Author: VU Faculty

A question posed to our agency management faculty: "I am an agency owner. At one time we changed to an 'S' corporation and our CPA told us it was best to be a 'C' corporation. We changed and since then I'm of the opinion we should have remained an 'S.' Can you give any insight on the matter? We are about $15,000,000 in volume if that is of any help."

"I am an agency owner. At one time we changed to an 'S' corporation and our CPA told us it was best to be a 'C' corporation. We changed and since then I'm of the opinion we should have remained an 'S.' Can you give any insight on the matter? We are about $15,000,000 in volume if that is of any help."

We ran this by the VU agency management faculty and, while they are not attorneys or accountants, they provided the following observations. Keep in mind that the information referenced below might have been factual at the time of original publication of this article, but could change without notice at any time. If you have questions about this issue, feel free to use our "Ask an Expert" service.

There are pluses and minuses to each and neither is inherently better than the other. The key is to do two things. First, explain in detail what your plans are for your agency to your CPA. Too often CPAs think their client's only goal is to minimize their immediate taxes and they never bother to ask any other questions. Explain when you plan to sell, whether you plan to sell internally or externally, and explore with your CPA tax minimization strategies for both an S corp. and C corp. My experience has been that most agencies, with enough planning, can achieve approximately the same tax rate under either.

The second issue is to find a good CPA that will sit and listen, without jumping to conclusions regarding what is best for your agency.

One item that jumps out in your question is that you note that, "At one time we changed to an "S" corp...." If you were a C corp. and then switched to an S corp. and then your CPA recommended going back to a C corp., were you discussing a sale of your agency with him? I ask because a lot of agencies mistakenly change to an S corp. from a C corp. when they're planning to sell within ten years. The IRS attaches what is called a built-in capital gains tax on companies that were C corps that switched to S corps and then sold within 10 years of becoming an S corp.

In a “c” corporation, you get to shelter the first fifty thousand dollars of earnings at the capital gains rate every year, from a federal income tax standpoint. So, if you retain earnings it lightens your tax burden.

In an “S” corporation you pay ordinary taxes on earnings, as owners.

When you sell the assets of an “s” corporation, you get the personally take the capital gains treatment for the sale of the assets.

When you sell the assets of a “c” corporation, you not only have to pay the full corporate tax on the sale, but you get the pleasure of having to pay personal income tax rates on the remainder after you pay your corporate taxes. You can potentially lose between 55% and 70% of the value of your agency to the government if you are a “c” taxpayer.

There is also a ten year look back by the IRS for conversion.

So, if you intend to sell, or liquidate the agency in the next ten years, you got some bad advice.

I also find that people take the “c” election to avoid paying taxes at the advice of their accountant, at year they do not want to pay any corporate taxes, so they drain down the cash and pay income tas on it, thus effectively taking away the advantage of the ”c” Election. They wind up paying ordinary rates on the corporate income, and then when they sell their agency they are in tax trouble, so they gave away the “c” advantage when they had it, AND they pay exorbitant taxes as liquidation!

The Government is getting it ALL their way and you are losing on both sides. “c” corporations are trouble if you sell them to outsiders. You are correct, you should be an “s” taxpayer. Or set up an LLC.

There is absolutely no reason to be a "C" corporation. You have limited your options if you intend to sell. Most buyers are not interested in a "C" because the only tax benefit is to the selller if they sell the stock. Most buyers are not interested in buying the stock and all of the accompanying liabilities, not to mention the fact that there is no ability to depreciate the purchase. Your accountant gave you. from my perspective, very bad advice.

One more thought about being S Corp - There is a 10 year look back, but as we found out, it can be pro-rated if an agency sells before the 10 years is done. So a company does S Corp election and gets a valuation this year. If they sell prior to 10 years, figures are pro-rated.

That is correct. I just closed two deals that fell into this situation.

I haven't heard of pro rating the tax. This sounds like a good question for a very good CPA. What they may be referring to is whether a tax must be paid on the entire sale at the highest tax rate or if the tax can be made to apply only to the difference between the agency's value at the time of the conversion and the time of the sale. The latter is possible and it is why every business that converts should have a valuation completed at the time of the conversion.

Unfortunately, many accountants do not tell their clients about this. The valuation can be done retroactively, but the quality of the data is likely to be less and ability of that valuation to withstand IRS scrutiny is also likely less because of the data, timing, and valuation purpose. But this is not a pro rata deal.
 
This gets to what I just said. I cannot find anything about pro-rating things.
 
