Sole proprietorship to S corporation

[taxwoman16]

Sole proprietorship in business since 2003 changing to sole shareholder S corporation August 2006. All 5 and 7 year previous placed in service assets fully section 179d each year. One new asset placed in service February 2006. Qualifies as section 351 transfer of all assets to s corp, including inventory and goodwill. Assume inventory sold in return for cost basis in gross receipts and sold to s corp. Do you recapture excess section 179 on Part V of F4797 of individual return and add to sch c as other income to offset excess self-employment taxes reduced in prior years, then restore basis of assets to use for adjusted basis of S corp assets and capital account basis of shareholder? What happens to assets placed in service in sole proprietorship in 2006? Are they subject to the "placed in service and taken out in same year ineligible for depreciation" rules? Would they then be required to only take "regular" MACRS depreciation when placed in service in S corp?

[Bees Knees]

TTB page 25-5 under Contributed Property Depreciation says: "For tax purposes, the partnership or corporation continues to depreciate the property under the same depreciation schedule using the same depreciation method and holding period as the contributing partner or shareholder immediately prior to the contribution. For the year of contribution, allocate the current year depreciation between the two businesses before and after the contribution."

It then gives an example of how to do this.

[taxwoman16]

Sole Proprietorship to S corporation prior section 179

Thank you for your response, Beesknees.
Understandably so, the transfer of the assets from the sole proprietorship to the s corporation has no tax consequences in this scenario by qualifying for section 351 treatment. That is why the adjusted basis of the assets pulled out of the sole proprietorship is considered both the adjusted basis of the s corporation of the asset, as well as the basis of the stock received in the transaction being used as the balance of the capital account.
The problem I have is that someone could section 179 the assets fully using them in a sole proprietorship, reduce their SE tax by that, and then still within the 5 or 7 year class life period take the asset out of use in that business and place it in service in a different business, still within the class life time period and have no depreciable basis in it when it is used in a business not subject to SE tax.
I am looking for guidance on whether the sole proprietorship is required to recapture the excess depreciation taken on the assets that were fully section 179d for 5 or 7 years, and yet only used in that business for 3 and a partial year using Part V of Form 4797. Then we would add back the excess section 179 taken on the Schedule C as other income on the Schedule C return and restore that amount of basis back to the assets being transferred. Then, those assets are placed in service in the s corporation at that adjusted basis.
The other complication is how to handle assets placed in service in the sole proprietorship in 2006 and taken out in 2006 and then placed in service in the S corporation because of the rule that "assets placed in service and taken out in the same year cannot be depreciated".

[Bees Knees]

The problem I have is that someone could section 179 the assets fully using them in a sole proprietorship, reduce their SE tax by that, and then still within the 5 or 7 year class life period take the asset out of use in that business and place it in service in a different business, still within the class life time period and have no depreciable basis in it when it is used in a business not subject to SE tax.
I am looking for guidance on whether the sole proprietorship is required to recapture the excess depreciation taken on the assets that were fully section 179d for 5 or 7 years, and yet only used in that business for 3 and a partial year using Part V of Form 4797. Then we would add back the excess section 179 taken on the Schedule C as other income on the Schedule C return and restore that amount of basis back to the assets being transferred. Then, those assets are placed in service in the s corporation at that adjusted basis.
The other complication is how to handle assets placed in service in the sole proprietorship in 2006 and taken out in 2006 and then placed in service in the S corporation because of the rule that "assets placed in service and taken out in the same year cannot be depreciated".

As I stated in my previous post, "For tax purposes, the partnership or corporation continues to depreciate the property under the same depreciation schedule using the same depreciation method and holding period as the contributing partner or shareholder immediately prior to the contribution. For the year of contribution, allocate the current year depreciation between the two businesses before and after the contribution."

The fact that you see a way to reduce SE tax by taking Section 179 prior to contributing to the corporation is irrelevant. Yes, it is a nice loophole isn't it. The Schedule C is not required to recapture Section 179 if it is contributed to a corporation under Section 351.

Its kind of like the rule that allows you to take 179 in year one, which reduces SE tax, then sell the asset in year two and recapture the 179 as ordinary income, but not have to pay SE tax on the sale.

Nice loopholes.

[outwest]

Shhh...

you hit on one of the permanent differences in the tax code. Depreciation and Section 179 in a sole proprietorship reduces SE tax. If you turn around the next year and sell the asset at a gain, the depreciation recapture is NOT subject to SE. It's a permanent ~15% tax break.

So: don't worry about SE recapture, wouldn't happen even if they were a sole proprietor all along.

Now, as to the placed in / taken out of service. The Section 351 incorporation is not treated as taking out of service but is continuation in service by a successor entity. That's why basis, life and schedule carry over.

[taxwoman16]

thank you

It just doesn't seem right...

[Bees Knees]

You can't apply fairness and right and wrong to the tax code. You will be confused if you think the law is consistently applied, or has to make sense.