S Corp.-Built in Gains

[Bird Legs]

Client, a C Corp., converted to an S Corp., 2 years ago. I cautioned the owner about
the S Corp. and built in gains if assets sold within 10 years. Owners response was,"
will not sell within the next 12 years". Well, guess what.
Now, the owner wants to get rid of the assets, except building and land, and sell all
equipment. The bldg. & land is owned by the S Corp. Stockholder, owner, will
retain the stock, and rent out bldg.
Problem: Equipment, original cost $50,000 less depreciation 46,000.
leaves basis of $4,000. FMV at date of conversion to S Corp. was $40,000. Less
basis of 4,000. built in gain of $36,000. reported on Sched. D form 1120-S.
Have never done this before, so, an additional question. Would this change the basis
for reporting the sale to $40,000.? Basis $4,000. plus gain of $36,000.?
Also, the S Corp. is on the accrual basis. How would this affect the Accts. Rec. &
Accts. Pay.?
Thank all of you for your help with this one.

[Bees Knees]

No.

The built in gain tax does not increase basis by the tax paid. However, it does reduce the gain passed through to the shareholder on the K-1. For example, the equipment sold for $50,000 with $46,000 depreciation recapture will produce ordinary income on the K-1 of $46,000. However, the $36,000 of built in gains will get taxed at 35%, or $12,600 built in gains tax. $46,000 minus $12,600 tax paid at the corporation level leaves $33,400 of ordinary income passed through on the K-1.

Remember that the built in gains tax is supposed to offset the double tax that was never paid as a C corporation due to the fact that it was converted to an S corporation. Had this corporation remained a C corporation, the $46,000 of gain would have been taxed first at the C corporation level, and then the remaining cash after tax distributed in the form of a dividend to the shareholder would have been taxed on the Shareholder’s 1040.

There is an example of this on page 19-11 of TheTaxBook that illustrates how to reduce the K-1 income by the built in gains tax paid.

[veritas]

It's a good thing your client was an accrual basis taxpayer because the accounts receivable would have been used to compute built in gains tax had he been a cash basis taxpayer. Although you can also offset built in gains with built in losses.