Built-In Gains Tax Recognition Period Permanently Reduced

May 2016       Download PDF      Print

In December, The Protecting Americans from Tax Hikes (PATH) Act of 2015 was signed into law, extending or making permanent certain tax-friendly provisions. One of these provisions permanently reduces the built-in gains (BIG) recognition period to five years. This is a significant change that will impact the exit plans of certain business owners.

So which business owners will this impact exactly and why is this change significant?

To answer these questions, let's review some basic information about exit planning and the tax liability associated with selling a company.

C-to-S Corporation Conversion

Owners of C corporations sometimes elect to convert to S corporation status to reduce their tax liability. The difference between the tax treatment for C corporations and S corporations is outlined below.

C Corporation Tax Treatment

C corporations are taxed at both the company and shareholder level, which is often referred to as "double taxation". After an asset sale, the company first pays corporate taxes at the ordinary rate. Then the shareholder must pay capital gains taxes on those proceeds.

S Corporation Tax Treatment

Unlike a C corporation, an S corporation does not have to pay taxes on the sale of its assets. Rather, the income from the sale of its assets is passed through to the shareholder, who is required to pay taxes at the capital gains rate.

Due to the differences above, whether you elect for C corporation or S corporation status can have a significant impact on the after-tax proceeds you receive when selling your company. The amount of taxes due from a sale might determine whether the proceeds from selling will be enough to fund your personal financial goals for retirement. Depending on the size of your company, converting to an S corporation could save you hundreds of thousands, or even millions, of dollars in taxes.

However, to prevent business owners from converting right before selling to avoid paying corporate-level taxes, there is a recognition period in place in which companies that convert from C to S corporations are subject to built-in gains tax. When a business owner converts to an S corporation, any increase in value of the company's assets over the tax basis at the time of conversion is subject to BIG tax. It is critical to obtain a business valuation to determine built-in gains at the time of conversion. If you don’t obtain a valuation at the time of conversion, then later sell your company within the BIG recognition period, the entire gain on the sale will be subject to BIG tax.

Brief history of the BIG recognition period

Prior to 2009, the built-in gain recognition period was 10 years. It was temporarily shortened to seven years under the American Recovery and Reinvestment Tax Act of 2009, then to five years under subsequent tax legislation introduced in both 2010 and 2012. The temporary reduction of the BIG recognition period expired in 2014, reverting back to ten years. The constant change and uncertainty has caused a lot of confusion, making it difficult for some business owners to plan ahead.

Benefits of making the recognition period permanent

The permanent reduction of the BIG recognition period will benefit business owners who have already converted, or plan to convert, from a C corporation to an S corporation, and plan to sell their companies in the near future.

If a business owner converted his company to an S corporation in 2014, he would have needed to wait until 2024 to sell in order to avoid paying BIG tax. Now that the recognition period has been reduced to five years, the same business owner can sell in 2019 and still avoid the additional taxes.

There are some business owners who have converted their companies from C to S corporations to take advantage of the significant tax savings, but would rather sell sooner than later. After all, ten years is a long time to wait considering that a lot of things can change over the course of a decade that impact both the value of a company and the longevity of the business owner. Being able to sell earlier and still reap the tax benefits of converting to an S corporation means that some business owners will be able to exit their companies sooner than expected and ensure financial peace of mind for themselves and their families.