Press Room: Tax Release

January 15, 2013

Fiscal Cliff Law May Benefit 2012 Purchasers of S Corporations

Law that averts the fiscal cliff includes beneficial rule for taxpayers who purchased stock of certain S corporations in 2012.

As a result of the impending tax rate change on capital gains (from 15% in 2012 to rates as high as 23.8 to 25% in 2013), many businesses, including S corporations, were sold in 2012 to recognize capital gain at the lower 2012 rates. Purchasers of S corporation stock may be able to treat such transactions as a purchase of assets rather than a purchase of stock to obtain a step-up in the inside basis of the assets of the S corporation by qualifying for and making a Sec. 338(h)(10) election. However, selling S corporation shareholders may not agree to such an election if the S corporation had to pay a significant corporate level tax on its built-in gain that may have existed at the time of the S election. Prior to January 2, 2013, this built-in gain tax would have been imposed on a 2012 transaction if the S corporation (that was previously a C corporation) had not been an S corporation for more than ten years.  

The buyers of S corporation businesses have been given a potential tax planning opportunity by the American Taxpayer Relief Act of 2012 that was signed into law on January 2, 2013. The recognition period for built-in gain tax on an S corporation asset sale has been reduced from ten to five years for sales occurring in 2012 and 2013. 

Because the built-in gain tax is computed at the highest corporate rate, it is a significant impediment to asset sales by S corporations, even when the basis step-up of an asset sale is beneficial to the purchaser of the business. The reduction in the recognition period for the built-in gain tax from ten to five years removes this obstacle for S corporation transactions in 2012 that were outside the five year recognition period and opens the door to potential Sec. 338(h)(10) elections. As a consequence, a Sec. 338(h)(10) election may be a palatable option for the seller of stock in an S corporation that is beyond the five year recognition period – a potential tax win-win for the buyer and seller. The buyers get the benefit of a step-up in the basis of the assets while the sellers avoid the built-in gain tax.  

Next Steps
Purchasers will need to determine if the transaction meets the requirements for a Sec. 338(h)(10) election. A Sec. 338(h)(10) election has to be agreed to and made by both parties on or before the 15th day of the 9th month following the month of the transaction. Taxpayers that desire to make the Sec. 338(h)(10) election for 2012 purchases must act quickly to make the necessary filings with IRS. IRS has procedures for taxpayers to obtain an extension of time to file this election that may be available for taxpayers that are unable to meet the Sec. 338(h)(10) election filing deadline for a 2012 transaction.