Stimulus Bill Reduces Recognition Period for S Corporation Built-in Gains

February 13, 2009

The American Recovery and Reinvestment Tax Act of 2009 (the “Act”), which is expected to land on President Obama’s desk as early as this weekend, contains a provision that will reduce the so-called “built-in gains tax” for many S corporations. The provision will reduce from ten years to seven years the “recognition period” for built-in gain assets sold by S corporations in 2009 and 2010. Thus, S corporations that have had their S corporation election in effect for more than seven years, but less than ten years, generally will be able to sell built-in gain assets without paying a corporate level tax.

Small business corporations that meet certain requirements generally can escape the two level corporate tax regime by making an election to become an S corporation. S corporations generally do not pay tax; rather, their items of income, gain, loss, deduction, and credit pass through to their shareholders on a per share basis.

If a corporation that has not made an S corporation election (a “C corporation”) sells an asset with built-in gain, the corporation must pay tax on that gain. If it then distributes the net proceeds to its shareholders as a dividend, the shareholders will generally pay tax on that dividend. The gain, therefore, is taxed twice; once to the corporation and once to the shareholders.

To prevent corporations from avoiding the corporate level tax on built-in gain assets by making an S corporation election, the Internal Revenue Code contains a provision that imposes a corporate level tax on S corporations that sell assets with built-in gains (i.e., the fair market value of the asset exceeds the corporation’s basis in the asset) within a ten-year period (the “recognition period”) beginning on the first day the S election is effective. (The shareholders are also taxed on the gain, because it passes through the corporation, but an adjustment is made so that the S corporation and shareholders pay no more tax than would have been due if the corporation had not made an S corporation election and distributed the net proceeds as a dividend.) Any built-in gain assets sold after the ten-year recognition period are not subject to a corporate level tax. Thus, under current law, if a corporation makes an S election effective on January 1, 2001, it will be taxed at the corporate level if it sells any built-in gain assets before January 1, 2011.

For built-in gain assets sold in taxable years beginning in 2009 and 2010, the Act reduces the recognition period from ten years to seven years. Thus, for an S corporation that made its election effective January 1, 2002, no corporate level tax will be imposed on built-in gain assets it sells in 2009 or 2010. Without this change, the S corporation would have to wait unit January 1, 2012, to sell any built-in gain asset and not pay tax at the corporate level.