What s News in Tax Analysis That Matters from Washington National Tax Fiscal Cliff Legislation Includes BIG Tax Relief for Some S Corporations and REITs The recently enacted American Taxpayer Relief Act of 2012 extended the temporary five-year recognition period for the section 1374 builtin gains tax for tax years beginning in 2012 and 2013. This may be good news for some S corporations and REITs that disposed of assets in taxable transactions during tax years that began in 2012 or that are considering dispositions during tax years beginning in 2013. The legislation explicitly addresses how the temporary reduction in the recognition period interacts with the installment sale and taxable income limitation rules. S corporations and REITs, however, should be aware that not all states may follow the changes to the federal built-in gains tax rules. Monday, February 4, 2013 by Carol Kulish and Paul Kugler, Washington National Tax Carol Kulish and Paul Kugler are directors in WNT s Passthroughs group. Paul Kugler is a former IRS Associate Chief Counsel (Passthroughs and Special Industries). The authors express their appreciation to David Brandon and David Lee, both of WNT, for their contributions to this article. Background S corporations can be subject to the built-in gains tax of section 1374 (the BIG tax ) if they used to be C corporations or if they acquired assets from C corporations in carryover basis transactions. 1 REITs can also be subject to the BIG tax. 2 The BIG tax, however, only applies to the extent the S corporation or REIT has net recognized built-in gain in a tax year beginning in the recognition period. 3 Net recognized built-in gain can 1 2 3 See sections 1374(d)(8) and 1.1374-1(d) and -8 for rules relevant to carryover basis transactions, including the determination of the recognition period for assets acquired in such transactions. Except to the extent specified otherwise, all section references are to the Internal Revenue Code of 1986, as amended, or the Treasury regulations promulgated thereunder. Section 1374, on its face, applies only to S corporations. For the application of section 1374 to REITs, see section 1.337(d)-7(b). Generally, these regulations apply to REITs for the same types of carryover basis transactions as described in section 1374 for S corporations; however, there are minor differences in the scope of the provisions, a discussion of which is beyond the scope of this article. See section 1374(a). Net recognized built-in gain is the base for the BIG tax. An S corporation s net recognized built-in gain generally is determined by reference to the corporation s recognized built-in gain ( RBIG ) and recognized built-in loss ( RBIL ), but can be limited by the corporation s net unrealized built-in gain ( NUBIG ) limitation or its taxable income limitation for the year. Very generally, an S corporation s RBIG and RBIL reflect recognized built-in gains and losses (and some income and deduction items) that are viewed as attributable to a C corporation period. See sections 1374(d) and 1.1374-4 for the technical definitions of these terms. See section 1.337(d)-7(b)(2)(i) for the definition of net recognized built-in gain in the REIT context. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative, a Swiss entity.
Fiscal Cliff Legislation Includes BIG Tax Relief for Some S Corporations and REITs page 2 include gain recognized during the recognition period on certain asset dispositions, as well as certain income items taken into account during the recognition period. 4 The recognition period generally is the 10-year period that begins with the date of conversion to S corporation or REIT status (or the acquisition of assets in a carryover basis transaction, as the case may be). 5 However, previous legislation had the effect of temporarily shortening the recognition period for tax years beginning in 2009, 2010, and 2011. 6 The New Law, in General The American Taxpayer Relief Act of 2012 (the New Law ) includes a provision that shortens the BIG tax recognition period to five years for purposes of determining net recognized built-in gain during tax years beginning in 2012 and 2013. The shortened recognition period may need to be taken into account in preparing 2012 tax returns for some S corporations and REITs. Further, it may provide some S corporations and REITs with the opportunity to dispose of assets (or liquidate) in their 2013 tax years without triggering BIG tax to which they otherwise would have been subject. Consider the following examples. Unless otherwise indicated, references to section or sections in this article are to the Internal Revenue Code of 1986 (the Code ), as most recently amended, or to the U.S. Treasury Department regulations (the regulations ), as most recently adopted or amended. 4 5 6 Example 1 Calendar Year Corporation. A calendar year C corporation converted to S corporation status effective January 1, 2008. The corporation has not subsequently acquired any assets from C corporations in carryover basis transactions. For the corporation s tax years beginning in 2012 and 2013, the recognition period is the five-year period that began January 1, 2008, and that ended December 31, 2012. Thus, the S corporation would be subject to the BIG tax on net recognized built-in gain in 2012; however, it would not be subject to the BIG tax on net recognized built-in gain in 2013. In addition, unless the law is changed again, the corporation would be subject to BIG tax on net recognized built-in gain in 2014, 2015, 2016, and 2017 (i.e., because the recognition period reverts to 10 years after the tax year that began January 1, 2013). See sections 1374(d)(2)(3) and (d)(2)(5). In some situations, a taxpayer may be able to establish that certain gain or income is not attributable to the C period and, therefore, is not subject to the BIG tax. The BIG tax rules are very complex. A complete discussion of these rules is beyond the scope of this article. See sections 1374(d)(7)(a) and 1374(d)(8)(B). See section 1374(d)(7)(B).
