Estimated tax tip savings: You can save BIG by understanding how to avoid the evil builtin gains tax that often applies when you convert your C Corporation into an S corporation. Let’s say that you have decided the S corporation is the choice of entity for you. And let’s say further that you currently operate as a C corporation.
How do you change from a C corporation to an S corporation without paying governmentimposed double taxes? You see, the law does not simply let you switch. You need to consider the builtin gains taxes for which tax professionals use the acronym BIG.
Why BIG? Because when you trigger the builtin gains tax, your first tax of this double tax is at the 35 percent rate. And triggering this double tax is simple.
For example, say you operate your C Corporation on the cash basis. On the day you convert to the S
Corporation, your C Corporation has patients, customers, or clients who have not paid their bills. Now, because of the conversion, they pay those monies to the S corporation, which collects them as builtin gain receivables subject to the double tax.
The double tax works like this:
The first tax is 35 percent. The remaining 65 percent of the profits (the untaxed part) that reside in the S corporation now flow through to you, the owner, and tax law imposes taxes on your individual income at tax rates as high as 43.4 percent, depending on the nature of the monies causing the tax.
It’s likely that the BIG double tax has your attention. If so, you will be happy to know that this article helps you plan to reduce or, better yet, avoid the BIG tax! Let’s get started.
Setting the Stage
To give you a working knowledge of how the BIG tax works, we are going to use an example. Let’s say that your conversion from a C to an S corporation looks like this before you do any planning:
Receivables from clients, customers, or patients $ 50,000
11/4/2015 converting a C corporation to an S corporation: Save Thousands byAvoiding the “BIG” TaxProblem
Building (appreciation only) 200,000
Net assets subject to the
BIG tax, before planning $380.00
Here are four taxsaving strategies you can use to mitigate and perhaps even eliminate that nasty BIG double tax.
Strategy 1. Eliminate Goodwill
The BIG tax does not apply to goodwill if you don’t sell your S corporation during the builtin gains penalty period (10 years at the moment). The first strategy is to simply wait for the 10 years to elapse. That eliminates the goodwill problem.
But how do you know that you won’t sell the business during the next 10 years or so? You can say you won’t, but you are not in total control, as some unforeseen circumstance could disable or kill you and force the sale of the business.
To ensure avoidance of the BIG tax on goodwill, you need to plan before you convert the C Corporation to the S corporation.
Before we move to that planning, let’s define goodwill. At the time you sell a business, goodwill is the excess value paid for the business over the net identifiable tangible and intangible assets.
You might attribute some goodwill to the company’s name, trademarks, patents, or location. But in most small businesses, the business owner himself is the key reason clients, customers, and patients are attracted to the business. As a general rule, the more the business depends on the owner’s personal relationships, knowledge, skills, talent, reputation, or experience, the greater the personal goodwill.
This is where planning comes in. If the owner is the goodwill, then the goodwill is not a corporate asset.
Instead, the goodwill is a personal asset owned by the business owner.
The plan is to identify the personal goodwill at the time of conversion from C to S. You don’t get to personally decide this. You need a proper appraisal of the goodwill so you can prove to the IRS the amount allocated to personal goodwill.
Again, remember, the BIG tax on goodwill becomes an issue only if the goodwill is corporate goodwill, and you sell the S corporation during the BIG taxation period (more about this period and why it might be five and not 10 years, later).
Strategy 2. Reduce Building Appreciation with an Accurate Appraisal
The BIG tax on appreciation of assets applies only to that appreciation that occurred prior to becoming an S corporation and then only if you sell the asset during the BIG taxation period (currently 10 years from the date of conversion).
In this example, you have a building that looks like it has $200,000 of appreciation at the time you are going to convert your C Corporation to an S corporation. How do you prove that it’s only $200,000?
You could assemble some of your own documents, but those documents obviously appear selfserving and likely don’t have great reliability. So what you really need, and don’t skip this step, is an accurate appraisal of the assets at the time of conversion to an S corporation.
