Change in acctg method and built in gains

[Unregistered]

Client is a calendar-year end C corporation using the accrual method of accounting. They filed their 2004 1120 return, which included roughly $300,000 in accounts receivable (which they included as income on that return).

They are considering electing to be treated as an S-corporation for 2005, and also considering switching to the cash method of accounting beginning with their 2005 return.

Under IRC Sec. 481, it appears that the $300,000 of accounts receivable as of 12/31/04 would be a negative adjustment (decreasing income).

However, it would appear that the 481 adjustment would then be treated as a built in gain (per Reg. 1.1374-4(b) and (d), because of the S-corp election).

The net effect of that would be the taxation of the $300,000 of accounts receivable twice (once while an accrual-method C-corporation, once via BIG tax @ 35% as an S-corporation), although there would be an offset of the $300,000 for the negative Sec. 481 adjustment on the S-corp return.

Is my understanding correct, or would the a/r somehow escape BIG tax?

[Armando Beaujolais]

You're correct except the AR won't be taxed twice. The net on the C corp return will be zero. $300,000 AR - $300,000 negative 481 adjustment. The $300,000 will then be taxed as BIG on the S corp return as it comes in.

Another looming issue is the accounting method change itself. Unless the change falls under the automatic change procedures, you have to request and get approval from the IRS. That could throw a wrench in the works if you're trying to wrap all this up neat and tidy on December 31.

[Unregistered (O.P.)]

Change in acctg method and built in gains

Thanks, Armando.

The accounting change will indeed fall under automatic procedures.

Also, the 481 adjustment will occur as of 1/1/05, when they elect S-corp., so the "netting" of the negative 481 adjustment against the required adjustment for BIG purposes will be on the S-corp return, not the C-corp return.

Do you agree?