Fiscal Cliff Legislation Includes BIG Tax Relief for Some S Corporations and REITs page 3 Example 2 Assets Acquired in Carryover Basis Transaction. Same as Example 1, but the corporation also made a Qualified Subchapter S Subsidiary ( QSub ) election for an existing C corporation subsidiary on January 10, 2010. The QSub election was treated as a section 332 liquidation of the subsidiary (i.e., a carryover basis transaction). For the S corporation s tax years beginning in 2012 and 2013, the recognition period with respect to the QSub s assets is the five-year period that began January 10, 2010, and that will end January 9, 2015. Thus, the S corporation would be subject to BIG tax on net recognized built-in gain from a disposition of the QSub s assets during 2012 or 2013. (The QSub s assets are in a different pot than the assets held at the time of conversion and have a different recognition period.) Example 3 Short First S Year. A fiscal year C corporation converted to S corporation status effective July 1, 2008, and changed to the calendar year at that time (i.e., the corporation s first tax year as an S corporation began July 1, 2008, and ended December 31, 2008). 7 The corporation has not subsequently acquired any assets from C corporations in carryover basis transactions. For the corporation s tax years that began in 2012 and 2013, the recognition period is the five-year period that began July 1, 2008, and that will end June 30, 2013. Thus, the corporation could be subject to BIG tax if it recognizes gain on the disposition of an asset before July 1, 2013; however, it would not be subject to BIG tax if it disposes of an asset after June 30, 2013, but before January 1, 2014. In addition, unless the shortened recognition period is extended again, the corporation could continue to be subject to the BIG tax on gain recognized on asset dispositions on or after January 1, 2014, and before July 1, 2018. Changes Relative to Previous Laws/Installment Sale and Taxable Income Limitation Rules Laws that temporarily reduced the recognition period for tax years beginning in 2009, 2010, and 2011 ( Previous Laws ) were drafted 7 Most S corporations are required to use the calendar year. There are, however, some situations in which an S corporation may be allowed to use a fiscal year.
Fiscal Cliff Legislation Includes BIG Tax Relief for Some S Corporations and REITs page 4 differently than the New Law. 8 Not only did Previous Laws use different language to effect a shortened recognition period, but they also did not explicitly address how the temporarily shortened recognition period would interact with the installment sale rules or the taxable income limitation on net recognized built-in gain. Given the differences between the New Law and the Previous Laws, it is important to focus on the language of the New Law in assessing its application to dispositions and income in tax years beginning in 2012 and 2013. General Language Previous Laws provided that the BIG tax would not be imposed on net recognized built-in gain of an S corporation in a tax year beginning in 2009, 2010, or 2011 if a certain number of years in the recognition period had preceded such tax year. By contrast, the New Law generally provides that, for purposes of determining the net recognized built-in gain for tax years beginning in 2012 and 2013, the definition of recognition period is applied by substituting 5-year period for 10-year period. 9 Although the reason for taking this approach is not stated, the change in approach appears to go hand-in-hand with the New Law s addition of explicit rules (described below) regarding how the temporary shortened recognition period applies in the case of installment sales. Installment Sale Rules The New Law generally provides that if an S corporation sells an asset and reports the income from the sale using the installment method under section 453, the treatment of all payments received is governed by the recognition period rules of section 1374(d)(7) that apply to the tax year in which the sale is made. This provision is effective for tax years beginning after December 31, 2011. 10 As a result, an S corporation (or a REIT) that 8 9 10 See section 1374(d)(7)(B) for the provisions applicable to 2009, 2010, and 2011 tax years. More specifically, the New Law inserts a new section 1374(d)(7)(C) that provides that, for purposes of determining the net recognized built-in gain for tax years beginning in 2012 or 2013, subparagraphs (A) [relating to the general 10-year recognition period] and (d) [relating to special recognition period rules for banks] shall be applied by substituting 5-year for 10-year. The New Law s approach is consistent with the installment sale rules in the regulations currently in effect under section 1374. See section 1.1374-10(b)(4). The Senate Finance Committee considered other legislation (the Family and Business Tax Cut Certainty Act of 2012 ) a few months before the enactment of the New Law. That legislation included the temporary recognition period provision that ultimately was included in the New Law. The legislative history of the earlier legislation indicated that it is intended that under the provision Treasury regulations providing for the treatment of installment sales (as well as other Treasury regulations under section 1374) will continue to apply for tax years
