Question

Question: Old McDonald’s, Inc., a farm corporation, was incorporated as a C corporation on January 1, 1993. On January 1, 2015, the corporation made an election to be treated as an S corporation beginning in tax year 2015. At the time of the election, the corporation’s assets included 1,000 acres of unimproved farmland having a cost basis $2,250,000 and a fair market value of $7,000,000. A real estate developer has approached the shareholders with an offer to purchase the land in 2019 for a price of $10,000,000. The shareholders are seriously considering the offer but are concerned about the tax ramifications both for themselves and for the corporation. Since it is already October, one of the shareholders has suggested that they postpone the sale until January, 2020 thereby deferring the reporting of income and the payment of tax for an entire tax year.

Using the memo format previously provided, prepare a memo to the file explaining the various tax ramifications associated with this transaction including the suggestion that the sale be deferred until 2020. Keep in mind that this was previously a C corporation.

Can someone provide several relevant IRC tax rules about this scenario and explain them please? Thanks!

Answer 1

Built in Gains Tax (BIG) -

S Corp is required to pay 21% tax on sale or distribution of its asset only if it has unrealized bauilt in gains and the asset are sold within 5 years from the election of S corp Status.

Unrealized Built in gains = Excess if asset FMV over basis when a C corp elects S corp status.

In the given question,

If the asset is sold at October 2019

Unrealized Built in gain = $7,000,000 - $2,250,000 = $4,750,000

Thus Unrealized built in gain tax = $4,750,000 * 21% = $997,500

This tax shall be paid directly by the S corp.

For the remaining gain, $10,000,000 - $7,000,000 = $3,000,000 => tax shall be paid by the shareholders and the gain shall be treated as Capital Gains taxable at 0%/15%/20%.

If the asset is sold at January 2020

The holding period of 5 years post conversion of C corp to S corp has been completed and so no Built in gains tax would be levied.

The entire gain = $7,750,000 ($10,000,000 - $2,250,000) shall be taxable in the hands of shareholders as Capital Gain taxable ar 0%/15%/20%

Since, tax rate of 0%/15%/20% is lower than the tax rate of 21%. It is advisable to deffer tha tax upto the next year.

Feel free to ask for any clarification, if required. Kindly provide feedback by thumbs up. It would be highly appreciated. Thank You.