C corporations that elect S status are often subject to the built-in gains (BIG) tax under IRC § 1374. One of the aspects of the BIG tax that can be a trap for the unwary is the treatment of accounts receivable for cash-basis corporations. The fair market value of accounts receivable is usually the face value of the receivables. The basis in those receivables is usually zero, since the corporation is on a cash basis of accounting and has not recognized any income associated with the creation of those receivables. The collection of the receivables in the first S corporation year can create a BIG tax liability, as that gain on collection relates to a C corporation year and therefore falls within the scope of section 1374. The potential for being subject to BIG tax exists for the recognition period, which starts on the first day of the first tax year the corporation is an S corporation and continues for 10 years (section 1374(d)(7)(A)).
One of the overall limitations to a corporation’s BIG liability is its net unrealized built-in gain (section 1374(c)(2)). This amount is the excess of the fair market value of all the corporation’s assets over the aggregate basis of such assets as of the S effective date (section 1374(d)(1)). Amounts that are deducted during the recognition period but relate to periods prior to the first S corporation year are considered recognized built-in losses and reduce the amount potentially subject to the BIG tax (sections 1374(d)(4) and 1374(d)(5)).
In Private Letter Ruling 200925005, a cash-basis C corporation was contemplating electing S status. The taxpayer, a personal service corporation, billed its clients for services performed. As those client receivables were collected, the taxpayer paid salaries to both shareholder and nonshareholder employees. Presumably, the taxpayer’s net income was driven by its markup of the salaries of its professional shareholder and nonshareholder employees. The taxpayer sought confirmation from the IRS that the salary expenses that related to the outstanding receivables as of the S election date would be considered a built-in loss item under section 1374 and therefore reduce the taxpayer’s potential BIG tax liability.
Treas. Reg. § 1.1374-4(b)(2) holds that an item is treated as a built-in loss item if the item would have been properly accrued as a deduction by an accrual-method taxpayer in the period before the first S corporation year. Treas. Reg. § 1.1374-4(c) limits this rule for payments to related parties and payments for compensation. Amounts paid to related parties within the meaning of section 267(a)(2) (in this case, the shareholder employees) must be paid within the first 2½ months of the recognition period. Furthermore, prior to the S election date, all events establishing the fact of the liability must have occurred and the exact amount of the liability must be determined. For amounts paid to nonrelated parties, the fact of the liability must be established and the exact amount of the liability must be determined prior to the S election date, but the amount of the liability does not have to be paid within the first 2½ months of the recognition period.
The IRS allowed to be treated as a built-in loss item compensation owed to shareholder employees that was attributable to receivables as of the first day of the first S corporation year and was paid within the first 2½ months after such date. Compensation to nonshareholder employees and other accounts payable items related to the production of the accounts receivable outstanding on the first day of the first S year were also allowed as a built-in loss item if paid during the recognition period.
Advisers representing cash-basis corporations converting from C to S status need to be aware of the impact of BIG tax with respect to outstanding receivables on the effective date of the S election and the use of the compensation attributable to such receivables as a way to minimize this liability.
Private Letter Ruling 200925005 (June 19, 2009)
By Vinay S. Navani, CPA, shareholder, Wilkin & Guttenplan PC, East Brunswick, N.J.