Fiscal Cliff Legislation Includes BIG Tax Relief for Some S Corporations and REITs page 5 disposes of an asset in a tax year beginning in 2012 or 2013 that is not in the recognition period because of the New Law is treated the same under section 1374 regardless of whether or not it uses the installment method. Consider the following examples: Example 4 Sale During Temporary Relief Period. As in Example 1, assume that a calendar year C corporation converted to S corporation status effective January 1, 2008, and has not subsequently acquired any assets from C corporations in carryover basis transactions. Thus, for the corporation s tax years beginning in 2012 and 2013, the recognition period is the five-year period that began January 1, 2008, and that ended December 31, 2012. If the S corporation sells an asset in a taxable transaction on March 1, 2013, the gain recognized is not subject to BIG tax under the New Law. This is true even if the S corporation elects to use the installment method and receives payments in 2014, 2015, 2016, and 2017. Even if the general recognition period for these years reverts to 10 years, the treatment of the payments received is governed by the recognition period provisions applicable to 2013 (the year of the sale). Consequently, the temporary nature of the recognition period reduction does not make installment sale treatment unattractive in this case. Example 5 Sale Prior to Temporary Relief Period. As in Example 4, assume that a calendar year C corporation converted to S corporation status effective January 1, 2008, and has not subsequently acquired any assets from C corporations in carryover basis transactions. Assume also that the corporation recognized gain on the disposition of a business on September 30, 2012. The corporation could be subject to BIG tax on the gain because the disposition took place within the recognition period. This result would not change if the corporation elected to use the installment method and to receive some payments in 2013. Even though dispositions that take place within 2013 would not give rise to BIG tax because they would not be within the recognition period, the beginning in 2012 and 2013 in the same manner as under the law in effect for tax years beginning prior to 2009, but applying the temporary 5-year recognition period in place of the 10-year recognition period in the case of dispositions of property during the temporary period. S. Rep. 112-208 (August 28, 2012) (the Earlier Senate Report ). This Earlier Senate Report also provides two examples of how the provision is intended to apply. These examples are similar to the examples in text.
Fiscal Cliff Legislation Includes BIG Tax Relief for Some S Corporations and REITs page 6 treatment of the payments received in 2013 would be governed by the recognition period rules applicable to 2012 (the tax year in which the sale was made). Thus, the S corporation cannot use the recognition period rules of the New Law to push gain from a year in which such gain would have been subject to the BIG tax to a year in which the shortened recognition period applies. (Note that a different analysis may apply to tax years that began on or before December 31, 2011. 11 ) Taxable Income Limitation An S corporation s (or a REIT s) net recognized built-in gain for a tax year can be limited by its taxable income limitation. The taxable income limitation generally is the S corporation s taxable income determined by using all rules that apply to C corporations, but without regard to the deduction under section 172, the deductions allowed by sections 241 through 247, or the deduction allowed by section 249. 12 When the amount that would be the taxable income of the corporation for a tax year if only recognized built-in gains and losses were taken into account exceeds the corporation s taxable income limitation for that year, the excess is treated as recognized built-in gain in the succeeding tax year. 13 In other words, the amount that is not taken into account by virtue of the taxable income limitation is carried forward to the next year of the recognition period. Effective for tax years beginning after 2011, the New Law clarifies that the rule for carrying forward excess amounts that are not included in net recognized built-in gain by virtue of the taxable income limitation applies only if such excess amounts arise in a tax year within the recognition period. 14 Thus, such amounts are not carried forward from a year that is outside the recognition period under the temporary five-year rule to a 11 12 13 14 As was indicated above, the New Law s installment sale rules apply to tax years beginning after December 31, 2011. In addition, the Previous Laws technically did not shorten the recognition period for 2009, 2010, and 2011 tax years, but instead provided that the BIG tax would not be imposed on recognized built-in gain in such a year if a certain number of years in the recognition period preceded such year. See sections 1374(d)(2)(A)(ii), 1.1374-2(a)(2), and 1375(b)(1)(B), for more information regarding the taxable income limitation. In the case of a REIT, the taxable income limitation is computed as provided in section 1.1374-2(a)(2), but is reduced by an amount equal to tax imposed under section 857(b)(5), (6), and (7). See section 1.337(d)- 7(b)(2)(i)(B). Sections 1374(d)(2)(B) and 1.1374-2(c). See section 1374(d)(2)(B), as amended by the New Law. See the Earlier Senate Report for a brief explanation of the provision.
