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Tax Section Website › Newsletters › Tax Assessments, June 2011 › The Taxable Sale of S Corporation Stock or Assets: Navigating Section 338(h)(10) and the Built-in Gains Tax

The Taxable Sale of S Corporation Stock or Assets: Navigating Section 338(h)(10) and the Built-in Gains Tax

Article Date: Monday, June 27, 2011

Written By: C. Wells Hall, III

Editor's Note: This is the second of two installments on recent developments of interest to the S corporation advisor.

One of the advantages of S corporation status is the opportunity to sell the assets of the business without a corporate level tax, or for the shareholders to sell the stock with an election to treat the sale as a qualified stock purchase and a deemed asset sale under Section 338(h)(10) of the Code. The asset sale, or deemed asset sale, permits the buyer to obtain a full basis step-up for the assets of the business, including goodwill subject to amortization.

Where the target has been an S corporation for its entire history and has not acquired the assets of a C corporation in a carryover basis transaction within the built in gains tax recognition period (formerly 10 years; reduced to 7 years for sales in 2009 and 2010, and 5 years for sales in 2011, reverting to 10 years for 2012 and subsequent years), the corporate level gain from an asset sale (or a deemed asset sale) is, for federal (and most state) income tax purposes, subject to only a single level of tax at the shareholder level. The amount realized is allocated among the individual assets in accordance with section 1060 and the section 338 regulations as applicable. The character of the gain or loss is determined by reference to the nature of the corporation's purpose in holding the particular asset sold, e.g., depreciable real property used in a trade or business or section 1231 property, inventory, depreciation subject to recapture, or property held for investment, including corporate goodwill.
Where the corporation has acquired assets of a C corporation in a tax-free reorganization within the built-in gains recognition period, or converted to S status during such period, the corporate level tax applies to the corporation's built-in gains. This provision prevents a C corporation from avoiding the corporate level tax by converting to S status immediately before a planned sale of assets. (Note, however, the Tax Court decision in Ringgold, discussed at the conclusion of this article, where aggressive asset valuations minimized the built-in gains tax on a sale that occurred 11 months after the effective date of the S election.)

The S Corporation and Section 338(h)(10)
Where 80 percent or more of the stock of an S corporation is being sold to a corporate purchaser (a qualified stock purchase or "QSP"), all shareholders of the S corporation and the purchasing corporation may elect to treat the stock sale as a deemed asset sale for federal income tax purposes under Section 338(h)(10). This results in shareholder level gain or loss on the deemed liquidation. The character of the gain may be a significant consideration when the sale is treated as a deemed asset sale and the target corporation has ordinary income assets or recapture items. and may be required to recognize ordinary income in the year of the sale passed through to the selling shareholders. Further, the purchase price in a deemed asset sale is grossed up to include liabilities assumed or taken subject to (the "adjusted deemed sale price or "ADSP"). Thus, in various instances, a straight-up sale of stock may produce a more favorable result to the selling shareholders than a deemed asset sale and liquidation under Section 338(h)(10). Regulations endorse the use of the installment sale method for section 338(h)(10) elections made by S corporation target shareholders. Reg. §1.338(h)(10)-1(d)(8).
The election is made jointly by the purchasing corporation (or its common parent) and all of the S shareholders by filing Form 8023. Consent of all S shareholders is required even if some of the shareholders do not sell their shares. Reg. §1.338(h)(10)-1(c)(2). The section 338(h)(10) election must be made no later than the 15th day of the 9th month after the month in which the acquisition date occurs. Reg. §1.338(h)(10)-1(c)(3). See Rev. Proc. 2003-33 (automatic extensions and late election relief). Treas. Reg. §301.9100-3. Once made, the election is irrevocable. Reg. §1.338(h)(10)-1(c)(3).

The Step-Transaction Doctrine and Kimble-Diamond. A fundamental, judicially-created doctrine of Federal income taxation is the "step-transaction" doctrine, frequently applied in the corporate income tax area. Basically, the step-transaction requires that, in addition to the form of the transaction selected by the taxpayer, the IRS and the courts will look to the substance of the transaction in assessing its tax impacts. Therefore, where a planned or integrated series of "steps" are part of a single transaction, the steps will be collapsed to determine the type and consequences of the transaction.
Prior to the enactment of section 338, the step-transaction doctrine was applied where a corporation purchased the stock of a target and immediately liquidated the target to acquire its assets. The purchase of the stock was ignored, and the transaction was treated for tax purposes as an asset sale for both the buyer and the seller. The application of the step transaction to recast a stock sale into an asset purchase, by application of former Section 334(b)(2), was known as the Kimbell-Diamond doctrine based on the historic case Kimbell-Diamond Milling Co. v. Comm'r, 14 TC 74 , aff'd per curiam, 187 F.2d 718 (5th Cir.).

