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8.4 Built-in gains
Publication date: 31 Dec 2022
us Income taxes guide
If a US entity converts from C corporation status to S corporation status (taxable to nontaxable), the IRS will impose a tax on any “built-in gains” recognized on sales of assets that occur within five years following the conversion date. A built-in gain represents the excess of the fair market value over the tax basis of an asset as of the conversion date. If an asset is sold within five years after the conversion date, even though the entity’s income generally is not subject to tax, the portion of any gain from the sale that is attributable to the built-in gain at the date of conversion would be subject to income tax.
ASC 740-10-55-64 states that an entity converting from C corporation to S corporation status should continue to record a deferred tax liability to the extent it will be subject to the built-in gains tax. As the timing of realization of a built-in gain determines whether it will be taxable, actions and elections that are expected to be implemented should be considered in determining the deferred tax liability to be recorded. For example, if an entity expects that depreciable fixed assets will be retained in the operations of the business for at least five years following the conversion to S corporation status, no amount would be subject to the built-in gains tax.
8.4.1 Measurement of the DTL for built-in gains
When there is a net unrealized built-in gain at the date of conversion, it might be necessary, as discussed in ASC 740-10-55-65, to continue to recognize a deferred tax liability after the change to S corporation status—the question is how to determine the amount, if any. Only the assets and liabilities that have temporary differences at conversion need to be considered. Even though the actual built-in gain is based on fair market value at the date of conversion, no consideration would be given to any appreciation above the book value as of the conversion date.
Under the tax law, any actual tax liability for built-in gains is based on the lower of the net recognized built-in gain and taxable income (computed as a C corporation) for the year. As such, there would be no built-in gain tax if a company has no taxable income in such year; however, tax may be assessed in a later year if the company has taxable income in any of the remaining years of the 5 year recognition period. Even if a company expects future losses, a deferred tax liability on any built-in gains is recorded at the time of conversion because it is inappropriate to anticipate tax consequences of future tax losses under ASC 740-10-25-38. The tax benefit of the future losses should be recognized as incurred in future years to the extent that the built-in-gains are absorbed by those losses.
Any built-in losses may be used to reduce built-in gains. Thus, when calculating the net built-in gain deferred tax liability in accordance with ASC 740-10-55-65, the lesser of the unrecognized built-in gain (loss) or the existing temporary difference (on an asset-by-asset basis) as of the conversion date is used. That is, the unrecognized built-in gain (loss) for each asset is limited to the existing temporary difference as of the conversion date. At each financial statement date, the deferred tax liability should be remeasured until the end of the recognition period. Changes in the liability should be recorded in income tax expense (benefit) in the period of the change.
Example TX 8-5 illustrates recording deferred taxes for built-in gains.
EXAMPLE TX 8-5
Recording deferred taxes for built-in gains
Assume that an entity’s S corporation election became effective on January 1, 20X2. On December 31, 20X1, the entity had the following temporary differences and built-in-gains:
Marketable securities |
Inventory |
Fixed assets |
|
Expected to be used in operations and not sold within 5 years |
No |
No |
Yes |
Fair market value [A] |
$2,000 |
$860 |
N/A |
Tax basis [B] |
1,800 |
900 |
|
Book value [C] |
1,900 |
850 |
|
Built-in gain (loss) [A – B] |
200 |
(40) |
|
Existing taxable / (deductible) temporary difference [C – B] |
100 |
(50) |
Assume that (a) the marketable securities and inventory will be sold the following year, (b) the entity has no tax loss or credit carryforwards available at December 31, 20X1 to offset the built-in gains, and (c) the applicable corporate tax rate is 21%.
How would the S corporation calculate the deferred tax liability for the built-in gain at the date of conversion?
Analysis
The deferred tax liability for the built-in gain at January 1, 20X2, would be calculated as follows:
Built-in gain on marketable securities |
$100
|
|
Built-in loss on inventory |
(40) |
|
Net unrecognized built-in gain |
60 |
|
Applicable corporate tax rate |
21% |
|
Potential deferred tax liability for built-in gain |
$13 |
The net deferred tax liability for built-in gain is $13. This is the amount that should be reflected in the S corporation’s accounts (which would replace the deferred tax liability for marketable securities and inventory on the books of the C corporation at the date of conversion).
8.4.2 Built-in gains—financial statement reporting
The calculation of any deferred tax liability is made and reflected in the financial statements as of the date of the election of S corporation status if approval is not necessary (i.e., the date of the change in tax status). When the election precedes the effective date of the change, projections of the book bases of assets expected to be on hand at the effective date (book basis) and estimates of their fair market values (tax basis) are necessary in order to determine the deferred tax liability. That analysis has to be updated in preparing subsequent balance sheets until the effective date.
In addition, the deferred tax liability will have to be reassessed at each balance sheet date subsequent to the conversion date. In addition to changes in the deferred tax liability that result from changes in expectations, the financial statements will reflect tax expense in the years when dispositions take place for differences between the built-in gain tax paid and the amount previously provided, including the tax applicable to unrecognized appreciation at the conversion date.
* The difference between the fair market value and tax basis is $200, but in the calculation of the deferred tax liability, the built-in gain is limited to the amount of the book over tax temporary difference ($1,900 - $1,800).
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