Many taxpayers use S corporations or C corporations to legally reduce income taxes, payroll taxes, and self-employment taxes for their businesses. However, without careful planning, a taxpayer may have a surprise tax bill from using a corporation for federal tax purposes.
What follows will tell you when these unexpected tax hits can happen and how the taxpayer can avoid them with proper planning.
✅ Entity Formation
If a taxpayer contributes appreciated property to a corporation in exchange for its shares, the taxpayer may recognize a gain equal to the fair market value (FMV) of the stock received less the adjusted basis of the property contributed.
However, if a taxpayer contributes appreciated property for stock, and the group of taxpayers capitalizing the corporation owns 80% or more of the stock immediately after the exchange, the taxpayer does not recognize gain. The gain becomes deferred but not eliminated; the taxpayer’s basis in the stock shares is equal to the adjusted basis in the property contributed.
• Example 1. Meghan contributes land held for investment over one year with an FMV of $200,000 and an adjusted basis of $100,000 in exchange for 20 percent of an S corporation’s shares. She is the only contributor to the transaction. She must recognize $100,000 of long-term capital gain; her basis in S corporation stock shares is $200,000.
• Example 2. Brian contributes land held for investment over one year with an FMV of $200,000 and an adjusted basis of $100,000 in exchange for 100 percent of a C corporation’s shares. He does not recognize gain in the exchange; his basis in his C corporation stock shares is $100,000.
🛑 One more situation to avoid: When capitalizing a corporation, if the contributing taxpayer receives consideration other than stock in the tax-deferred exchange, they must recognize gain to the extent of the FMV of that consideration. In this case, the taxpayer’s basis in the stock is the adjusted basis of the property contributed plus any gain recognized in the exchange less the FMV of the non-stock consideration.
• Example 3. Logan contributes land held for investment over one year with an FMV of $110,000 and an adjusted basis of $50,000 in exchange for 50 percent of an S corporation’s shares plus $10,000 in cash. Other individuals receive the remaining 50% of the shares at the same time. Logan must recognize $10,000 of long-term capital gain due to receiving the $10,000 additional cash. His basis in the S corporation stock shares is $50,000 ($50,000 adjusted basis plus $10,000 gain recognized less $10,000 cash received).
✅ Debt Assumption
If a taxpayer transfers debt to a corporation in a tax-deferred exchange, they generally will not recognize gain due to the transfer unless:
- The transfer is to avoid tax;
- No bona fide business purpose exists for the transfer;
- The aggregate amount of debt transferred exceeds the basis in the property transferred (determined on a shareholder-by-shareholder basis).
The taxing authorities treat a recourse liability as assumed by the corporation if, based on the facts and circumstances, the corporation agrees and is expected to satisfy the liability regardless of whether the transferring taxpayer has relief of the liability. A nonrecourse liability is assumed by the corporation when any assets subject to that liability transfer to the corporation. A liability is not included if payment of the liability gives rise to a deduction.
When a limited liability company (LLC) elects to be taxed as a corporation, it is a deemed tax-deferred exchange of the assets of the LLC for the corporation stock. The taxpayer must take care to analyze the balance sheet of the LLC immediately before making the corporation election to avoid a gain recognition event.
• Example 4. On January 1, 2023, High Times, LLC, a disregarded entity Jackie owns, elects for taxation as an S corporation. On December 31, 2022, the LLC had $10,000 in cash and an $18,000 credit card balance. Jackie must recognize $8,000 in ordinary gain due to making the S corporation election.
🛑 A taxpayer can easily avoid gain recognition when electing corporation treatment for an LLC by either increasing the adjusted basis of the business’s assets (e.g., a cash capital contribution) or paying down or retaining any outstanding liabilities outside the corporation.
✅ Later Capital Contributions
A corporation’s sole shareholder can add additional capital to the corporation without issuing additional shares of stock; this can create unfortunate tax consequences related to the holding period of the stock shares.
The additional paid-in capital increases the taxpayer’s adjusted basis in the shares, but it resets a portion of the stock’s holding period from long-term to short-term. Therefore, if the taxpayer sells the stock within one year of the capital contribution or takes distributions exceeding the basis, they will recognize short-term capital gain instead of long-term capital gain.
• Example 6. On January 1, 2023, Ashley was a 100% S corporation shareholder, holding 10 shares with a basis of $5,000 each ($50,000 total), an FMV of $50,000, and a long-term holding period. She then contributes $50,000 cash as additional paid-in capital, but issues no other stock for the capital contribution. Immediately after, she holds 10 shares with a basis of $10,000 each ($100,000 total). Each share has a split holding period: 50% is long-term, and 50% starting on January 1, 2023. If the S corporation distributes $20,000 in excess of her stock basis for tax year 2023, Ashley will recognize $10,000 of short-term capital gain and $10,000 of long-term capital gain.
🛑 A taxpayer can avoid this problem by holding the stock for more than one year before engaging in a gain recognition transaction or making a bona fide loan to the corporation instead of a capital contribution.
✅ Appreciating Asset Distributions
If a corporation distributes property whose FMV is greater than its adjusted basis to a shareholder, it recognizes gain equal to the excess. Since the asset is not sold, this phantom gain can create a financial hardship by generating tax for which there is no cash to pay it.
• Example 7. Many years ago, Matt placed a residential rental property in an S corporation that he owns 100 percent. In 2023, he decided to close the corporation, but he wants to retain the rental to pass it by inheritance to his child. When the S corporation distributes it to Matt, it has an FMV of $450,000 and an adjusted basis of $150,000. The S corporation recognizes $300,000 of gain upon the distribution, which passes through to Matt as sole shareholder.
🛑 The simple way to avoid this problem is to avoid placing long-term appreciating assets within a corporation. By holding these assets directly, the taxpayer’s heirs can receive a step up in basis on the assets if passed by inheritance, wiping away any prior accumulated depreciation the decedent takes.
✅ Summary
Corporations, whether C corporations or S corporations, can be powerful tools for tax reduction. Like any other tax reduction tool, the devil is in the details, every action must be properly planned and executed to avoid unnecessary tax.
In the examples above, the taxpayers thought they were making smart tax moves with their corporations, but various provisions in the law caused them to recognize gain.
Only proactively working with taxpayers before transactions occur can prevent these types of problems from occurring.
🛑 If you want to get strategies in order to maximize your taxes, we can help you at Wave Tax. Contact us at info@wavetax.us