605.10    Built-in Gains Tax. The Section 1374 built-in gains tax applies to S corporations that were former C corporations and that, at the time of conversion from C to S status, held built-in gain assets (assets with FMV greater than tax basis). If such corporations sell (or make a liquidating distribution of) a built-in gain asset within 10 years of the date of conversion to S status, a corporate-level built-in gains tax [at the highest corporate tax rate under IRC Sec. 11(b)] applies.
 
   a. For the built-in gains tax to apply, the corporation generally must be a former C corporation that made an S election after 1986 (or 1988 for certain purposes) and that had built-in gain assets on hand as of the effective date of the S election. S corporations that made their election after 1986 and before 1989 are exempt from the built-in gains rule under Section 1374 only if (1) they were small S corporations when the election was made (more than half of the company’s stock was held by ten or fewer qualified persons since August 1, 1986 and total value was $10 million or less) and (2) their most recent S election occurred before 1989 (Reg. 1.1374-10).
 
   b. Corporations that have always been S corporations or that filed S elections before 1987 (or, in some cases, 1989) are generally not exposed to the built-in gains tax. However, such corporations can become exposed to the tax if they acquire certain transferred-basis property. Transferred basis property means property with a basis that is determined in whole or in part by reference to the basis of such asset (or any other asset) in the hands of a C corporation (or another S corporation that was subject to the built-in gains tax). An example is property obtained in a tax-free merger with a C corporation by an S corporation. Reg. 1.1361-4(b)(3)(ii) clarifies that an acquired S corporation for which a qualified Subchapter S subsidiary (QSub) election is made is not temporarily treated as a C corporation. Thus, there is no built-in gain tax exposure in such a transaction.
 
   c. In Ltr. Rul. 200329011, the IRS held that an S corporation/personal injury law firm’s legal fees received after converting from C corporation status, which were attributable to a contingent fee arrangement, are not subject to the Section 1374 built-in gains tax. The ruling addresses the built-in gains tax treatment of contingent fee arrangements for cases that are in various stages of resolution, as well as the treatment of associated litigation costs, for a firm that is a cash method taxpayer both before and after converting to S corporation status.
 
605.11    Planning Tip:  The built-in gains tax generally applies only to assets that have a FMV in excess of tax basis as of the effective date of the S election. This means the tax does not apply to assets that are acquired or created after that date or to appreciation after that date. To avoid unwarranted exposure to the built-in gains tax, S corporations should be careful to properly identify and allocate sales proceeds to assets (e.g., intangible assets) that did not exist on the effective date of the S election. Also, the excess of FMV over basis of assets existing on the effective date of the S election should be identified and documented. (Ideally, this will have been done when the S election was made.) Only that excess is subject to the built-in gains tax. Later increases in the value of such assets are not subject to the tax.
 
605.12    Practice Tip:  Corporate-level built-in gains tax on assets sold by the corporation (or treated as sold because they are distributed to shareholders in liquidation) is allocated to the recognized built-in gains in proportion to those gains and offsets the gain passed through to the shareholders. Thus, the built-in gains tax is treated as a reduction in the amount of gain actually passed through to shareholders [IRC Sec. 1366(f)(2)].
 
605.13    The following examples show the corporate-level tax impact of liquidating distributions to S corporation shareholders. See also Example 6-12 following paragraph 605.4.

I am not sure you can "Pro Rate" it. I have seen a couple of agencies who sold, think about doing something like this and the accountants pulled away from it. You can use it to your advantage, I am not completely sure how this works and I am sure an accountant can get creative, but I think I this is how it works and I have the IRS language here for you to support my supposition.

I would love to think it would "Pro Rate," but I think perhaps what the IRS intends is to allow you to segregate business that is written after the trigger point where the S election was made, and allow you to take the capital gain on the business that was written after the S election. The S Corporation, as I understand it, can only claim flow through tax treatment on the gain or loss recognized since the election to become an S taxpayer. 
 
So, I feel the 10 year look back applies to the "Corporate Valuation" including the balance sheet and the assets at the time of conversion to S status. Thus, if the corporation grows, the "growth" can be liquidated and the tax consequences can flow through to the corporate shareholders at personal capital gains without taxation at the corporate level, to the extent the allocation of assets purchased is subject to capital gains or ordinary tax. The rest of the allocation would not be taxed at the corporate level but would still be subject to personal rates (capital gains or ordinary income) as allocated.
 
