[guscusi]

I own a FL C Corp since 2001, but am considering to elect S Corp tax status. I have read about eventual tax consequences of appreciated property and passive income when switching from C Corp to S Corp.

In my case, my C Corp has no property or investments. It only has inventory for resale, cash at the bank and a little Accounts Receivables. It just has a significant amount of Retained Earnings.

Question: Does the Inventory, Cash or Retained Earnings "qualify" as "appreciated property" OR "passive income". Logically, the answer would be NO, as I believe appreciated property should refer to stocks, real estate or other investments and "passive income" should mean typical income from real estate rentals, interest from bank accounts, dividends, etc... The definitive question is... "Will I have any tax consequence by selecting the S Corp status?"

Please notice that am not selling or transferring the company, just changing the tax status from c Corp to S Corp.

Thanks!

[AtlantaTaxExpert]

This is a complex corporate tax question that is beyond my skill set.

Ebaines may be able to answer your question, but I strongly recommend you contact a local CPA or enrolled agent to get a definitive answer.

[guscusi]

Thank you. I thought it was a bsic question.

Regards,

[Five Rings]

To be sure it is a basic question. So basic in fact that I suggest you bestir yourself and consult:
Instructions for Form 1120S (2008)
And
Publication 542 (2/2006), Corporations

Afterward, if you are still in doubt, perhaps it is not so basic after all and professional help might be required.

[guscusi]

Thank you. I had read that material already and everything I found online and on Internal Revenue Service about S Corps, corps, etc...

I could not find a clear definition to determine if the Retained Earnings from the corporations' main activity, the resale of furniture, will be considered PASSIVE in the case of a C Corp electing to be an S Corp. I do not think so, as these result from a non-passive activity.

Thanks again.

[ArcSine]

All corporate assets on the day of the C-to-S change are to be evaluated for their potential impact on the Built-In-Gain / Built-In-Loss (BIG and BIL, respectively) tax.

Essentially, Guscusi, you'll compare your Inventory's and AR's basis with their fair values on the date the S election takes effect. Any difference becomes their BIG / BIL.

One item that trips up a lot of cash-basis corps is the fact that if you're cash basis, your receivables have a zero basis (you haven't booked them at all). So when they're subsequently collected in the S-period, those cash collections potentially trigger BIG tax.

Of course, if you've already picked up the AR tax marbles on the accrual basis (as a C corp), their subsequent collection as an S won't trigger any BIG issues (since their fair values = their tax basis on the changeover date).

Cash, of course, is a non-issue for this purpose. Retained Earnings isn't an asset, and thus doesn't have any direct BIG implications. (However, a tax concept called "C Corp Earnings & Profits", which is closely related to Retained Earnings, will have other potential implications, such as for the "passive activity" tax, and the treatment of dividend distributions while an S corp.).

For all these issues--BIG tax; passive activity tax; C corp E & P--you'll want to either do some serious homework or get chummy with a corporate tax pro, because the details underneath these issues get a tad more complex than the high-level overview would suggest.

[guscusi]

Hello, ArcSine,

Thank you for the explanation. Honestly, I do not understand why the differences in the balance of AR & Inventories (not their values) represent a BIG or BIL. The balance changes day by day, as products are shipped and AR are collected. But this is only a shift within the assets. Now, if the inventory increases in value (the same quantity at higher prices, for example, for some reason), then I do understand a logical gain due to market conditions. The same with AR. If they decrease due to bad debts, for instance, then again I would understand a BIL, perhaps.

Maybe I should find out where I can find IRS literature explaining these concepts: BIG, BIL and retained earnings / distributions.

Regarding the latter, I believe that if, once the S Corp status is approved, I distribute dividends that were generated as a C Corp, there would be a logic to have them taxed in a special manner, so the IRS does not "miss" on the double taxation it would have "earned" if they had been distributed bvefore the C to S switch.

Do you know where I can read about these issues, related to the C to S switch and, hopefully, with examples?
Thanks in advance for your help.

[ArcSine]

The BIG / BIL computations are, in effect, "snapshots" you take at midnight, just as your C is becoming an S. You take one snapshot for each asset, and you determine a BIG or BIL for each one.

Suppose at the end of the last C day, your inventory on hand has a 'basis' (that is, your cost, or the amount showing on your balance sheet) of $100. However, using its expected selling price as a guide, you see that its fair value is $120.

