A “small business corporation” that elects to be an S corporation is generally not subject to federal income tax. Instead, the corporation’s income “flows through” to its shareholders and is includible in computing their taxable incomes. Internal Revenue Code (IRC) §§1363, 1366. However, if a corporation has not been an S corporation since the commencement of its corporate existence, but, rather, its election to be an S corporation (S election) is made effective as of some later date, the electing corporation itself is subject to tax throughout a statutory “recognition period.” The tax, imposed at the highest rate (currently 21 percent) applicable to corporations other than S corporations (C corporations) on the corporation’s “net recognized built-in gain” during any taxable year that begins within the recognition period, is often referred to as the “built-in gains,” or “BIG,” tax. For taxable years prior to 2009, the recognition period generally extended for 10 years from the effective date of the S election; it is now five years from that date. IRC §1374.
The definition of an S corporation’s “net recognized built-in gain” generally includes all gains and losses that are recognized by it during the recognition period upon its disposition of assets. However, the corporation may exclude gains (1) with respect to assets that the corporation did not own at the effective date of the S election and (2) that are greater than the “built-in gain,” that is, the excess of the fair market value over the adjusted basis of an asset, at that effective date. Because of this exclusion, if a C corporation makes an S election and then disposes of assets during the recognition period, disputes often arise with the Internal Revenue Service as to whether gain from that disposition is attributable in whole or in part to assets owned by the corporation at the time of the S election and, if so, as to the existence and extent of built-in gain, at the effective date of the S election, with respect to those disposed assets.
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