Unlike traditional C-Corporations, S-Corporations are pass-through entities, meaning the corporation's income and losses pass through to the shareholders' personal tax returns. This structure helps to avoid double taxation of C-Corporations, as shareholders are taxed at their individual income tax rates only. As a result, S-Corporations usually do not get taxed, nor do they pay corporate-level taxes.
However, in rare instances, S-Corporations that were previously C-Corporations may be subject to various corporate-level taxes.
If a certain event occurs within the former C-Corporation, that corporation may have to pay certain taxes as an S-Corporation. The taxes that S-Corporations can be subject to are the Built-In-Gains Tax, Excess Net Passive Income Tax, LIFO Recapture Tax, and the Investment Credit Recapture Tax.
One of the rare taxes that an S-Corp may be subject to is the Built-In Gains (BIG) tax. This tax is intended to prevent these corporations from avoiding corporate-level tax on the appreciation of assets that occurred while they were C-Corporations. The recognition period, during which the BIG tax can apply, was initially ten years but has been reduced to five years since 2011. Therefore, if an S-Corporation sells an asset that appreciated in value while it was a C-Corporation within this five-year period, it may be subject to the built-in gains tax.
The net recognized built-in gain is the lesser of the gain on the sale of the asset or the built-in gain on the S-Corp conversion date. The built-in gain at conversion is determined by subtracting the original cost/basis of the assets from the fair market value (FMV) of the asset on the date the C-Corp converts to an S-Corp. The BIG tax is then calculated by applying the corporate tax rate to the net recognized built-in gain.
For example: suppose a corporation was a C-Corporation until December 31, 2022, and then converted to an S-Corporation on January 1, 2023. It had an asset with a basis of $100,000 when it was a C-Corporation, which appreciated to $500,000 by the time of the S election. If this asset is sold for $600,000 during the recognition period, then the tax would be calculated as follows:
The S-Corporation reports this tax on Form 1120-S, U.S. Income Tax Return for an S-corporation, and the tax is paid by the S-Corporation (corporate-level).
The built-in gains tax ensures that the corporation pays tax on the increase in value of its assets that occurred while it was a C-Corporation, maintaining the integrity of the corporate tax system.
Another type of tax that an S-Corp may be liable for at a corporate level is the Excess Net Passive Income Tax (ENPIT). This tax is imposed on S-Corporations that have accumulated earnings and profits (AE&P) from their previous status as a C-Corporation and generate passive investment income that exceeds 25% of their gross receipts for a given tax year.
For example: let's consider an S-Corporation that was previously a C-Corporation, which had AE&P having the following financials for the tax year:
To determine if any ENPIT exists, the following would be done:
It is important to know that if an S-Corporation has been an S-Corporation since its inception or has no AE&P from previous years as a C-corporation, then this tax does not apply.
The Excess Net Passive Income Tax is designed to prevent S-Corporations that previously operated as C-Corporations from taking advantage of the pass-through tax status while earning substantial income from passive investments. This tax provision aims to ensure that such S-Corporations are not unfairly benefiting from their prior C-Corporation status by shielding their passive investment income from higher corporate tax rates.
The LIFO Recapture Tax is an additional corporate-level tax that may be imposed on an S-Corp. This tax is triggered when a C-Corporation, which previously used the LIFO (Last-In, First-Out) method, elects to become an S-Corporation or when a C-Corporation transfers LIFO inventory to an S-corporation at its basis rather than its fair market value.
The LIFO recapture amount is calculated as the difference between the inventory value under the FIFO (First-In, First-Out) method and the LIFO method at the end of the last tax year in which the corporation was a C-Corporation. This amount is included in the corporation's gross income for that previous year as a C-Corporation. The additional tax liability generated by including the LIFO recapture amount in income is payable in four equal installments. The first installment is due by the due date (without extensions) of the tax return for the last year when the corporation was a C-Corporation. Corporations must report this recapture amount and the associated tax on their tax returns and attach detailed calculations showing how the LIFO recapture amount was determined. For tax purposes, the S-Corporation must include the LIFO recapture amount in its taxable income in the year of the change.
