December 18, 2015 — Congress passed the Protecting Americans From Tax Hikes (PATH) Act of 2015, which permanently limited the BIG recognition period to 5 years.
Built-in gain, or BIG, is a term used by the IRS to describe gain that must be recognized by a corporation in addition to its shareholders. IRC § 1374. Built-in gain applies to 1) corporations previously taxed under Subchapter C (C-Corporations) of the Internal Revenue Code (IRC) that elect taxation under Subchapter S (S-Corporations) and whose assets appreciated before the election was made or 2) corporations that acquire assets with carry-over basis from a predecessor C-Corporation.
Entity-Level (Corporate) Taxation
Under Subchapter C, a corporation must recognize gain on the sale of assets in addition to other events. A shareholder must also recognize any increase in his/her share values associated with such gain when the shareholder either sells his/her shares in the corporation, the shareholder receives a distribution during the liquidation of the corporation, the corporation redeems a shareholder's stock, and other similar transactions. For a C-Corporation and its shareholders, the sale of an asset can impose two distinct taxes, however, the timing of the two taxes permits some opportunity for tax arbitrage depending upon when the shares are sold, if ever.
Pass-Through Taxation
Under Subchapter S, gain is passed through to shareholders and the corporation is not taxed on gain on the sale of assets. The shareholders recognize gain on the sale regardless of whether a distribution is made. For an S-Corporation, the sale of an asset triggers a single tax.
Calculating Built-In Gain
The calculation of BIG tax is a two-step process. First, a C-Corporation must calculate unrealized BIG when the corporation elects to be taxed under Subchapter S by subtracting the corporation's adjusted basis in a particular asset from the fair market value of the asset at that time. Second, if the corporation sells assets having unrealized BIG during "the recognition period", the corporation must pay a BIG tax based upon the lesser of the corporation's net recognized BIG or the corporation's taxable income. IRC § 1374(d)(2) & 1375(b)(1)(B).
Built-In Gain Recognition Period
For a C-Corporation that elects to be taxed under Subchapter S, the IRC imposes a period, usually 10 years - but 7 years in 2009 & 2010 and 5 years in 2011, during which the corporation must recognize gain on the sale of assets that appreciated before the election was made. The applicable recognition period is that which is in effect at the time of the sale, not the period in effect at the time the election was made.
For example, a C-Corporation elects taxation under Subchapter S during 2011 in which the IRC requires the recognition of BIG for 5 years from that date of the election. If the corporation sells an asset in 2017 that appreciated before the election was made and Congress does not change the current law, i.e. the holding period in 2017 is 10 years, the corporation will be liable for tax on BIG associated with the sale of the asset regardless of the 5-year period that was in effect at the time of the election in 2011.
This brief overview of some important considerations associated with built-in gains is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.