The Kimbell-Diamond doctrine was strongly criticized by commentators as creating uncertainty and the prospect for possibly whipsawing an unsuspecting seller of stock into a "double-tax" asset sale. It was replaced in 1982 by Section 338. The use of Section 338 was reduced to a large extent by the 1986 repeal of the General Utilities doctrine. General Utilities permitted a corporation to distribute its assets, or the proceeds of the sale of assets, to its shareholders in complete liquidation without a corporate level tax. After the Tax Reform Act of 1986, the corporate level tax could no longer be avoided by the complete liquidation of the corporation after a sale transaction.

The 338(h)(10) election is now the most commonly taken route to section 338, unless the target has substantial loss carryovers available to offset the corporate level gain triggered by the deemed asset sale and liquidation. Under section 338(d)(3), a section 338 transaction requires that there be a qualified stock purchase or QSP (involving the purchase of 80% or more of the target's stock within a 12-month testing period).  

Still, under step-transaction principles, the acquisition of target stock solely for stock of the acquiring corporation in an apparent Type B reorganization could be recast as a Type C reorganization if the acquiring corporation immediately caused the target to be liquidated or otherwise liquidated the target in a planned (step transaction doctrine) sequence.

Step-Transaction Doctrine Turned Off for QSP. In Rev. Rul. 90-95, the Service ruled that the step transaction doctrine does not apply to treat a QSP followed by the immediate liquidation of the target into the acquiring corporation as an asset purchase. The subsequent liquidation is ignored even if it was planned as an integral part of the transaction. The rationale for the Service's position was that Section 338 overrode the step-transaction doctrine as espoused by Kimbell-Diamond. CCA 200230026 (April 15, 2002).

In Rev. Rul. 2001-46, the Service ruled that, under certain circumstances, such as the qualification for a statutory merger under Section 368(a)(1)(A), step transaction principles do apply to characterize the transaction prior to the determination of whether a QSP has been made. In such cases, Rev. Rul. 90-95 will not apply and there will be no QSP.

In July 2003, the Service issued final and temporary regulations that permit taxpayers to "turn off" the step transaction doctrine by making a Section 338(h)(10) election in certain multi-step transactions, as set forth in Rev. Rul. 2001-46.  The notion is that where a Section 338 election is made by the parties, the transaction will be treated as a deemed asset sale and the step transaction doctrine will not apply even though the target corporation is immediately liquidated into the acquisition subsidiary or acquiring corporation. Reg. §1.338(h)(10)-1(c)(2). If the Section 338(h)(10) election is not made, Rev. Rul. 2001-46 will continue to apply so as to recharacterize the transaction as a reorganization under section 368(a). See Reg. §1.338(h)(10)-1(e), Ex. 11.

Reverse Merger of Acquiring Corporation into Target Corporation Treated as Qualified Stock Purchase. When the acquiring corporation (or a wholly owned subsidiary of the acquiring corporation) is merged into the target S corporation (a "reverse merger") and the former shareholders of the target receive cash consideration, the transaction is treated as a qualified stock purchase eligible for treatment as a deemed asset sale under section 338(h)(10). Rev. Rul. 90-95, supra. The gain from the deemed asset sale is passed through to the cashed out shareholders of the S corporation.

Forward Merger of Target into Acquiring Corporation (or LLC) Treated as Asset Sale.
The same tax consequences resulting from a section 338(h)(10) election may be accomplished if the target company is acquired through a forward merger of the target into the acquiring corporation, where the selling shareholders receive cash and no stock (a "cash merger"), in which event the transaction is treated as an asset sale. Rev. Rul. 69-6. Similarly, the forward cash merger of the target corporation into a LLC taxable as a partnership or disregarded as an entity separate from its sole owner is treated as a deemed asset sale, with the buyer obtaining a basis in the assets equal to the purchase price. The transaction is treated as if the assets were sold by the target and the proceeds distributed to the selling shareholders in a liquidating distribution. PLR 200628008.

