Built-in Gains Tax
The Tax and Accounting office of Certified Public Accountant can assist you in choosing the right legal form for your business. Choosing the proper business entity is a complex matter, which should be handled by an accountant professional. Many C corporations who are tired of the double taxing drawback – income is taxed to the corporation as it is earned and then again to you personally wh
en it is paid out in compensation or dividends – choose to covert to an S corporation. However, in trying to avoid this double tax predicament, business owners might run into built-in gains tax.
The built-in gains tax can blindside business owners who convert from a C corporation to an S corporation. In some cases, the conversion may not even be worth the price of admission. Nevertheless, with some advance planning from a professional certified public accountant, you may be able to minimize the impact of the built-in gains tax or discover additional tax benefits through a C corporation continue with you current business structure.
A corporation may owe income tax at regular income tax rates on a net recognized built-in gain occurring within the 10 years following a conversion to S corp status. The amount of the tax is based on the difference between the fair market value of property sold or otherwise disposed of and the basis of the property at the time of the conversion. The built-in gains tax generally applies to a corporation if:
- It was a C corporation prior to the S corporation election
- The election was made after 1986
- It has a recognized built-in gain within the 10-year recognition period; and
- The net recognized built-in gain for the tax year doesn’t exceed the net unrealized built-in in gain minus the net recognized built-in gain for prior years in the recognition period (to the extent such gains were subject to tax).
The built-in gains tax is computed by applying the highest corporate tax rate to the S corp’s built-in gain for the year. Currently, the top tax rate is 35%.
Nevertheless, the situation may not be as awful as it appears. For starters, any net operating loss (NOL) carryforward in a year in which the corporation was a C corporation may be deducted against the net recognized built-in gain of the S corporation. In addition, your firm may use capital losses carried forward from prior years to offset the built-in gains tax. Finally, excess business credits carried over from prior years may reduce the tax liability on built-in gains.
If you are contemplating a switch to S corporation status, it is important to have a professional accountant evaluate your situation and provide you with an in-depth analysis. Tax law is an extremely complicated area, especially the tax rules concerning a conversion from a C corporation to an S corporation status. Take advantage of a tax expert, like Emil Estafanous, CPA and don’t pay extra tax than what the law requires. Contact the Tax and Accounting office of Certified Public Accountant, Emil Estafanous at (562) 868-6333 and he will be glad to provide you with assistance for all your accounting and tax needs.
Business Structures
When beginning a business, you must decide what form of business entity to establish. Your form of business determines which income tax return form you have to file. The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation. A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute. Legal and tax considerations enter into selecting a business structure.
For additional information, refer to Small Business Administration’s Choose A Structure webpage.
Sole Proprietorships
A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.
If you are a sole proprietor use the information in the chart below to help you determine some of the forms that you may be required to file:
References/Related Topics
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Publication 334, The Tax Guide for Small Business (for Individuals Who Use Schedule C or Schedule C-EZ)
Partnerships
A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.
A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership’s income or loss on his or her tax return.
Partners are not employees and should not be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions.
If you are a partnership or a partner (individual) in a partnership, use the information in the charts below to help you determine some of the forms that you may be required to file.
Chart 1 (Partnership)
| If you are a partnership then you may be liable for… | Use Form… |
| Annual return of income | 1065,U.S. Return of Partnership Income (PDF) |
Employment taxes:
|
941, Employer’s Quarterly Federal Tax Return (PDF) and 943, Employer’s Annual Federal Tax Return for Agricultural Employees (for farm employees) (PDF)940, Employer’s Annual Federal Unemployment (FUTA) Tax Return (PDF) 8109-B, Federal Tax Deposit Coupon (PDF) |
| Excise Taxes | Refer to the Excise Tax Web page |
Chart 2 (Individual Partners in a Partnership)
| If you are a partner (individual) in a partnership then you may be liable for… | Use Form… |
| Income Tax | 1040, U.S. Individual Income Tax Return (PDF) and Schedule E (Form 1040), Supplemental Income and Loss (PDF) |
| Self-employment tax | 1040, U.S. Individual Income Tax Return (PDF) and Schedule SE (Form 1040), Self-Employment Tax (PDF) |
| Estimated tax | 1040-ES, Estimated Tax for Individuals (PDF) |
References/Related Topics
- Election for Husband and Wife Unincorporated Businesses
- Husband and Wife Business
- IR-2005-143, IRS Extends Transition Relief to Partnerships and Pass-Thru Entities Under New Code Section
- IR-2005-146, IRS Releases Schedule M-3 for Partnerships
- Other Useful Forms for Partnerships
- Publication 541, Partnerships
- Publication 583, Starting a Business and Keeping Records
Corporations
In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.
