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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.
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:
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
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
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.
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.
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.
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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