The availability of Section 338(h)(10) permits the parties to an acquisition of an S corporation to structure the transaction in a tax efficient manner, with one level of tax for the sellers on the proceeds of sale. The purchaser is entitled to recover its investment without adverse tax consequences through depreciation of the cost of the tangible assets and amortization of the cost of the intangible assets, including goodwill.

The Built-in Gains Tax

As noted above, section 1374 imposes a corporate-level tax on the built-in gains of S corporations that were previously C corporations triggered during the "recognition period." The tax rate is presently 35% (the highest rate of tax imposed under Section 11(b)) on the S corporation's "net recognized built-in gain." Section 1374(b)(1).

Statutory Changes to the Section 1374 Recognition Period. Prior to the enactment of the 2009 Recovery Act, the "recognition period" was generally defined as the 10-year period following the first day of the tax year for which the corporation was an S corporation. To provide relief to small businesses faced with the need to dispose of assets to satisfy debts as a result of the financial crisis, the 2009 Recovery Act amended section 1374(d)(7) to reduce the recognition period from ten years to seven years for sales of assets occurring in 2009 and 2010. . Section 1374(d)(8)(B)(i).

Section 2014(a) of The Creating Small Business Jobs Act of 2011 amends Section 1374 to reduce the recognition period to 5 years for taxable years beginning in 2011. The provision does not apply to years beginning after 2011- unless further legislation is enacted, the recognition period reverts to 10 years for 2012 and subsequent years.

New Section 1374(d)(7)(B) may apply differently (based on calendar years rather than taxable years) to assets acquired in a carryover basis transaction under Section 1374(d)(8). Section 1374(d)(8) and Reg. §1.1374-8(a) provide that if an S corporation acquires any asset in a transaction in which the S corporation's basis in the acquired asset is determined in whole or in part by reference to a C corporation's basis in such asset, Section 1374 applies to the net recognized built-in gain attributable to the asset so acquired.

Separate Tranches of Assets Require Separate Recognition Periods and Section 1374 Tax Attributes. Reg. §1.1374-8(b) provides that for purposes of applying the built-in gain tax, separate recognition periods apply with respect to the assets the S corporation held when it became an S corporation, assets acquired in one Section 1374(d)(8) transaction, and assets acquired in another Section 1374(d)(8) transaction. Similarly, an S corporation's Section 1374 attributes when it became an S corporation may only be used to reduce the built-in gain tax imposed on dispositions of assets the S corporation held at that time. Likewise, an S corporation's Section 1374 attributes acquired in a Section 1374(d)(8) transaction may only be used to reduce the built-in gain tax imposed on dispositions of assets the S corporation acquired in such transaction.

Consequently, every asset acquisition by an S corporation from a C corporation (or from an S corporation subject to the built-in gain tax) in a carryover basis transaction, including a stock purchase followed by a QSub election, will result in a separate tranche of assets subject to a separate determination as to the amount of net unrealized built-in gain and net recognized built-in gain, as well as to a separate recognition period beginning with the date of the purchase transaction. This rule applies to all S corporations, regardless of whether they have always been S corporations.

Recent Rulings and Cases Involving the BIG Tax
IRS Confirms that Payment of Compensation to Shareholder-Employees Within the First 2 1/2 Months of Conversion to S Corporation Status Constitutes Built-In Deduction Item for Purposes of Built-In Gain Tax. In PLR 200925005, the IRS ruled that the payment of certain salary expenses and other outstanding costs relating to the production of the outstanding accounts receivable of the corporation at the time of its conversion to S status, including the payment of compensation to shareholder-employees of the corporation within the first 2 ½ months following the corporation's conversion to S corporation status, would constitute built-in deduction items reducing the amount of net unrealized built-in gain (NUBIG), which serves as an overall cap on the amount that may be subject to the built-in gain tax during the recognition period.

Under the facts of the ruling, the taxpayer is a cash basis C corporation with a calendar tax year. The corporation is a personal service corporation that is wholly-owned by a number of professionals. The corporation bills its clients for the services performed by the professionals and when invoices are paid, the corporation pays salaries and wages to the professionals. Additionally, the corporation has other employees, such as non-shareholder clerical staff and non-shareholder professionals to which it pays wages.

