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.

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• Sole Proprietorships
• Partnerships
• Corporations
• S Corporations
• Limited Liability Company (LLC)

For additional information, refer to Small Business Administration’s Choose A Structure webpage.

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

• Other Useful Forms for Sole Proprietorship
• Publication 334, The Tax Guide for Small Business (for Individuals Who Use Schedule C or Schedule C-EZ)
• Publication 583, Starting a Business and Keeping Records
• Husband and Wife Businesses
  
• Distinguishing Between Self-Employed Individuals and Independent Contractors

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)

Chart 2 (Individual Partners in a Partnership)

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

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.

References/Related Topics

• Other Useful Forms for Corporations
• S Corporations
• Publication 542, Corporations
• Publication 583, Starting a Business and Keeping Records
• Business Structures
• e-file for Business and Self-Employed Taxpayers

To qualify for S corporation status, the corporation must meet the following requirements:

• Be a domestic corporation
• Have only allowable shareholders
  • including individuals, certain trust, and estates and
  • may not include partnerships, corporations or non-resident alien shareholders
• Have no more than 100 shareholders
• Have one class of stock
• 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:

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

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).

References/Related Topics

• Forming a Limited Liability Company
• Single Member Limited Liability Companies
• LLC Filing as a Corporation or Partnership
• Possible Repercussions
• Forms for Limited Liability Companies
• Form 8832