To understand the concept at work, suppose a C-Corporation named MSG Corp uses the LIFO (Last-In, First-Out) method to account for its inventory. On December 31, 2023, MSG Corp decided to convert to an S-Corporation effective January 1, 2024. The inventory values under LIFO and FIFO at the end of 2023 are as follows:
Steps to Calculate LIFO Recapture Tax:
The LIFO recapture tax for MSG Corp amounts to $42,000 and is payable over four years, with each installment totaling $10,500. The initial $10,500 installment is due by the original deadline of the tax return for the last year as a C-Corporation (without extensions), while the remaining installments are payable in subsequent years.
The provision for LIFO Recapture Tax is designed to prevent corporations from avoiding income tax that would have been recognized under the FIFO (First In, First Out) method by changing to an S-corporation status after using LIFO (Last In, First Out). This provision ensures that tax liabilities are adjusted to account for changes in accounting methods and corporate structure, maintaining fairness and preventing manipulation of the tax system.
The final type of corporate-level tax an S-Corp may be subject to is the Investment Credit Recapture Tax. This type of recapture tax involves the potential requirement to pay back certain tax credits that were previously claimed under the general business credit when the company was a C-Corporation, specifically the investment credit. The investment credit includes several components such as the Rehabilitation Credit, Energy Credit, and other credits that fall under Form 3468. Recapture is triggered when the property used to claim the investment credit is disposed of or its use is significantly altered before the end of the recapture period (typically five years). The amount of credit to be recaptured is generally proportional to the time remaining in the recapture period.
For example, if the property is disposed of two years into a five-year recapture period, 60% of the credit might need to be recaptured. The recapture of the investment credit is determined and reported using Form 4255. The S-Corporation must include this form with its tax return for the year in which the recapture event occurs. Since the credit was claimed during the years when a company was a C-Corporation, the recapture tax is paid at the corporate level, not passed through to the shareholders.
To demonstrate how an S-corporation (formerly a C-Corporation) would handle the recapture of an investment credit, let’s consider the case of MSG Manufacturing Inc.: It was initially established as a C-Corporation in 2015. In 2019, MSG Manufacturing invested in specialized machinery and claimed an investment tax credit of $50,000 with a 5-year recapture period on Form 3468. In 2020, MSG Manufacturing elected to convert to an S-corporation.
In 2023, the company decided to sell the machinery as it was upgrading to more advanced technology. Since the property was disposed of within the recapture period, the entire $50,000 credit initially claimed in 2018 is now subject to recapture. As a result, MSG Manufacturing completed Form 4255, Recapture of Investment Credit, to calculate the recapture amount. Assuming the calculation from Form 4255 yields a 10% recapture rate for a 4th year disposal of specialized machinery, the recapture investment credit tax would amount to $5,000 (50,000 x 10%).
In this scenario, MG Manufacturing Inc. is responsible for paying the $5,000 recapture tax at the corporate level due to the disposal of assets within the recapture period that were initially purchased and credited during its tenure as a C-Corporation. The recapture tax is then reported on Form 1120-S, U.S. Income Tax Return of MSG Manufacturing, for the year 2023.
The investment credit recapture tax is a provision that aims to ensure that the tax benefits received from claiming the investment credit align with the economic or environmental benefits the assets intend to generate over a specified period. This provision is designed to prevent any misuse or misallocation of tax benefits and to ensure that the benefits received under the C-Corporation status are accurately adjusted when the credited assets are disposed of. By incorporating this provision, the tax system seeks to maintain fairness and integrity in utilizing investment credits and their associated tax benefits. The investment credit recapture tax ensures that the tax benefits provided by the investment credit align with the intended economic or environmental benefits the assets should provide over a certain period. This also ensures that the tax benefits gained under the C-corporation status are appropriately adjusted upon the disposal of the credited assets.
S-Corporations are typically not subject to corporate-level taxes because they pass their income through to their shareholders. However, as outlined in this article, certain circumstances can lead to S-Corporations being liable for built-in gains tax, excess passive investment tax, LIFO recapture tax, and investment credit recapture tax.
These tax provisions ensure that S-Corporations with specific characteristics, such as those transitioning from C-Corporation status, contribute their fair share of taxes following the overarching tax principles that apply to corporate and individual taxation.
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