That means your inventory, starting with the first day of being an S, has a BIG of $20. When you eventually sell that inventory your S corp will have a BIG gain of $20. (Whether or not your S corp is actually hit with a Net BIG tax, and if so how much, is one of those "underlying details" issues I mentioned yesterday.)

There are no BIG issues w.r.t. inventory which you acquire on and after the first S day. You only determine the 'built-in' gain on the inventory which you bring over from C to S.

Receivables are probably a non-issue if your C corp has been accrual. The receivables you own at the moment of C-to-S transition have already been taxed, because--under the accrual method--you already reported them on a C-corp return. Thus their tax 'basis' equals their fair value, and they have no BIG or BIL. (I'm assuming that their fair value = their face amount here. If there are some uncollectibles in that 'snapshot' you could make an argument that the AR's fair value is less than their face amount, in which case you might have some BIL in the AR.)

If your C corp was cash basis, though, your transition-day AR has a BIG equal to their total face amount. You can see the logic there. If your C is cash basis, it would only have reported the income on the AR when the AR is collected. Absent the BIG rules, a cash basis C could generate AR through sales, immediately switch to S, and then collect that AR as an S. Thus the taxable income from collecting the AR would be reported on the S return, and thereby escape C-level taxation.

Electronic Code of Federal Regulations:

That's a link to the full text of Treasury Regulation 1.1374-3, which provides guidance on calculating the Net Unrealized Built-In Gain. It has some examples you might find helpful. Be aware, though, that it's only one piece of the larger set of rules which cover the whole BIG issue. Hope that helps out a bit.

[ArcSine]

BTW, as pointed out in Section (a)(2) of that Reg, any accounts payable of a cash-basis C corp serve to reduce the NUBIG--think of it as being the opposite, mirror image of the cash-basis AR I mentioned in the previous post. So if your C corp was indeed cash basis, don't forget to include any transition-moment AP in the calculation, as it's to your benefit.

[guscusi]

Thank you very much. This clarifies the issue quite a bit. I do have to read your suggested IRS material yet, but it seems that the goal for the IRS is to tax, at the C Corp level, all the profit (or future profits, lets say) that the "now" S Corp will be making when realizing the assets, so they do not lose on the double C Corp taxation for actions previous to the switch.

Lets see if I understood:

If my inventory has just one product at my purchase cost of $100 at the C Corp's "snap shot"' moment, and then, after S Corp approval, my "restocking" or purchase price is still $100, BUT I will sell it at $150, I will have to pay the BIG tax on the $50 gain. It seems that the IRS does not want to miss out on the double taxation of the assets being transferred...

Ia) s this interpretation close to the real idea?
b) Regarding the Ret. Earnings issue,. when I pay dividends, already as an S Corp, I believe I will have to pay the 15% Cap. Gains rate for the portion transferred from the C Corp (I think I will have to make some type of formal "election" to do this). Any dividends (actually, "distributions") from the now S Corp, from earnoings generated from the S Corp, would go to my 1040 income.

Correct?

Thanks again for all you greatly professional help!
Thanks!

[ArcSine]

Your 1(a) is correct as to capturing the fundamental logic of the Sec 1374 rules. BIG only seeks to determine what 'unrealized' profit exists within the assets which are transferred from C to S, and then taxing them later--when the profit realized--as if they were still owned by a C corp. Any assets acquired after the changeover are irrelevant for BIG purposes.

Now, the matter of whether, and how much, tax will actually be owed in your illustration, is a function of the detailed rules covering this issue, and depends on the particulars of any given situation.

Your thinking with respect to Retained Earnings is generally correct. Post-transition you'll generally have a RE amount which has two components--the C corp E & P (pre-transition undistributed profits) and S corp earnings. Whenever you make a distribution / dividend, the tax treatment thereof depends on which layer the dividend is deemed to be coming from.

As I recall (it's been a while) there is a prescribed set of 'ordering' rules for this purpose, as well as an election--which you mention--to override the default ordering scheme. One reason you might elect to clear out the C-corp E&P first--and bite that tax bullet--is that the presence of C E&P sometimes causes 'passive activity' difficulties for S corps in certain scenarios.

[guscusi]

Thank you very much for further clarifying these complex concepts. I will do my homework and read your suggested material. Thanks again...