The taxpayer had built-in gain from its outstanding accounts receivable on the effective date of the S election. The taxpayer requested the ruling to determine whether certain salary expenses and other outstanding costs relating to the production of the outstanding accounts receivable as of the date of the corporation's conversion to S status would qualify as built-in losses under Section 1374, and specifically, whether the amounts paid to its shareholder-employees within the first 2 1/2 months of the recognition period for salary and wage expenses that are related to the production of accounts receivable that are outstanding as of the effective date of the S election would constitute built-in deduction items under Section 1374(d)(5)(B).

In addition to gain recognized on the sale or disposition of an appreciated asset held by a corporation as of the date of its conversion to S corporation status during the recognition period, any other item of income that is properly taken into account during the recognition period but is attributable to periods prior to the date of the corporation's conversion to S status is treated as a recognized built-in gain for the tax year in which it is properly taken into account. This specifically includes the collection (after the conversion to S corporation status) of pre-conversion accounts receivable by a cash-basis taxpayer (i.e., the accounts receivable of a cash-basis taxpayer constitutes a built-in gain item for purposes of the built-in gain tax imposed under Section 1374 on corporations converting from C corporation status to S corporation status).

"Recognized built-in loss" means any loss recognized during the recognition period on the disposition of any asset to the extent that the S corporation can show that (1) such asset was held by it as of the effective date of its conversion to S status and (2) the loss recognized does not exceed the amount of such asset's built-in loss (the excess of the corporation's adjusted tax basis in the asset over the asset's fair market value) as of the effective date of the corporation's S election. Sections 1374(d)(3) and 1374(d)(4).

Section 1374(d)(5)(B) further provides that any amount which is allowable as a deduction during the recognition period but which is attributable to a period prior to the date of the corporation's conversion to S status will be treated as a recognized built-in loss for the tax year for which it is allowable. An example is the payment, after the conversion to S status, of an expense item that accrued prior to the date of conversion. This type of item is generally referred to as a "built-in deduction item."

In determining whether an item constitutes a built-in income or built-in deduction item under Sections 1374(d)(5)(A) and 1374(d)(5)(B), the focus is therefore on whether such item is attributable to a period prior to the date of the corporation's conversion to S status. The IRS adopted an accrual method rule in determining whether an income item or a deduction item is attributable to a period prior to the date of the corporation's conversion to S status. Specifically, Reg. §1.1374-4(b)(1) provides that any item of income properly taken into account during the post-conversion recognition period is recognized built-in gain if the item would have been included in gross income before the date of conversion to S status by a taxpayer using the accrual method of accounting. Likewise, Reg. §1.1374-4(b)(2) provides that any item of deduction properly taken into account during the post-conversion recognition period is recognized built-in loss if the item would have been properly allowed as a deduction against gross income before the date of conversion to S status by a taxpayer using the accrual method of accounting. Consequently, the benchmark for whether an item constitutes a built-in income or built-in deduction item under Section 1374(d)(5) is whether such item would have been includable in income, or allowed as a deduction, prior to the corporation's conversion to S status if the corporation had been an accrual basis taxpayer. The regulations generally provide that in making such determination, all rules applicable to an accrual basis taxpayer apply, specifically including Section 267(a)(2) (relating to the timing of deductions by an accrual basis payor with respect to a cash basis payee that is a related party) and Section 404(a)(5) (relating to the timing of deductions for deferred compensation).
Section 267(a)(2) generally prohibits an accrual basis taxpayer from deducting an item payable to a cash basis payee until the amount is includable in the cash basis payee's income if the payor and payee are related within the meaning of Section 267(b). Similarly, Section 404(a)(5) generally prohibits a corporation from taking a deduction for any amounts deferred under a non-qualified deferred compensation plan, until such amounts are includable in the employee's gross income. The legislative history and the House Report which accompanied TAMRA provides the following explanation:

As an example of these built-in gain and loss provisions, in the case of a cash basis     personal service corporation that converts to S status and that has receivables at the
time of the conversion, the receivables, when received, are built-in gain items. At the same time, built-in losses would include otherwise deductible compensation paid after the conversion to the persons who performed the services that produced the receivables, to the extent such compensation is attributable to such pre-conversion services. To the extent such built-in loss items offset the built-in gains from the receivables, there would be no amount subject to the built-in gains tax. H. R. Rep. No. 100-795, 100th Cong., 2d Sess. 63-64.