The "Corporate Valuation" at the time of the change from a C to an S would be taxed at the corporate level as well as the personal level at the time of liquidation of assets. This makes sense to me as this is the way the IRS would be likely to look at it. They would still get their "pound of flesh" as you had taken preferred tax treatment on your earnings from the C Corporation, whether you took advantage of retaining earnings or not. The "NUBIG" (see below) would be allowed to flow through and be treated as an asset sale from as S Corporation. The old basis would still be taxed at the C Corporation level as well as the personal level until the ten year look back has passed.
 
This is treated by section 1374 of the IRS code. The net unrealized gain or loss would fall into this category. What follows is an official IRS explanation, as near to English as I can come up with.  
 
So to say you can "Pro Rate" it does not do the job. You can only take advantage of the S election on the growth or loss "NUBIG" of "NUBIL".

Background and Explanation of Provisions

Section 1374 of the Internal Revenue Code of 1986 (Code) generally imposes a corporate level tax on the income or gain of an S corporation that formerly was a C corporation to the extent the income or gain is attributable to the period during which the corporation was a C corporation. Congress amended section 1374 to provide this rule as part of the Tax Reform Act of 1986, which repealed the General Utilities doctrine. Under the General Utilities doctrine, a C corporation, in certain cases, could distribute appreciated assets to its shareholders, or sell appreciated assets and distribute the sale proceeds in connection with a complete liquidation to its shareholders, without recognizing gain. Section 1374 prevents a corporation from circumventing General Utilities repeal by converting to S corporation status before distributing its appreciated assets to its shareholders, or selling its appreciated assets and distributing the sale proceeds in connection with a complete liquidation to its shareholders.
 
Specifically, section 1374 imposes a tax on an S corporation’s net recognized built-in gain attributable to assets that it held on the date it converted from a C corporation to an S corporation for the 10-year recognition period beginning on the first day the corporation is an S corporation. Under section 1374, the total amount subject to tax is limited to the S corporation’s net unrealized built-in gain (NUBIG), which is the “aggregate net built-in gain of the corporation at the time of conversion to S corporation status.” See H.R. Conf. Rep. No. 99-841, at II-203 (1986). Section 1374 also imposes a tax on an S corporation’s net recognized built-in gain attributable to assets that it acquired in a carryover basis transaction from a C corporation for the 10-year recognition period beginning on the day of the carryover basis transaction. The legislative history of section 1374 provides that each acquisition of assets from a C corporation is subject to a separate determination of the amount of net unrealized built-in gain and is subject to a separate 10-year recognition period. See H.R. Rep. No. 100-795, at 63 (1988).
 
Sections 337(d) and 1374(e) authorize the Secretary of the Treasury to prescribe regulations as necessary to carry out the purposes of General Utilities repeal generally and section 1374 specifically. The Treasury Department and the IRS have promulgated regulations consistent with these provisions. See, e.g., §§1.337(d)-4 through 1.337(d)-7, 1.1374-1 through 1.1374-10.
 
Under §1.1374-3, an S corporation’s NUBIG generally is the amount of gain the S corporation would recognize on the conversion date if it sold all of its assets at fair market value to an unrelated party that assumed all of its liabilities on that date. Consistent with the legislative history of section 1374, section 1374(d)(8) and §1.1374-8 require a separate determination of the amount subject to tax under section 1374 for the pool of assets the S corporation held on the date it converted to C status and each pool of assets acquired in a carryover basis transaction from a C corporation.
Under the current rules, therefore, if X, a C corporation, elects to be an S corporation when it owns all of the stock of Y, a C corporation, X’s NUBIG will reflect the built-in gain or built-in loss in the Y stock. That built-in gain or built-in loss may be duplicative of the built-in gain or built-in loss in Y’s assets. If Y later transfers its assets to X in a liquidation to which sections 332 and 337(a) apply, the built-in gain and built-in loss in Y’s assets may be reflected twice: once in the NUBIG attributable to the assets X owned on the date of its conversion (including the stock of Y) and a second time in the NUBIG attributable to Y’s former assets acquired by X in the liquidation of Y. A similar result would obtain if, on the date of its conversion to an S corporation, X owned less than 80 percent of the stock of Y and later acquired the assets of Y in a reorganization to which section 368(a) applies. These results are inconsistent with the fact that a liquidation to which sections 332 and 337(a) apply, and the acquisition of the assets of a corporation some or all of the stock of which is owned by the acquiring corporation in a reorganization under section 368(a), generally have the effect of eliminating the built-in gain or built-in loss in the redeemed or canceled stock of the liquidated or target corporation.

