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S Corporations: Excessive Passive Income Penalty and Built-in Gains Tax

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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.

Capital Gains and Losses: Tax Implications for Individuals and C-Corporations

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Capital gains and losses defined

Capital gains and losses result from the taxable realized sale or exchange of capital assets. In general, capital assets include investments (such as stocks and real estate) and fixed assets, as opposed to personal-use property.

Capital gains result when the sale or exchange price is greater than the adjusted basis of the capital asset. Conversely, capital losses occur when the adjusted basis is higher than the sale or exchange price, and certain expenses associated with the sale may be added to the loss. The holding period of the capital asset being sold or exchanged will determine whether the capital gain or loss is long-term (held for more than a year) or short-term (held for less than a year).

Netting Capital Gains and Losses (Individual taxpayers)

Each taxable year, capital gains and losses are aggregated or “netted” on Schedule D. First, long-term capital gains and losses are netted. Second, short-term capital gains and losses are netted. Four possible scenarios will result from this two-step process:

Scenario A: A long-term gain and short-term gain
Scenario B: A long-term gain and short-term loss
Scenario C: A long-term loss and short-term gain
Scenario D: A long-term loss and short-term loss

In scenario A, the short-term gain will be taxed with the taxpayer’s ordinary income at his or her marginal rate. For the long-term capital gain, the favorable long-term capital gains tax rate will apply, depending upon the taxpayer’s tax bracket.

In scenario B, there are two possible outcomes depending upon which result is larger, the loss or the gain. If the short-term loss is greater than the long-term gain, a net short-term loss will result, and up to $3,000 can be used to offset other income, with additional amounts can be carried forward to subsequent tax years. Alternatively, if the long-term gain is larger than the short-term loss, then a net long-term gain will result, and the favorable long-term capital gains tax rates will apply.

In scenario C, there are two possible outcomes depending upon which result is larger, the loss or the gain. If the long-term loss is larger than the short-term gain, then a net long-term loss will result, and (as with scenario B) up to $3,000 can be used to offset ordinary income. Any unused amount above $3,000 can be carried forward to subsequent years as long-term loss. Alternatively, if the short-term gain is larger than the long-term loss, then a net short-term gain will result, and it will be taxed at the taxpayer’s marginal rate.

In scenario D, there are several possible outcomes. First, if the total long-term and short-term losses combined total $3,000 or less, then the amount may be used to offset ordinary income. However, if the total amount of short-term losses exceed $3,000, then the first $3,000 of short-term loss will be applied to offset other income, and any remainder will be carried forward to subsequent years as a long-term loss. If the short-term loss is less than $3,000, then that amount will be applied to offset ordinary income, and any amount of available long-term loss making up the difference between the short-term loss applied and $3,000 will also be used to offset ordinary income (with the additional, unused amounts carried forward).

Capital Gains and Losses (C Corporations)
C corporations, unlike individuals, do not receive favorable tax rate on capital gains. Capital gains must be included as part of ordinary income, in their entirety.

Further, capital losses must be used only to offset capital gains, and are non-deductible against ordinary income for C corporations. Net capital losses can be carried back to the three preceding years (and are applied in chronological order, beginning with the earliest tax year) provided the corporation has capital gains to offset. Additionally, corporate taxpayers may carry forward the capital loss five years from the year of loss, again provided that there are capital gains to offset. Carryforwards expire after the fifth year. Importantly, all losses carried back or forward are considered to be short-term.

Offsetting Capital Gains and Losses
Are you a taxpayer interested in benefiting from the capital gains and losses tax rules? Do you have questions about selling capital assets such as stocks or real estate for tax purposes, and how to best time your transactions in order to pay less taxes? Are you concerned about how new capital gains and loss tax changes may affect your situation?

Sherayzen Law Office can guide you with all of your capital gains and losses questions, and help you plan ahead so that you pay less taxes.

Call NOW to discuss your case with an experienced tax attorney!