In determining whether an item would be deductible by an accrual basis taxpayer for purposes of the built-in gains tax, however, the regulations modify the rules generally applicable to accrual basis taxpayers in several respects. First, Reg. §1.1374-4(c)(1) provides that any amounts properly deducted in the recognition period under Section 267(a)(2), relating to payments to related parties, will be treated as recognized built-in loss to the extent that the following requirements are met:

• All events have occurred that establish the fact of the liability to pay the amount, and the exact amount of the liability can be determined, as of the date of conversion to S status; and

• The amount is paid in the first 2 1/2 months of the recognition period or is paid to a related party owning (under the attribution rules of Section 267) less than 5% (by voting power and value) of the corporation's stock, both as of the date of conversion to S status and when the amount is paid.

Additionally, Reg. §1.1374-4(c)(2) provides that any amount properly deducted in the recognition period under Section 404(a)(5), relating to payments for deferred compensation, will be treated as recognized built-in loss to the extent that the following requirements are met:

• All events have occurred that establish the fact of the liability to pay the amount, and the exact amount of the liability can be determined, as of the date of conversion to S status; and

• The amount is not paid to a related party to which Section 267(a)(2) applies.

An item classified as a built-in income item will be treated as a recognized built-in gain when taken into account by the S corporation during the recognition period, and thus, potentially be subject to the built-in gain tax imposed under Section 1374. Section 1374(d)(5)(A). Under Section 1374(d)(5)(C), a built-in income item also has the effect of increasing the corporation's NUBIG. NUBIG is important because it is an overall cap on the amount that may be subject to the built-in gain tax during the recognition period. Likewise, an item that is classified as a built-in deduction item will be treated as a recognized built-in loss when allowed as a deduction to the S corporation during the recognition period, and thus, will be available to offset any built-in gains recognized by the S corporation during such tax year. Section 1374(d)(5)(B). A built-in deduction item also has the effect of decreasing the corporation's NUBIG under Section 1374(d)(5)(C).

Even if an item does not constitute a built-in loss item within the meaning of Section 1374(d)(5)(B), it still may potentially affect a corporation's NUBIG. For example, an accrued bonus payable to a C corporation's sole shareholder-employee that is not paid by the corporation within the first 2 1/2 months following the date of its conversion to S status would not constitute a built-in deduction item under Section 1374(d)(5)(B) since, under both Sections 267(a)(2) and 404(a)(5), such amount would not have been deductible by the corporation prior to the date of its conversion if it were an accrual basis taxpayer. The accrued bonus would, however, still serve to reduce the corporation's NUBIG limitation since Reg. §1.1374-3(a)(2) provides that NUBIG is decreased by the amount of any liability of the corporation to the extent the corporation would be allowed a deduction on payment of such liability. In other words, the accrual method rule does not apply in determining whether a liability decreases a corporation's NUBIG.

Since built-in deduction items (such as accounts payable of cash-basis corporations) are taken into account in determining NUBIG of an S corporation under Section 1374(d)(5)(C), and the payment of such amounts is treated as a recognized built-in loss that may be matched against built-in income items (such as a cash-basis corporation's accounts receivable), a common method employed by practitioners to avoid the built-in gain tax imposed on the accounts receivable of a cash basis service corporation is to accrue bonuses (in an amount equal to its collectible receivables) to its shareholder-employees in its last tax year as a C corporation and pay such bonuses to its shareholder-employees in its first tax year as an S corporation. Even though such accrued bonuses may or may not be characterized as built-in deduction items (depending on whether they are paid in the first 2 ½ months following conversion), the effect of accruing such bonuses nevertheless may be either to eliminate the potential application of the built-in gain tax altogether by reducing the corporation's NUBIG to zero, or alternatively, if the corporation has goodwill or other appreciated assets, to minimize recognition of any built-in gains by reducing the corporation's NUBIG by the amount of such accrued bonuses.

