How does the potential built-in gains tax on inventory affect my decision to convert from a C corporation to an S corporation?

Built-In Gains Tax Implications for Inventory in C-to-S Corporation Conversion

Overview of Built-In Gains Tax

When a C corporation elects to become an S corporation, it may be subject to the built-in gains (BIG) tax. This tax is imposed on the gain that was built into the assets of the corporation at the time of the S election if those assets are sold within a certain period after the election. The BIG tax is intended to prevent C corporations from avoiding double taxation on corporate income by converting to an S corporation status just before selling assets or liquidating.

Recognition Period for Built-In Gains Tax

The recognition period for the BIG tax is generally the first five years following the S corporation election. During this period, gains from the sale of assets owned at the time of the S election are subject to the BIG tax at the highest corporate tax rate, which is currently 21% as specified in [Sec. 1374(b)(1)].

Inventory Considerations

- LIFO Recapture Rule: If the corporation was using the last-in, first-out (LIFO) inventory method, it must recognize income related to the LIFO inventory as part of the final C corporation tax return. This is known as the LIFO recapture rule under [Sec. 1363(d)]. The LIFO recapture amount is the difference between the inventory's value under the LIFO method and its value under the first-in, first-out (FIFO) method.

- Payment of LIFO Recapture Tax: The tax attributable to the LIFO recapture amount is paid in four installments. The first installment is due by the unextended due date of the final C corporation tax return, with the remaining installments due on the unextended due dates of the S corporation's subsequent tax returns.

- Built-In Gains Tax on Inventory: For inventory, the BIG tax applies to the built-in gains on inventory that was on hand at the time of the S election. The fair market value (FMV) of the inventory for BIG tax purposes is determined using a bulk sale approach, and the timing of the recognition of the built-in gain is tracked by the same inventory method used for tax purposes ([Regs. Sec. 1.1374-7].

Tax Planning Strategies

- Recognizing Built-In Losses: To mitigate the BIG tax, an S corporation can recognize built-in losses in the same year as built-in gains, subject to the current recognition limit.

- Utilizing Taxable Income Limit: The BIG tax in any year is limited to the corporation's taxable income computed as if it were a C corporation. If the S corporation shows a loss under these rules, no BIG tax is imposed for that year.

- Deferring Sales of Assets: If possible, deferring the sale of assets with built-in gains until after the recognition period can avoid the BIG tax.

State Considerations

- State-Level BIG Tax: Some states, like Minnesota, impose their own BIG tax on S corporations with recognized built-in gains [Minnesota Statutes § 290.9727]. The tax rate and rules may vary by state.

Conclusion

The election of S corporation status by a C corporation has significant tax implications for inventory, especially when the LIFO method is used. The BIG tax and LIFO recapture rules must be carefully considered to ensure compliance and optimal tax planning during the transition period.

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Sources:

S corporations | Internal Revenue Service 2024-03-12

Instructions for Form 1120-S (2023) | Internal Revenue Service 2024-03-10

The built-in gains tax - The Tax Adviser 2024-04-29

LIFO Inventory Considerations When Making a C-to-S Conversion 2024-06-26

26 U.S. Code § 1374 - Tax imposed on certain built-in gains 26 U.S. Code Chapter 1 - NORMAL TAXES AND SURTAXES 26 U.S. Code Subchapter S - Tax Treatment of S Corporations and Their Shareholders 26 U.S. Code Part III - SPECIAL RULES 2023-12-11

Minnesota Statutes Various State Taxes and Programs (Ch. 289A-295) § 290.9727. Tax on certain built-in gains 2023-01-01