Sixteen years ago, Biff, Buffy, and Buffy, Jr. organized Beach Wear Inc. (BWI) t
ID: 2425039 • Letter: S
Question
Sixteen years ago, Biff, Buffy, and Buffy, Jr. organized Beach Wear Inc. (BWI) to sell beach wear throughout California. The sole class of common stock of BWI is owned by Buffy (60%), and her husband, Biff (20%), and Buffy, Jr (20%). On December 1 2016, BWI files an S election. As of December 31 of the same tax year, BWI's balance sheet includes the following:
Assets AB FMV
Accounts Receivable $0 $300,000
Payments Due Under:
Installement Sale 450,000 600,000
Machinery 0 225,000
During the next tax year, BWI collected the accounts receivables receiving $300,000. BWI also collected the one of two payments still due on the installment sale of $300,000. BWI's taxable income for the same tax year is $900,000.
New assumption: BWI invested in common stock of another corporation, Apple Computer, which represented a fractional interest in the company. BWI elected S status beginning Janurary 1, of the year specified for the exam. BWI purchased the Apple stock for $300,000 in January, 10 years ago. On December 31, of last year, the stock was still worth $300,000. On December 30, same specified year, the stock was sold for $900,000. BWI had earnings on profits as a C corporation of $600,000 on December 31, last year. BWI had the following items of income and expenses for December 31, this specified year.
Operational Income $1,155,000
Tax Exempt Income 45,000
Gain from sale of Apple Stock 600,000
Total Income $1,800,000
Operational Expense 600,000
Depreciation 15,000
Investment Advice 18,000
Interest Expense 117,000
Total Expenses $750,000
Total Net Income $1,050,000
a Built-in gains tax is due
b Non Passive investment income tax is due
c Passive investment income tax is due since the gains from the stock and tax exempt income totalling $645,000 are more than 25% of the $1,800,000 gross receipts.
d None of the above
Which answer is the correct and why?
Explanation / Answer
Built-In Gains Tax
The built-in gains tax is a corporate level tax on the net recognized “built-in gain” of an S corporation during the ten-year period beginning on the effective date of its S election. The tax does not apply to an S corporation that has been an S corporation for each of its taxable years except with respect to assets acquired from a C corporation in a tax-free transaction. As a result, its application will generally be limited to former C corporations that converted to S corporations and to S corporations that have merged with C corporations since that date.
The tax is imposed at the highest corporate income tax rate on the lesser of
(a) the corporation s recognized built-in gain for the year reduced by its recognized built-in losses,
(b) its taxable income for the year in which the built-in gain is recognized, or
(c) the amount by which its net unrealized built-in gain for all assets as of the S election date exceeds its net recognized built-in gain for all prior years.
If the corporation s net recognized built-in gain for a year exceeds the corporation s taxable income for the year, the excess is carried over and treated as a recognized builtin gain in the next taxable year. The built-in gains tax is treated as a loss having the same character as the gain giving rise to the tax, and, therefore, effectively reduces the amount of the corporation s gain required to be taken into account by its shareholders.
Tax on Passive Investment Income
An S corporation s passive investment income may be subject to tax if the corporation has accumulated earnings and profits from a period when the corporation was a C corporation. This tax, therefore, will never apply to a corporation that has always been an S corporation and has never been involved in a merger or other tax-free reorganization with a corporation that had subchapter C earnings and profits.
The tax is payable if the corporation s passive investment income exceeds 25% of its gross receipts during the taxable year. The tax is imposed at the highest corporate income tax rate on the lesser of
(a) the corporation s taxable income or
(b) its “excess net passive investment income.” Under IRC §1375(b)(1), excess net passive investment income equals the product of (a) the corporation s passive investment income reduced by any allowable deductions directly connected with the production of this income, multiplied by (b) the ratio of passive investment income exceeding twenty-five percent of gross receipts to total passive investment income. The tax may be waived in certain circumstances involving a good faith mistake as to the existence of earnings and profits. IRC §1375(d). The amount of the tax reduces the amount of the corporation s passive investment income required to be taken into account by its shareholders.
Conclusion
The temporary five-year recognition period for built-in gains added by ATRA effectively eliminates the carryover of built-in gain to a later year if that year is after the five-year recognition period. If the recognition period is later lengthened , the change to the recognition period will not change that result. So Built in gains Tax is better option.
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