Fiscal Cliff Legislation Includes BIG Tax Relief for Some S Corporations and REITs page 7 subsequent year that is back in the recognition period under the general 10-year rule. Consider the following example: Example 6 Taxable Income Limitation. As in Example 1, a calendar year C corporation converted to S corporation status effective January 1, 2008. The corporation has not subsequently acquired any assets from C corporations in carryover basis transactions. In 2012 (a year that is still within the corporation s recognition period), the corporation disposed of several assets, generating $500,000 of recognized built-in gain. However, the corporation did not have any taxable income for 2012; therefore, the corporation s net recognized built-in gain for such year was zero and the $500,000 excess of recognized built-in gain over taxable income was carried to 2013. 15 Because 2013 is not within the corporation s recognition period (due to the temporary relief provision), the corporation is not subject to BIG tax on the $500,000 of recognized built-in gain that was carried over from 2012. Further, the New Law makes clear that that $500,000 is not carried over to 2014 as recognized built-in gain. In effect, the New Law recognizes that, once a taxable income carryforward amount is carried to a year that is outside the recognition period, that amount is no longer subject to BIG tax; it does not spring to life again after the temporary reduction in the recognition period expires. Practical Considerations Relating to NUBIG As was explained above, moving in and out of the recognition period can raise practical issues regarding the application of the taxable income limitation. It likewise can raise issues regarding another limitation on the amount of an S corporation s (or REIT s) net recognized built-in gain the NUBIG limitation. Very generally, an S corporation s NUBIG limitation reflects the net amount of gain that was inherent in the corporation s assets at the time it converted from C corporation to S corporation status (i.e., its NUBIG ), reduced by the net recognized built-in gain taken into account in 15 As was indicated in text above, the amount of the corporation s taxable income is determined in accordance with the rules set forth in sections 1374(d)(2)(A)(ii) and 1.1374-2.
Fiscal Cliff Legislation Includes BIG Tax Relief for Some S Corporations and REITs page 8 computing the BIG tax in previous years. 16 If an S corporation recognizes income or gain during a year to which the New Law s temporary relief provision applies, that income or gain is not recognized built-in income or gain, does not give rise to net recognized built-in gain, and is not subject to the BIG tax. 17 Although this is a favorable result with respect to that year, keep in mind that, under a technical reading of the New Law, the income or gain does not appear to reduce the corporation s NUBIG limitation (i.e., because it does not reduce the corporation s net recognized built-in gain). This may create an unwelcome surprise if the S corporation recognizes income or gain in a subsequent year in which it is back in its regular 10- year recognition period. Consider the following example: Example 7 NUBIG Limitation. As in Example 1, a calendar year C corporation converted to S corporation status effective January 1, 2008. At that time, the corporation s NUBIG was $1 million (reflecting gain of more than $2 million, reduced by certain losses and liabilities). The corporation has not subsequently acquired any assets from C corporations in carryover basis transactions. The corporation pays BIG tax on total net recognized built-in gains of $100,000 from January 1, 2008, through December 31, 2012, thereby reducing its NUBIG limitation to $900,000. On March 15, 2013, the corporation disposes of assets that would have resulted in $900,000 of net recognized built-in gain if the corporation had been in the recognition period. However, because 2013 is outside the corporation s recognition period (under the New Law), the gain recognized on the asset disposition does not result in net recognized built-in gain and does not trigger imposition of the BIG tax. If the corporation disposes of additional assets in 2014 (during the remainder of its normal 10-year recognition period) and triggers $500,000 of recognized built-in gain, the amount of the corporation s net recognized built-in gain in that year apparently would not be limited by its NUBIG limitation because the NUBIG limitation was not reduced as a result of the disposition that took place in 2013. 16 17 See section 1.1374-3 for more information regarding NUBIG. As was indicated above, Previous Laws were drafted differently than the New Law. Thus, a different analysis may apply to the application of the NUBIG rules in the case of gain or income recognized during years that were not subject to BIG tax because of the Previous Law. The discussion in text supra is limited to the New Law provision.
Fiscal Cliff Legislation Includes BIG Tax Relief for Some S Corporations and REITs page 9 Caveat about State Taxes The BIG tax provisions described above are changes to the federal tax law. Although some states may adopt the shortened recognition period provision for purposes of their tax laws, other states may not. Thus, some states may impose state BIG taxes in situations in which the federal BIG tax does not apply. A discussion of different state laws is beyond the scope of this article. Please consult with a member of KPMG s State and Local Tax (SALT) practice regarding the relevant state and local tax rules. Conclusion As was described above, the New Law BIG tax provisions may be relevant to 2012 returns of some S corporations and REITs. In addition, the provisions may be helpful to some S corporations and REITs that are interested in disposing of assets (or liquidating) during their 2013 tax years. S corporations and REITs to which the shortened recognition period may apply should be aware of the special rules for installment sales and, if relevant, how the taxable income and NUBIG limitations apply in their situations. Further, they should be cautioned that different rules may apply for state and local tax purposes. KPMG s What's News in Tax is a publication from Washington National Tax that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.