S Corporations: Excessive Passive Income Penalty and Built-in Gains Tax
Corporations that make valid election to be taxed under Subchapter S (“S corporation”) are treated as pass-through entities. This means that the S corporation’s gains, losses, income and expenses are passed onto shareholders who will pay the applicable federal income taxes; the S corporation itself does not pay any taxes (as opposed to a regular corporation taxed under Subchapter C (“C corporation”)). However, there are two fairly common circumstances in which an S corporation may have to pay taxes: the excessive passive income penalty and the Built-in-Gains tax (Note that for the few S corporations that utilize the Last-In-First-Out (“LIFO”) inventory accounting method, and also previously operated as a C corporations before electing to become S corporations, a LIFO Recapture Tax may be applied in certain situations).
Excessive Passive Income Tax and Penalty
There are situations where S corporations may have previously operated as C corporations before their conversion. In some circumstances, after conversion, the S corporation still retains profits that it made as a C corporation. These profits are called “Accumulated Earnings and Profits” (“AEP”). Since an S corporation does not usually pay taxes at a corporate level, one can see that a C corporation would be able to avoid taxes at the corporate level on AEP by simply converting to an S corporation. In order to prevent C corporations from taking advantage of these status conversions, Congress imposed a steep penalty (or tax) on an S corporation’s AEP. Moreover, in some situations, an S corporation status may even be terminated.
Here is a general summary of the AEP tax. If an S corporation has AEP and “net passive income” exceeding 25% of its gross receipts in a taxable year, an excessive passive income penalty is imposed at the highest corporate tax rate on the lesser of taxable income or excess net passive income. Passive investment income consists of gross receipts from dividends (with certain exceptions), interest, capital gains, royalties, rents, and other related sources of income.
Furthermore, S corporation status is automatically terminated if an S corporation is penalized with the excessive passive income tax for three years in a row.
Built-in Gains Tax
In general, if an S corporation, that operated as a C corporation prior to its conversion, sells or distributes assets that it held during the time in which the entity was a C corporation for an amount above the adjusted basis, the resulting recognized gain (“Built-in Gains”) will be taxed at the highest corporate tax rate. The Built-in Gains will be taxable if recognized at any time within ten years after the effective date of an entity’s S corporation election. For purposes of the Built-in Gains tax, assets held during the entity’s existence as a C corporation and distributed after conversion to the S corporation’s shareholders for an amount above the adjusted basis will be treated as if these assets were sold.
As with the excessive passive income penalty, the Built-in-Gains tax is designed to prevent a C corporation from avoiding taxes by converting to an S corporation status and then selling or distributing appreciated assets. This is because for C corporation, recognized gain on sales of appreciated assets would be taxed at the corporate tax rate, whereas for an (traditional, non-converted) S corporation, the gain would be passed to the shareholders (likely on a pro rata basis), who will pay the tax based on their individual income tax rates, which may be lower than the C corporation’s tax rates.
The calculation of the Built-in-Gains tax is fairly complex, with a computation involving a determination of net gains, Net Operating Losses and loss carry forwards from years the entity operated as a C corporation, general business credit carryovers from C corporation years and the special fuel tax credit, as well as other items. Furthermore, due to accounting complications, converting from a C corporation to an S corporation may result in some unanticipated items, such as accounts receivable, being treated as Built-in-Gain and subject to tax.
Conclusion
Are you thinking about converting a C corporation to an S corporation, and concerned about possible taxes that your business may face if doing so? Are you looking for legal tax strategies to best structure a conversion, or to handle transactions with an already converted S corporation in order to limit your company’s taxes? Give Sherayzen Law Office a call to discuss your tax situation with an experienced Minnesota business tax lawyer.