An S corporation that was previously a C corporation is subject to the built-in gains tax under Section 1374 if appreciated assets held by the corporation (measured from the beginning of the S corporation’s first taxable year) are disposed of during the “recognition period.” The built-in gains tax is imposed at the corporate, rather than the shareholder, level. Thus, corporations subject to the built-in gains tax must be keenly aware as to which action will result in imposition of the tax. In Ltr. Rul. 201722008, the IRS ruled that an S corporation will not recognize gain or loss, and thus will not trigger the built-in gains tax imposed under 1374 to which the S corporation was subject, when it converts its preferred interests in a limited liability company to common interests.
Under the facts of the ruling, an S corporation owned a controlling interest in a limited liability company classified as a partnership for federal income tax purposes. The limited liability company has both preferred and common membership interests outstanding, with the S corporation owning all of the preferred interests while other members own the common interests. Under a proposed recapitalization for the limited liability company, the S corporation will convert all of its preferred interests into common interests in the limited liability company. In connection with the proposed transaction, the S corporation represented that the fair market value of the preferred interests will equal the fair market value of the common interests to be received in the conversion, there will not be a shift in the ownership of the capital in the limited liability company associated with the conversation, and the recapitalization will not result in a deemed distribution in excess of basis as a result of any change in any member’s share of the liabilities of the limited liability company.
Section 1374 Recognition Period
Section 1374(a) provides that for any taxable year beginning in the recognition period that an S corporation has a net recognized built-in gain, there is imposed a tax on the income of such corporation for such taxable year. Section 1374(d)(2) provides that the term “net recognized built-in gain” means, with respect to any taxable year in the recognition period, the lessor of (i) the amount which would be the taxable income of the S corporation for such taxable year if only recognized built-in gains and recognized built-in losses were taken into account, or such Corporation’s taxable income for such taxable year.
Section 1374(d)(3) provides that the term “recognized built-in gain” means any gain recognized during the recognition period on the disposition of any asset except to the extent that the S corporation establishes that (A) such asset was not held by the S corporation as of the beginning of the first taxable year for which it was an S corporation, or (B) such gain exceeds the excess (if any) of the fair market value of such asset as of the beginning of such first taxable year over the adjusted basis of the asset as of such time. Reg. Section 1.1374-4(a)(1) provides that Section 1374(d)(3) applies to any gain or loss recognized during the recognition period in a transaction treated as a sale or exchange for federal income tax purposes. In other words, the built-in gains tax only applies to gains that are recognized by the corporation under general principles of tax law. Section 1374(d)(7) provides that the term “recognition period” means the five (5) year period beginning with the first day of the first taxable year for which the corporation was an S corporation.
Based upon the information submitted and the representations made, the Service ruled that no gain or loss would be recognized by the S corporation as a result of the conversion of its interest in the limited liability company, and as such, there would be no built-in gains tax imposed under Section 1374 as a result of the conversion.
About the Author:
Stephen R. Looney is the chair of the Tax department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at email@example.com.