The American Recovery and Reinvestment Act of 2009 and The Small Business Jobs Act of 2010 Reduce Tax Imposed on Certain Asset Sales by S Corporations in 2010 and 2011

The American Recovery and Reinvestment Act of 2009 and The Small Business Jobs Act of 2010 Reduce Tax Imposed on Certain Asset Sales by S Corporations in 2010 and 2011

By Lisa Petkun and Timothy Leska

The American Recovery and Reinvestment Act of 2009 (the Stimulus Bill) eliminates the imposition of tax upon certain S corporations (but not their shareholders) in taxable years beginning in 2009 and 2010. Recently, President Obama signed into law the Small Business Jobs Act of 2010 (the Jobs Bill), P.L. 111-240, which extends the elimination of tax on S corporations to taxable years beginning in 2011. Accordingly, S corporations that may be considering selling assets in 2010, 2011 and, in some situations, 2012 should evaluate whether they qualify for the relief provided in the recent tax legislation.

Background

An S corporation is a corporation that elects to be taxed under Subchapter S of the Internal Revenue Code of 1986, as amended (the Code). A corporation that does not elect to be an S corporation is a C corporation and pays tax as an entity. An S corporation, however, generally does not pay an entity level corporate tax. Rather, the income earned by the S corporation flows through the corporation and is currently taxed to the S corporation's shareholders. For example, if an S corporation sells an asset that it acquired for $10 and receives $20, the $10 gain recognized by the S corporation generally is only subject to tax in the hands of the S corporation's shareholders.

Notwithstanding this general flow-through treatment for S corporations, an S corporation is subject to a 35 percent corporate level tax (the Built-In Gains Tax) on income and gain from the disposition of certain assets. There are three prerequisites for the Built-In Gains Tax to apply:

  • Entity Rule: The S corporation must have either (i) elected S status after a period in which it was classified as a C corporation, or (ii) acquired assets from a C corporation in a tax-free transaction, such as a merger.
  • Asset Rule: The S corporation must recognize gain with respect to assets (collectively, Covered Assets) that were either (i) owned by the corporation when it elected to be an S corporation or (ii) acquired from a C corporation in a tax free transaction, such as a merger.
  • Timing Rule: The gain from the sale of Covered Assets must be recognized in the "recognition period" (discussed below).

If all of these rules are satisfied, the S corporation is subject to the Built-In Gains Tax on the gain recognized from the Covered Assets that existed as of the date of the S election or the date of the acquisition of the assets from a C corporation. For example, assume a C corporation owns an asset that it acquired for $10 and which has a fair market value of $20. If the corporation elects to be an S corporation on November 1, 2010 and sells the asset for $20 on November 5, 2010, the $10 gain recognized by the S corporation is subject to 35 percent tax and the corporation is liable to pay the tax. This tax is in addition to the tax imposed on the shareholders.

Relief Under the Stimulus Bill and the Jobs Bill

The Timing Rule acts as a disincentive for S corporations to sell Covered Assets. Because a sale within the recognition period requires payment of an additional 35 percent tax, S corporations subject to the Built-In Gains Tax often elect to defer sales until the recognition period expires.

To remove this disincentive and encourage sales, Congress passed the Stimulus Bill to modify the Timing Rule for taxable years beginning in 2009 and 2010. The recognition period has historically been 10 years from either (i) the S corporation election date or (ii) the date the Covered Assets were acquired from a C corporation in a tax-free transaction, whichever applies to the particular asset being sold. In the Stimulus Bill, Congress shortened the recognition period to seven taxable years for taxable years beginning in 2009 and 2010.

Congress continued to remove the disincentive of the Built-In Gains Tax and encourage sales by passing the Jobs Bill. The Jobs Bill further reduces the recognition period to five years for taxable years beginning in 2011.

The difference between taxable years and years in defining the recognition period is important. The historical 10-year recognition period and the Job Bill's five-year recognition period are measured as calendar years from the relevant election or acquisition date. The Stimulus Bill's seven-taxable-year recognition period, however, is measured by the number of taxable years from the relevant election or acquisition date. By using taxable years as opposed to calendar years, the Stimulus Bill permits exemption from the Built-In Gains Tax even in cases where fewer than seven calendar years have passed.

The table below illustrates different situations in which an S corporation may be eligible to avoid the Built-In Gains Tax if it sells Covered Assets in taxable years beginning in 2010 and 2011. Where the table refers to a fiscal year corporation, it is assumed that the corporation remains on the fiscal year after its S election. The result is different if the corporation had switched to a calendar year, which is often required when an S election is made.

If Then
Calendar year corporation with S election effective on 1/1/03. No Built-In Gains Tax imposed on the sale of Covered Assets after 1/1/10 and before 1/1/12.
5/30 fiscal year corporation with S election effective on 6/1/03. No Built-In Gains Tax imposed on the sale of Covered Assets after 6/1/2010 and before 5/30/2012.
Calendar year corporation with S election effective on 1/1/04. No Built-In Gains Tax imposed on the sale of Covered Assets after 1/1/11 and before 1/1/12.
5/30 fiscal year S corporation with S election effective on 6/1/04. No Built-In Gains Tax imposed on the sale of Covered Assets after 6/1/2011 and before 5/30/2012.
Calendar year corporation with S election effective on 1/1/06. No Built-In Gains Tax imposed on the sale of Covered Assets after 1/1/11 and before 1/1/12.
5/30 fiscal year corporation with S election effective on 6/1/06. No Built-In Gains Tax imposed on the sale of Covered Assets after 6/1/2011 and before 5/30/2012.
Calendar year corporation with S election effective on 1/1/07. Built-In Gains Tax imposed on the sale of Covered Assets at any time in 2010 and 2011.
5/30 fiscal year S corporation with S election effective on 6/1/07. Built-In Gains Tax imposed on the sale of Covered Assets at any time in 2010 and 2011.

Pepper Perspective: Overall, the Stimulus Bill and Jobs Bill attempt to encourage transfers of assets by limiting the application of the Built-In Gains Tax in 2010, 2011 and, in some circumstances, 2012. Therefore, S corporations that may be subject to the Built-In Gains Tax should consider whether they qualify for the relief un . . . .

Lisa B. Petkun is a partner in the Tax Practice Group of Pepper Hamilton LLP. Ms. Petkun concentrates her practice on sophisticated tax planning on behalf of individuals, partnerships and corporations. Her areas of concentration include choice of business entity, structuring bankruptcy workouts and reorganizations, taxation of lawsuit payments and recoveries, tax issues associated with nonprofit organizations, and estate, gift and personal planning.

Timothy J. Leska is an associate with Pepper Hamilton LLP, resident in the Philadelphia office. Mr. Leska focuses his practice on general tax matters. Prior to joining Pepper, Mr. Leska was an attorney in the Office of Chief Counsel for the Internal Revenue Service in Washington, DC. While at the IRS, Mr. Leska participated in the issuance of IRS pronouncements, including final regulations regarding partnership allocations of creditable foreign tax expenditures. Mr. Leska earned a B.A.,
magna cum laude, in political science and philosophy from Lycoming College in 2001, and a J.D., cum laude, from Temple University School of Law in 2004. At Temple, he was a member of the Temple Law Review and received a graduation award for outstanding achievement in taxation. Mr. Leska also earned his LL.M. (taxation), with distinction, from the Georgetown University Law Center in 2007.


The material in this publication is based on laws, court decisions, administrative rulings, and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The Information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

This article is republished with permission of Pepper Hamilton, LLP. Further duplication without the permission of Pepper Hamilton, LLP is prohibited. All rights reserved.

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