As you may know by now, on December 18, 2015, President Obama signed into law “The Protecting Americans From Tax Hikes Act”, which made permanent many expiring or expired provisions of tax law and further extended other provisions. Hidden among the provisions as a significant change affecting S corporations and their shareholders.
S corporations generally pass through income, income tax liability and tax attributes to their individual shareholders. One major exception to this rule is where an S corporation was previously treated as a “C” corporation and converts to an S corporation. In that event, the S corporation may have to pay corporate tax (at rates up to 35%) on the “built-in gains” on the corporation’s assets determined at the time of the conversion. Typically, a company has to perform an appraisal of the business as of the conversion date and the built-in gains would include goodwill or going concern value inherent in the business. The S corporation would have to recapture and pay tax on the built-in gains if the gains are realized any time during a specified period following the conversion.
Before the new tax act, the recapture period was 10 years. The new tax Act permanently cuts in half the 10-year period to 5 years on which S corporations that converted from corporate tax, or “C,” status have to pay corporate taxes on built-in gains. So, if the built-in gains are realized more than 5 years after the date of the conversion to S corporation status, no built-in gains tax will be due. This will be an incredibly important planning tool for S corporations that desire to sell their assets or business in 2016 and beyond.
The five-year provision on built-in gains has been a priority for several years for the S Corp Association, which enlisted the help of Rep. Dave Reichert (R-Wash.) to introduce legislation in the House Ways and Means Committee. Congress previously reduced the threshold from 10 years to seven years in 2009 and 2010, then to five years in 2012, 2013 and 2014—but only temporarily, and that provision expired at the end of 2014. In 2015, the recapture period returned to 10 years but only for that year.