Time to Purge C Corporations

This was originally published on September 15th, 2010.

Generally in this blog addresses specific developments - a tax court decision or a private letter ruling for example - issued in the last few months.  I'm celebrating entity extended due date (one of the four major holy days in the tax nerd religion) by pointing out a major planning opportunity.  It requires action before December 31 and if applicable may require significant study, so the time to start looking at it is right now. 

Are you involved in anyway with a C corporation with significant appreciated assets ?  A youngster might wonder how such a thing came to be.  Well have you ever noticed that when you see a copy of the Code it says Internal Revenue Code of 1986 ?  Did you ever wonder what it was like before that ?  Under the Internal Revenue Code of 1954 that is.  Individual rates were much much higher.  The maximum individual rate was 70% (and that was down from higher levels).  There was a special maximum rate on earned income of 50%.  The first 50,000 of corporate income was taxed at significantly lower rates.  Prior to the Tax Reform Act of 1969 it was possible to have multiple corporations with common ownership take advantage of this feature.  (That is getting before my time.)

The neat thing that you could do back then was sell the assets of the corporation in a complete liquidation without recognizing gain at the corporate level.  The proceeds were then distributed to the shareholders who had capital gains treatment.  Eliminating this feature, sometime referred to as the General Utilities doctrine, was one of the biggest changes in TRA 1986, which is really saying something.  To prevent people getting around the gain recognition by a last minute S election, the S corporation built in gain tax was created.  If in 1985 you had a C corporation the thing to do was to look at it closely and see if there was a reason to not make an S election.  Over the years I've encountered a few instances of C corps that really should have converted in 1985.  I suspect there are probably a few still kicking around. As a matter of fact, I just read about one in the case of Estate of Marie J. Jensen, et al. v. Commissioner, TC Memo 2010-182.  The decedent had owned stock in a corporation that owned real estate, a moribund summer camp.  In valuing the stock interest the estate was allowed to deduct the capital gains tax that the corporation would have to pay if the real estate were sold.  Now I wouldn't want to deprive the Jensen estate of its discount, but there is a strategy that an entity like that might consider.

The built-in gains tax (Section 1374) only applies to the appreciated value of the real estate at the time of the S election. (I know you don't think that there is any such thing as appreciated real estate anymore, but you have to remember we might be talking about something a corporation purchased in 1957.)  So any future appreciation will not be subject to double taxation.  More significantly the built-in gains tax only applies for ten years.  (Well maybe I should not have used the word "only" there.)   So imagine you have inherited Oldco, Inc, a C corporation, which owns land worth $10,000,000.  Your basis in the stock is $5,000,000.  The corporations basis in the land is $500,000. 

If you can take a long view an S election can solve the double tax problem.  You have to be able to wait out the ten years, though.  An installment sale will not do the trick.  A like-kind exchange will.  I have written here and there about the perils of like-kind exchanges, but there is no question that they can be a fantastic wealth building device.  The owners of Oldco, Inc would have to do a really bad job in selecting a target property to make them wish they had just paid the taxes.  A likely strategy would be property that is triple net leased to a credit tenant.  You always wanted to own a Walgreen's right ?  So now Oldco, Inc without incurring any tax is flowing through $800,000 of rental income to its shareholders subject to a single tax.  The built in gains tax taint has transferred from the raw land to the Walgreen's, but it will go away in 10 years and nothing prevents you doing another like kind exchange.   Everything would be great except that now you have an S corporation with excess passive income(Section 1375).  So your $800,000 is subject to double taxation.  And you are not going to be able to wait out the ten years, because if you have excess passive income for three years running your S election is revoked.  The two sections 1374 and 1375 sit their like Scylla and Charybdis waiting to devour you (I leave it to one with better classical training to decide which section is Scylla and which Charybdis).

There are at least two approaches to solve the problem.  One is to make sure that Oldco Inc has active business income at least three times as great as its passive income.  I could go on at length about this strategy.  It could work, but it has the danger of creating a tail wagging the dog type of problem.  I will note, though, that rental income which is passive for purposes of the passive activity loss rules might be considered active for purposes of the S corporation tax on excess passive income.  Conceivably you might solve the problem by swapping your triple net Walgreen's for a strip mall, but there is another solution. Section 1375 applies to S corporations that have excess passive income and accumulated earnings and profits.  If Oldco, prior to making its S election, distributes its accumulated earnings and profits it will be not be subject to the tax on excess passive income.

Why is this timely ?  Under current law dividends are taxed at 15%.  So Oldco's purging of its accumulated earnings and profits may be much less expensive if it is accomplished in 2010.  Assuming Oldco is really on the old side determining what the amount of its earnings and profits is may turn out to be a non-trivial question.  As Biker and Eustice note :

To compute a corporation's earnings and profits is often no simple task, especially if the corporation has gone through a series of reorganizations or other adjustments. It may be necessary to decide how a transaction occurring many years ago should have been treated under a long-interred statute because of its effect on accumulated earnings and profits; and, because there is no statute of limitations governing the effect of prior transactions on accumulated earnings and profits, it is advisable to retain corporate records permanently.

There may be a host of other problems to solve including, most likely, stubborn inertia.