To avoid double taxation, a C corporation may consider converting to an S corporation. However, when the fair value of an entity’s assets at the relevant date of conversion is more than its tax basis, a C corporation may incur the built-in gains tax,1 which applies to certain assets that have appreciated or are converted to cash after a C corporation changes to an S corporation.2
This extra tax can surprise “converting” businesses, especially contractors that use a more favorable revenue recognition method for tax purposes, such as the cash basis or completed-contract method (CCM). Let’s look at the nuances that affect the built-in gains tax.
Impact of Deferred Income & Other Attributes
The unrecognized built-in gains at the time of conversion is not just the unrecognized gain on the sale of appreciated assets. The built-in gains tax is also impacted by deferred income.
Deferred Income Example
Let’s assume that a contractor converted from C corporation to S corporation status during 2016. At the time of conversion, the contractor has four contracts in progress, on which $1 million of gross profit would be recognized if the percentage-of-completion method (PCM) had been used.
However, the contractor qualifies for exemption from IRC § 460 under the small contractor’s exemption and uses the CCM.3 The calculation at right shows what taxes would be due if all four contracts were completed during 2017.4
The S corporation and its shareholders pay $607,400 of total tax: $350,000 at the corporate level and another $257,400 at the shareholder level. This represents an effective rate of more than 57% on the $1 million of unrecognized contract profits as of the date of conversion to S corporation status. The effective rate may be even higher if state income taxes are applicable.