In the course of developing these proposed regulations, the Treasury Department and the IRS considered a number of approaches to address the issue raised by the situations described above. In particular, the Treasury Department and the IRS considered adopting an approach that would provide for a single determination of NUBIG for all of the assets of an S corporation and, thus, a single determination of the amount subject to tax under section 1374. While this approach may have produced results similar to those that would have been produced had the S corporation remained a C corporation and acquired the assets of another C corporation, it was rejected because such an approach appears to be inconsistent with the legislative history of section 1374, which seems to mandate a separate determination of tax for each pool of assets. See H.R. Rep. No. 100-795, at 63.

Instead, these regulations adopt an approach that adjusts (increases or decreases) the NUBIG of the pool of assets that included the stock of the liquidated or acquired C corporation to reflect the extent to which the built-in gain or built-in loss inherent in the redeemed or canceled C corporation stock at the time the pool of assets became subject to the tax under section 1374 has been eliminated from the corporate tax system in the liquidation or reorganization. These proposed regulations provide that, if section 1374(d)(8) applies to an S corporation’s acquisition of assets, some or all of the stock of the C corporation from which such assets were acquired was taken into account in the computation of NUBIG for a pool of assets of the S corporation, and some or all of such stock is redeemed or canceled in such transaction, subject to certain limitations, the NUBIG of the pool of assets that included the C corporation stock redeemed or canceled in the transaction (other than stock with respect to which a loss under section 165 is claimed) is adjusted to eliminate any effect any built-in gain or built-in loss in the redeemed or canceled C corporation stock had on the initial computation of NUBIG for that pool of assets. For this purpose, stock that has an adjusted basis that is determined (in whole or in part) by reference to the adjusted basis of any other asset held by the S corporation as of the first day of the recognition period (i.e., stock described in section 1374(d)(6)) is treated as taken into account in the computation of the NUBIG for the pool of assets of the S corporation.

Adjustments to NUBIG under these proposed regulations, however, are subject to two limitations. First, the NUBIG is only adjusted to reflect the amount of the built-in gain or built-in loss that was inherent in the redeemed or canceled stock at the time the pool of assets became subject to tax under section 1374 that has not resulted in recognized built-in gain or recognized built-in loss at any time during the recognition period, including on the date of the acquisition to which section 1374(d)(8) applies. For example, suppose that on the date X, a C corporation, converts to S corporation status, it owns the stock of Y, which has a basis of $0 and a value of $100. The gain inherent in the Y stock contributes $100 to X’s NUBIG. During the recognition period and prior to the liquidation of Y, Y distributes $20 to X in a distribution to which section 301(c)(3) applies. That amount is recognized built-in gain under section 1374(d)(3). If Y later distributes its assets to X in a distribution to which sections 332 and 337(a) apply, pursuant to these regulations, X must adjust its original NUBIG to reflect the elimination of the Y stock. X will reduce that NUBIG by $80, the original built-in gain in such stock ($100) minus the recognized built-in gain with respect to such stock during the recognition period ($20).

Second, an adjustment cannot be made if it is duplicative of another adjustment to the NUBIG for a pool of assets. This rule is intended to prevent more than one adjustment to the NUBIG of a pool of assets for the same built-in gain or built-in loss stock.

Any adjustment to NUBIG under these proposed rules will only affect computations of the amount subject to tax under section 1374 for taxable years that end on or after the date of the liquidation or reorganization. It will not affect computations of the amount subject to tax under section 1374 for taxable years that end before the date of the liquidation or reorganization.

Hope this helps...   I am not a tax expert but have been down this road before!

Maybe pro rate isn't the correct term but one thing is for certain, if the agency can not identify specific assets prior to the conversion to a "S" status the ability to prove what was there before and after becomes a very fine line. One of the responses above suggests a valuation at the time the conversion occurs. I believe that more is necessary to make a solid case for using both tax provisions in the event of a sale.

Recently, an agency went from a "C" to an "S." On the date that this occurred, the agency separated its books of business. In other words, all existing business on the books was labeled for descriptive purposes Agency "C" for renewal purposes and all new business and their subsequent renewals were written to Agency "S." An appraisal of Agency "C" would certainly be a good thing but what really happens is 7 or 8 years down the road, the agency is actually able to provide evidence of the book of business assets that are subject to "C" taxes and the same with "S" provisions.

Of course what will happen in 7 to 8 years is what everyone should know is that Agency "C" without new business will diminish even with a great retention ratio. And, of course in 7 to 8 years Agency "S" will have grown (or at least that would be the hope). This will provide a clean method of ascertaining what is taxed under the "C" rules and what is taxed as "S" rules. The valuation that is completed at the time of the sale will have very specific evidence and data to support the amount applied.