The IRS expressly concludes in the ruling that the taxpayer's payments to its shareholder-employee of salary and wages relating to the production of accounts receivable on the effective date of the S election, if paid in the first 2 1/2 months of the recognition period, qualify as built-in loss items under Section 1374(d)(5)(B). Additionally, the IRS found that the taxpayer's payments to its non-shareholder employees of salary and wages related to the production of outstanding accounts receivable on the effective date of the S election, if paid at any time during the recognition period, will qualify as built-in loss items under Section 1374(d)(5)(B). Finally, the IRS concluded that the taxpayer's payments of other unpaid payable expenses and accounts payable related to the production of the accounts receivable outstanding on the effective date of the S election, if paid at any time during the recognition period, will qualify as built-in loss items under Section 1374(d)(5)(B). PLR 200925005 did not specifically state that any type of special bonus had to be accrued prior to the last day of the corporation's last tax year as a C corporation or require any written evidence of such accrual in the corporate minutes or other documentation. Rather, the IRS simply concluded that the payment of salary and wages to the shareholder-employees of the corporation that related to the production of the accounts receivable on the effective date of the S election would qualify as built-in loss items if paid in the first 2 1/2 months of the recognition period.

While PLR 200925005 does not address all the open questions dealing with the mechanics of accruing year end bonuses as built-in loss items, it makes it clear that the built-in gain tax on accounts receivable can be avoided by having the converted corporation pay out compensation related to such accounts receivable to its shareholder-employees within the first 2 1/2 months of the corporation's first tax year as an S corporation. This guidance is welcomed by S corporation practitioners, and this strategy will likely become the method most commonly employed to avoid imposition of the built-in gain tax on the accounts receivable of a cash basis service corporation upon conversion to S status.

S Corporation Allowed to Identify Publicly Traded Partnership Units Acquired Prior to the Conversion Date to Avoid Built-In Gain Tax. PLR 200909001 (obtained by the author of this article) addresses the application of the built-in gains tax to a sale of units in a publicly traded master limited partnership (MLP) taxed as a partnership where the S corporation or its subsidiaries own some MLP units with a holding period less than the (then applicable) 10-year recognition period and other MLP units with a holding period greater than the applicable recognition period.

The taxpayer, S, was a corporation that elected to be taxed as an S corporation on Aug. 1, 1998 (Date 1), which was more than 10 years prior to the ruling. S was engaged in the propane gas distribution business. S owned all the stock of General Partner ("GP"), which had been a QSub since Date 1 and owned all the stock of Sub1, which had been a QSub since Date 2 (Date 2 date was less than 10 prior to the ruling request). GP owned all of the outstanding interests in LLC1, a single member LLC treated as a disregarded entity. LLC1 owned all of the stock of Sub2, a corporation which had been a QSub since Date 1. Prior to Date 1, S and all of its corporate subsidiaries were taxed as C corporations.
GP owned all of the outstanding general partnership units of MLP1, a state law limited partnership. MLP1 was classified as a publicly traded partnership under Section 7704(b). While not stated in the ruling, MLP1 met the qualifying income exception under Section 7704(c) for treatment as a partnership for tax purposes and was not treated as a corporation under Section 7704(a). GP also owned all of the general partner units of the operating limited partnership (OLP2), a state law limited partnership that operates the business. MLP1 owned all of the common units of OLP2. The common units of MLP1 were publicly traded, however the general partner units of MLP1 and the general and limited partner units of OLP2 were not publicly traded.

S directly owned MLP1 common units and indirectly owned MLP1 common units through Sub1 and Sub2. As of Date 1, S, either directly or through GP, held a substantial number of MLP1 common units. Since Date 1, S acquired additional MLP1 common units for cash. Additionally, after Date 1, S made several acquisitions of unrelated target C corporations and liquidated each corporation pursuant to Section 332. As a result, pursuant to Section 1374(d)(8), the assets acquired by S pursuant to these Section 332 liquidations become subject to new 10-year recognition periods. After acquiring these assets, S contributed the assets to MLP1 for additional MLP1 common units and MLP1 general partner units and to OLP2 for additional OLP2 general partner units. Under Section 1374(d)(6), the MLP1 common units, MLP1 general partner units and OLP2 general partner units acquired pursuant to these contributions possess the same 10-year recognition period taint as the contributed assets under Section 1374(d)(8).
Finally, S represented that it had identified in its books and records the specific assets acquired in each of the C corporation acquisitions and identified the MLP1 and OLP2 units received in exchange for the contribution of those assets to MLP1 and OLP2, respectively. S also represented that it had not sold or disposed of any identified MLP1 or OLP2 units.

