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Dear Client:
You recently informed me that you are considering converting your C corporation to an S corporation. I'm writing to make sure that you understand the effects of a built-in gains tax that may apply when appreciated assets held by the corporation at the time of the conversion are subsequently disposed of and what we can do to minimize its impact. Although an S corporation is normally not subject to tax, where a C corporation converts to S corporation status the tax law imposes a tax at the highest corporate rate (35%) on the net built-in gains of the corporation. The idea is to prevent the use of an S election to escape tax at the corporate level on the appreciation that occurred while the corporation was a C corporation. This tax is imposed where the built-in gains are recognized (i.e., the appreciated assets are sold or otherwise disposed of) during the ten-year period after the S election takes effect (referred to as the “recognition period”). The tax applies to the lowest of the following:
(1) the amount that would be the taxable income of the S corporation for the tax year taking into account only recognized built-in gains and recognized built-in losses;
(2) the corporation's taxable income for that tax year; or
(3) the excess of the net unrealized built-in gain over the net recognized built-in gain for earlier tax years during the recognition period.
The tax may apply even if the S corporation does not make any unusual asset dispositions. For instance, a cash method corporation that collects an account receivable that accrued during the C corporation period or an accrual method corporation that disposes of inventory that was acquired during the C corporation period may be subject to the built-in gains tax.Any C corporation net operating losses (which are otherwise not usable in an S corporation year) are allowed as a deduction against net recognized built-in gain. Where net recognized built-in gain is not taxed because of the taxable income limitation ((2) above), the gain is carried forward and may be taxed in later years. The recognized built-in gain is passed through to the shareholders as income, in addition to being taxed at the corporate level (at a 35% rate). This unfortunate result is mitigated somewhat by treating the tax as a corporate loss which passes through to the shareholders.You can see how important it is to plan for the impact of the built-in gains tax, since, at a minimum, it is necessary to establish the amount of built-in gains (and losses) at the time of the conversion to an S corporation. After the conversion, we can plan by timing the sale of assets, matching gains and losses, and so on. But right now the important thing is to value the corporation's assets and have appraisals, where feasible, of the assets including inventory, as of the date the S corporation election will take effect in order to ensure that appreciation that takes place after that date will not be subject to the built-in gains tax. We can assist you in getting the necessary appraisals, as well as in identifying any built-in losses that could reduce the effect of the built-in gain tax.

We look forward to discussing these matters with you in greater detail.

Very truly yours, TaxCaffe

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