recognition period permanent has yet to be seen. The provision may be extended every year or an item that only comes about to alleviate economic hardship. For now, it is important for S Corporations to review the applicability and related opportunities with their tax advisor.