PLR 200909001 held that the S corporation's sale of separately identified MLP1 common units, after the units had been held for more than the 10-year recognition period under Section 1374(d)(7), will not be subject to the built-in gains tax under Section 1374(a), citing Reg. §1.1223-3(c)(2) as authority by analogy. The ruling does not express an opinion on the sale of any MLP1 or OLP2 general partner units.

Reg. §1.1223-3 deals with the determination of the holding period of a partnership interest for purposes of determining long and short term capital gain treatment. Generally, the holding period of a partnership interest is divided if the partner acquires portions of an interest at different times. The holding period of a portion of a partnership interest generally must be divided in the same ratio as the holding periods of the partner's entire partnership interest. Reg. §1.1223-3(c)(2)(ii).

However, a special rule can apply to sale of a portion of an interest in a publicly traded partnership such as MLP1. Under Reg. §1.1223-3(c)(2)(i), a partner in a publicly traded partnership may use the actual holding period of a portion of a partnership interest transferred if (i) the ownership interest is divided in identifiable units with ascertainable holding periods, (ii) the selling partner can identify the portion of the partnership interest transferred, and (iii) the selling partner elects to use the identification method for all sales or exchanges of interests in the partnership after September 21, 2000. Thus, PLR 200909001 approves the use of Reg. §1.1223-3(c)(2)(i) to avoid the imposition of built-in gains tax in this unique factual situation.

The exception contained in Reg. §1.1223-3(c)(2)(i) for purposes of determining long or short term capital gain turns on whether a partnership interest may be segregated into distinct parts for purposes of certain determinations under the Code. It follows from PLR 200909001 that if units of a MLP can be segregated for purposes of determining their long term versus short term holding period, they should be similarly segregated for purposes of determinations under Section 1374, provided that the units can be adequately traced to account for events material to Section 1374 determinations. In this respect, the regulations under Section 1374 require identification of (1) a partnership interest owned at the beginning of the recognition period and (2) disposition of the partnership interest, and also compute the S corporation's RBIG limitation by reference to the amount that would be realized if, at the beginning of the first day of the recognition period, the corporation had remained a C corporation and had sold its partnership interest (and any assets the corporation contributed to the partnership during the recognition period) at fair market value to an unrelated party, over the corporation's adjusted basis in the partnership interest (and any assets the corporation contributed to the partnership during the recognition period) at the time of the hypothetical sale. Reg. §1.1374-4(i)(1), (3), and (4)(i).

Therefore, although a partnership interest generally has been treated on a unitary basis, the segregated publicly traded partnership unit concept contained in Reg. §1.1223-3(c)(2) seems as applicable to Section 1374 as it does to the long-term versus short-term holding period determination under Section 1223. Reg. §1.704-1(b)(2)(iv)(b) provides that "(f)or purposes of this paragraph, a partner who has more than one interest in a partnership shall have a single capital account that reflects all such interests, regardless of the class of interests owned by such partner (e.g., general or limited) and regardless of the time or manner which such interests were acquired…." Similarly, Rev. Rul. 84-53 provides that a partner has a single basis in a partnership interest, even if such partner is both a general partner and a limited partner in the same partnership (the "unitary basis rule").

Although not discussed in PLR 200909001 or articulated in its conclusion, Reg. §1.1374-8(c) requires a separate determination with respect to the assets that an S corporation acquires in each Section 1374(d)(8) transaction, as well as any other assets held by the S corporation. Reg. §1.1374-4(i)(3) provides a specific rule for the application of Section 1374 to dispositions of partnership interests by S corporations: the amount that may be treated as RBIG on a disposition of a partnership interest cannot exceed the S corporation's RBIG limitation over its partnership RBIG limitation during the recognition period. Reg. §1.1374-4(i)(4)(i) provides that an S corporation's RBIG limitation is the gain the S corporation would have realized on the sale of the partnership interest at the beginning of the first day of the recognition period.    

To apply the RBIG rules to the sale of a partnership interest held by an S corporation when the partnership holds assets both subject to and not subject to Section 1374, the S corporation must bifurcate the partnership interest into Section 1374 and non-Section 1374 components and track the separate components. This requirement is in direct contravention of the unitary basis rule of Rev. Rul. 84-53.

