In an effort to provide some tax relief for small businesses, Congress included in the recently enacted American Recovery and Reinvestment Act of 2009 (ARRA) a special provision to benefit corporations that have elected to be taxed as subchapter S corporations. Although subchapter S corporations are generally not subject to corporate income tax, corporations previously taxed as "regular" (subchapter C) corporations must pay a 35 percent corporate income tax on any "built-in gains" recognized during an initial period following their subchapter S election. Built-in gains may arise from the realization of gain attributable to appreciated assets that either were held on the date the subchapter S election took effect or were acquired from a subchapter C corporation in a tax-free transaction that occurred after that date. ARRA shortens this built-in gains recognition period and thus accelerates the elimination of the 35 percent corporate income tax for some corporations that have made the subchapter S election.

Before ARRA was enacted, the built-in gains recognition period was 10 years, measured either from the effective date of subchapter S election or the date of the tax-free transaction in which subchapter C corporation assets were acquired. Section 1251 of ARRA amends Section 1374(d)(7) of the Internal Revenue Code to provide that "in the case of any taxable year beginning in 2009 or 2010," no built-in gains tax would be imposed for a corporation electing S corporation status "if the 7th taxable year in the recognition period preceded such taxable year."  For an S corporation acquiring subchapter C corporation assets, ARRA shortened the recognition period to seven calendar years from the date of the tax-free transaction. By partially tying the recognition period to taxable years and limiting the relief to 2009 and 2010 taxable years, ARRA created many uncertainties for taxpayers attempting to apply the new provisions. Questions include:

  • Do short taxable years occasioned by changes in the S corporation's accounting period count? If so, may an S corporation change its accounting period to take advantage of the tax relief afforded by the provision?

  • Does a subchapter S corporation revert to the former, 10-year recognition period in 2011 if that period has not run by the close of 2010? While that result appears to follow from the statute, the legislative history flatly states that "no tax" will be imposed under Section 1374 after the seventh taxable year in which the election has been in effect.

  • Do subchapter S corporations receiving payments in taxable years beginning in 2009 or 2010, under agreements for the installment sale of built-in gain assets entered into when the 10-year recognition period was in effect, remain subject to the built-in gains tax on such payments?

  • If the recognition period is intended to revert to 10 years, do subchapter S corporations receiving payments in taxable years beginning after 2010, under agreements for the installment sale of built-in gain assets entered into in taxable years beginning in 2009 or 2010, become subject to the built-in gains tax?

  • Are subchapter S corporations with built-in gain carryover to taxable years beginning in 2009 or 2010, because of a taxable-income limitation on the recognition of built-in gain in a tax year beginning before 2009, subject to built-in gains tax on the carryover in 2009 or 2010?

  • If the recognition period is intended to revert to 10 years, are subchapter S corporations that recognize all of the net built-in gain unrealized as of the effective date of their subchapter S election in their taxable years beginning in 2009 and 2010 subject to built-in gains tax on additional built-in gain recognized in a tax year beginning after 2010?

The Internal Revenue Service may issue guidance with respect to these issues. The Tax Group of Ballard Spahr Andrews & Ingersoll, LLP advises S corporations and their shareholders in appropriately structuring transactions to maximize the tax benefits available to them under ARRA. For more information, please contact Wayne R. Strasbaugh at 215.864.8328 or strasbaugh@ballardspahr.com.


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