The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.
If you are a C corporation, use the information in the chart below to help you determine some of the forms you may be required to file.
Corporations that have assets of $10 million or more and file at least 250 returns annually are required to electronically file their Forms 1120 and 1120S for tax years ending on or after December 31st. For more e-file information, see References/Related Topic listed below.
| If you are a C corporation or an S corporation then you may be liable for… | Use Form… |
|---|---|
| Income Tax | 1120, U.S. Corporation Income Tax Return (PDF) |
| Estimated tax | 1120-W, Estimated Tax for Corporations (PDF) and 8109-B, Federal Tax Deposit Coupon (PDF) |
| Employment taxes:
|
941, Employer’s Quarterly Federal Tax Return (PDF) or 943, Employer’s Annual Federal Tax Return for Agricultural Employees (PDF) (for farm employees)940, Employer’s Annual Federal Unemployment (FUTA) Tax return (PDF)
|
| Excise Taxes | Refer to the Excise Tax Web page |
References/Related Topics
S Corporations
S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income.
To qualify for S corporation status, the corporation must meet the following requirements:
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Be a domestic corporation
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Have only allowable shareholders
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including individuals, certain trust, and estates and
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may not include partnerships, corporations or non-resident alien shareholders
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Have no more than 100 shareholders
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Have one class of stock
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Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.
In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation (PDF) signed by all the shareholders.
Filing Requirements:
| If you are an S corporation then you may be liable for… | Use Form… |
|---|---|
| Income Tax | 1120S (PDF) (Instructions for Form 1120S (PDF)) 1120S Sch. K-1 (PDF) ( Instructions for Form 1120S Sch. K-1 (PDF)) |
| Estimated tax | 1120-W (PDF) (corporation only) and 8109 |
Employment taxes:
|
941 (PDF) ( 943 (PDF) for farm employees)940 (PDF) 8109 |
| Excise Taxes | Refer to the Excise Tax web page |
Chart 2 – S Corporation Shareholders
| If you are an S corporation shareholder then you may be liable for… |
Use Form… |
|---|---|
| Income Tax | 1040 and Schedule E (PDF) |
| Estimated tax | 1040-ES (PDF) |
References/Related Topics
- Compensation and Medical Insurance Issues
- Employees, Shareholders and Corporate Officers
- S Corporation Stock and Debt Basis
- Special Rules for Health Insurance Costs of 2-Percent Shareholder-Employees (IRB 2008-2 Notice 2008-1)
- Other Business Structures
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.
Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner.
A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.
Classifications
The federal government does not recognize an LLC as a classification for federal tax purposes. An LLC business entity must file as a corporation, partnership or sole proprietorship tax return.
An LLC that is not automatically classified as a corporation can file Form 8832 to elect their business entity classification. A business with at least 2 members can choose to be classified as an association taxable as a corporation or a partnership, and a business entity with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner, a “disregarded entity.” Form 8832 is also filed to change the LLC’s classification.
Effective Date of Election
The election to be taxed as the new entity will be in effect on the date the LLC enters on line 8 of Form 8832. However, if the LLC does not enter a date, the election will be in effect as of the form’s filing date. The election cannot take place more than 75 days prior to the date that the LLC files Form 8832 and the LLC cannot make the election effective for a date that is more than 12 months after it files Form 8832. However, if the election is the “initial classification election,” and not a request to change the entity classification, there is relief available for a late election (more than 75 days before the filing of the Form 8832).
