A provision in the American Recovery and Reinvestment Act of 2009 (ARRA) may temporarily help to lessen the tax burden on S corporations selling assets—including deemed sales of assets pursuant to Code section 338(h)(10) elections. This new provision modifies the "built-in gains" (BIG) tax for S corporations by shortening the "recognition period" for the BIG tax to seven years for sales that occur in taxable years beginning in 2009 or 2010. As a result, certain S corporations that would have been subject to the BIG tax may be able to sell their assets without being subject to the corporate-level tax in those years. This change may help streamline the acquisition of affected S corporations by not only lowering the tax cost of a transaction, but also by eliminating the valuation issues that occur with respect to goodwill and other assets that were held by such a corporation at the time that it converted from a C corporation to an S corporation.
Applicability of the BIG Tax
In general, the BIG tax applies to assets received by an S corporation in either: (1) a conversion of an existing C corporation; or (2) a transaction in which the basis of the assets received were determined by reference to the basis of such assets (or other property) in the hands of a C corporation (an "applicable transfer"). The BIG tax is a corporate-level tax, at the highest corporate rate, that applies when the S corporation disposes of such assets within the recognition period. The amount of tax is based upon the difference between the fair market value and the basis of such assets at the time of the conversion or applicable transfer.
The BIG tax recognition period has historically been 10 years. The ARRA reduced this period to seven years for sales occurring in taxable years beginning in 2009 or 2010. Therefore, S corporations that were converted from C corporations (or that received assets in applicable transfers) from 1999 through 2003 may benefit from this change in law. Careful analysis of the applicability of the BIG tax in these situations will be warranted for the next few years.
Seven-Year Recognition Period Is Temporary
The normal 10-year BIG tax recognition period continues to apply to sales occurring in taxable years beginning in 2011 and beyond. Consequently, some S corporations may find that if they do not sell assets by the end of 2010, they will once again be subject to the BIG tax for some period of time. For example, assume that a calendar-year C corporation elected to become an S corporation effective January 1, 2003. The seven-year recognition period for that S corporation would expire at the end of 2009. Thus, the corporation would escape the BIG tax on a sale of affected assets in 2010. Starting with 2011, however, the corporation's recognition period would again be 10 years (absent another law change), and the corporation would be subject to the BIG tax if it sold affected assets in 2011 or 2012. The corporation would therefore have to wait until 2013 to sell its affected assets without being subject to the BIG tax.
S corporations that were converted from C corporations (or that received assets in applicable transfers) need to be aware of the potential opportunity to avoid the BIG tax during taxable years beginning in 2009 and 2010 and the fact that the historic 10-year recognition period will spring back for taxable years thereafter.