Depending on the nature of the assets in the C Corporation, you should choose an appraiser with credentials that the IRS will accept, with designations such as:
- Accredited in Business Valuation (ABV) of the AICPA
- Accredited Senior Appraiser (ASA) of the American Society of Appraisers
- Certified Valuation Analyst (CVA) of the National Association of Certified Valuation
- For real estate, works of art, and other specialized needs, you may need an appraiser with designations such as:
- Commercial Property Appraiser designation awarded by the Appraisal Institute (MAI)
- Senior Residential Appraiser (SRA)
- Senior Real Estate Appraiser (SREA)
- Senior Real Property Appraiser (SRPA)
The appraiser will give you an appraisal with a lengthy valuation report detailing the valuation methods used and assetbyasset listings with corresponding values.
Your plan to get an appraisal for less than $200,000 of building appreciation might include engaging multiple appraisers. Say you obtain a credible valuation that shows only $150,000 of appreciation. You just knocked $50,000 off your assets subject to the BIG tax while meeting the IRS’s burden of proof.
If you have an asset such as a building and you have a BIG tax problem once you consider all your strategies, it’s likely to be in your best interest to try and get a lower appraisal.
Strategy 3. Give Yourself a Bonus
You’re reading this right—eliminate some of your tax by giving yourself money!
Even though your C corporation is on the cash basis, the builtin gains and losses include income and deduction items that would have been recognized by your cashbasis C corporation had it used the accrual method of accounting.
So just to clarify—neither your C Corporation nor your S corporation uses the accrual method of accounting. But on the day you convert from the C corporation to the S corporation, the law makes your accounting pretend that you are on the accrual method. That’s why your cashbasis accounts receivable at the date of conversion are subject to the BIG tax.
So how does this pretending to use accrual rule help you? If you documented that you were underpaid in prior years or that you deserve a bonus for the good work completed, you make those underpaid bonus amounts payable to you and then have the S corporation pay them within two and a half months after conversion.
As a result, you have a builtin loss to offset the builtin gains.
Example. You can prove that your C Corporation underpaid you in the five years prior to electing S Corporation status, and you establish an accrued liability to make up the pay deficit.
|Year||Actually Paid||Fair Compensation|
he date of conversion, your S corporation recognizes the liability to pay the $180,000 shortfall and does, in fact, pay that shortfall within the first two and a half months after conversion. Presto; you have a $180,000 builtin loss.
Strategy 4. Wait to Sell
Historically, the holding period to avoid the BIG tax has been 10 years, which begins on the first day of the first taxable year that the law treats the C Corporation as an S corporation. Lawmakers reduced the 10 years to five years for 2012, 2013, and 2014. You can hope this happens for 2015 and future years, but your best bet is to make a plan to avoid the tax altogether.
Why? See this example
|Description||Before the Plan||After the Plan|
|Receivables from clients, customers, or patients||$ 50,000||$50,000|
|Building (appreciated portion)||200,000||150,000|
|Bonus to owner-employee||-0-||-180,000|
|Net assets subject to BIG tax, before planning||$380,000||-0-|
Let’s say you made no plan other than to either wait the 10 years or hope for a shorter period. In year 1, you would have a BIG tax on $30,000 because you collected the $50,000 of receivables and paid the $20,000 of liabilities.
The BIG tax is evil and nasty. But with proper planning you can keep the BIG tax to a minimum and possibly eliminate it altogether.
Rule 1 is to absolutely know what the BIG problem is before converting your C Corporation to an S
Corporation. Remember, the BIG tax is first 35 percent and then regular tax on the remaining 65 percent. If you are in the 40 percent regular bracket, your tax on $500,000 is $305,000. That’s a 61 percent tax.
Your plan to reduce or eliminate the BIG tax (let’s call it the BIG double tax) might include some or all of the following:
Eliminate the corporate goodwill by making the goodwill personal goodwill, or avoid the goodwill problem by not selling the business until after the BIG tax period is over (10 years now, hopefully five years with new legislation).
Make sure you to have an accurate appraisal of building value (appreciation) on the date of conversion.
Create a bonus that you can prove and sustain and pay it within two and a half months after you elect S corporation status.
Plan your BIG tax income and deduction recognitions to take place in the same tax year so they offset each other