Accordingly, PLR 200909001 reaches the correct conclusion in the context of the built-in gain tax, although the logic through which the ruling reaches the right conclusion may be criticized. See Jackel & Crnkovich, "IRS Deviates from Single Partnership Basis Approach," 76 BNA Daily Tax Rpt. J-1 (April 23, 2009).

Tax Court Determines Value of Partnership Interests Subject to the Built-In Gain Tax. In Ringgold Telephone Co. v. Comm'r, TCM 2010-103, the Tax Court determined the fair market value of a partnership interest owned by an S corporation for purposes of determining the built-in gain tax imposed under Section 1374.

The taxpayer was a C corporation which elected to be taxed as an S corporation effective Jan. 1, 2000 (the "Conversion Date"), and was engaged in providing telecommunication services to customers in Georgia and Tennessee. The taxpayer owned a 25% partnership interest in Cellular Radio of Chattanooga ("CRC"). The remaining interests of CRC were owned 25% by BellSouth Mobility, Inc. ("BellSouth"), Trenton Telephone Co. and Bledsoe Telephone Co. The primary asset of CRC was a 29.54% limited partnership interest in Chattanooga MSA Limited Partnership ("C-LP"), which provided wireless telecommunication service in Chattanooga, Tennessee. The General Partner of C-LP was wholly owned by BellSouth.

On Nov. 27, 2000, BellSouth acquired the taxpayer's 25% interest in CRC for $5,220,423. The taxpayer reported the recognized built-in gain attributable to the sale of its interest in CRC using a fair market value as of the Conversion Date of $2.6 million. The IRS, on the other hand, asserted a deficiency based on a fair market value equal to the $5,220,423 sales price of the CRC interest.

The court went through an exhaustive analysis of the evidence presented by the taxpayer's expert, the evidence presented by the IRS's expert, the probative value of the sale to BellSouth, the effect of the right of first refusal contained in the Partnership Agreement, and the unique circumstances surrounding BellSouth's purchase of the partnership interest. The court found that the taxpayer's expert was the more persuasive of the two expert witnesses, and in particular, that the taxpayer's expert was familiar with the telecommunications industry and considered the distribution history of C-LP (a factor likely to be an important consideration for a purchaser of a minority interest). However, the court noted that the taxpayer's expert failed to adequately consider the sale to BellSouth in his analysis, and the court determined that the sale to BellSouth must be taken into consideration in determining the fair market value of the interest. After considering all of the evidence in the records, the court concluded that the values yielded by the business enterprise analysis ($2.718 million), the distribution yield analysis ($3.243 million) and the BellSouth sales price ($5,220,423) should be weighted equally in arriving at the fair market value of the CRC interest, resulting in a fair market value of $3,727,141 as of Jan. 1, 2000 (notwithstanding the sale to BellSouth 11 months later for a price of $5,220,423). Finally, the court concluded that the taxpayer would not be subject to an accuracy related penalty under Section 6662 because the court concluded that the taxpayer acted with reasonable cause and in good faith.

The Tax Court decision in Ringgold suggests that aggressive valuation strategies may still pay off in minimizing the built in gains tax, even in the face of a sale of assets early in the post-S election built in gains tax recognition period. Consideration must be given to the valuation and appraisal fees, as well as the costs of a potential Tax Court proceeding, including expert witnesses and legal fees.  
In Ringgold, the recognition period was 10 years. With the possibility of a permanent reduction in the recognition period, perhaps to the 5 year period in effect for tax years beginning in 2011, advance planning may be the best option.  An S election may now be advantageous if a sale of the business is anywhere in the foreseeable future.
    
Conclusion
Many newly converted S corporations will be pleased to learn that the built-in gains recognition period has been reduced to 5 years for sales occurring in tax years beginning in 2011. An S corporation that converted from C to S status in 2006 can plan a sale in the current year, when capital gains tax rates are favorable under the 2010 Tax Act. The availability of Section 338(h)(10) permits the parties to structure the transaction in a tax efficient manner, affording the purchaser with a stepped up basis in the assets equal to the purchase price of the stock (the ADSP). The tax benefits to the purchaser – recovering its investment through depreciation and amortization deductions – may translate into a higher price for the sellers.

Mr. Hall is a partner with Mayer Brown, LLP in Charlotte.
Views and opinions expressed in articles published herein are the authors' only and are not to be attributed to this newsletter, the section, or the NCBA unless expressly stated. Authors are responsible for the accuracy of all citations and quotations.