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On February 17, 2009 President Barack Obama signed the “American Recovery and Reinvestment Act of 2009” (“ARRA of 2009) into law.  Section 1251 of the bill temporarily reduces the recognition period for “built-in” gains tax (BIG tax) on S Corporations from 10 years to 7 years for the 2009 and 2010 tax years.

Why is this important? 

Historically, if you were a shareholder in an S Corporation that converted from a C Corporation and sold the company within 10 years of the date of conversion, you would be subject to BIG tax.  For 2009 and 2010, that 10 year “recognition period” has been reduced to 7 years.  So, if you sell your S Corporation in 2009 or 2010 and it has been converted from a C Corporation at least 7 years prior, you will avoid the 35% BIG tax.  Companies originally organized as S Corporations have never, and remain, not subject to BIG tax.

A Closer Look

When you sell a C Corporation the proceeds from the sale of the assets are owned by the corporation.  They get taxed once at the corporate level (35%) and then again upon distribution to the shareholders where they are taxed at your personal rate.  This effective “double tax” makes it advantageous for the shareholders of a C Corporation to convert to an S Corporation prior to sale.  In an S Corporation the proceeds from sale are “passed through” directly to the shareholders and taxed ONLY at their individual tax rates.

Since the result of converting a C Corporation to an S Corporation is a reduction in revenue for the IRS, the IRS states that the conversion must occur prior to the recognition period or the proceeds from sale will be taxed on a prorated basis.

Example:

Assume a C Corporation converted to an S Corporation less than 7 years prior to sale.  A valuation of the company is needed at the date of conversion.  All sale proceeds up to the dollar amount of the valuation are taxed at the BIG tax rate of 35% and distributed to the shareholders where they are again taxed at the shareholders’ personal rates.  This effectively recognizes the value created within the company while it was organized as a C Corporation and taxes it accordingly (known as BIG Tax).

The valuation at the date of conversion is then subtracted from the sale price to determine the value created while the company was an S Corporation.  That value is “passed through” directly to the shareholder in accordance with S Corporation treatment.

Before February 17, 2009, BIG tax treatment could only be avoided if a C Corporation converted to an S Corporation at least 10 years prior to the date of sale.  Now, with the signing of the ARRA of 2009, a C Corporation that converted to an S Corporation in 2002 or prior can avoid the BIG tax by selling their business in 2009 or 2010.  A C Corporation that converted to an S Corporation in 2003 or prior can avoid paying BIG tax by selling their company in 2010.