The Protecting Americans from Tax Hikes (PATH) Act, which was signed into law on December 18, 2015, extends permanently or temporarily many business-related tax rules. In this blog, I focus on the changes related to S corporations.
Many small businesses function as S corporations. In fact, there were more than 4.6 million S corporation returns filed for 2014. The PATH Act made a number of favorable changes impacting S corporations.
Built-in gains tax
When a C corporation elects to be taxed as an S corporation and has appreciated assets at that time, the potential gain in those assets (technically called net unrealized built-in gain, or NUBIG) can be taxed to the S corporation. These are called built-in gains. When these assets are sold, the S corporation pays a 35% tax on the built-in gain (the highest corporate tax rate). However, if the S corporation holds the assets long enough, the built-in gains tax does not apply; any gain reaped by the corporation in this instance passes through to shareholders and is taxed at their capital gain rate (zero, 15%, or 20%, depending on the owner’s personal tax bracket).
The built-in gains period originally was 10 years. The period is measured by the length of time that the corporation has S status. Sales of assets with potential built-in gain within 10 years of the S election were subject to the tax at the corporate level. The built-in gains period was reduced to seven years for 2009 and 2010. Starting in 2011, the period was reduced to five years; this shorter period expired at the end of 2014. The PATH Act makes the five-year period permanent. For example, if a C corporation made an S election on January 1, 2012, and owned NUBIG property on that date with potential gain of $10,000, the S corporation won’t pay any tax if the property is held at least until January 1, 2017; the five-year period ends on December 31, 2016.
Donations of appreciated property
Because S corporations are pass-through entities, charitable donations are taken at the shareholder level. In the case of appreciated property, a rule made permanent by the PATH Act lets the corporation claim a deduction based on the property’s value but the shareholders reduce their basis in the corporation by their share of the corporation’s adjusted basis of the property. In other words, the reduction in shareholder basis is less than what they claim as a charitable deduction.
To oversimplify, assume the corporation donates property worth $10,000 that it acquired for $2,000. There is one shareholder, who can deduct $10,000 on her return. She reduces her basis in S corporation stock by $2,000. The small basis reduction will allow her to deduct more losses from the corporation, assuming that the corporation is not profitable in a future year.
S corporations are also impacted by various other changes made by the PATH Act. For example, those engaged in research activities may take a payroll tax credit. If they hire new employees from certain targeted groups, they can take the work opportunity credit that are passed through to shareholders. And if they buy certain equipment, they may take certain write-offs that are also passed-through to shareholders.
If your business operates as an S corporation, discuss with your tax advisor which tax breaks you may be eligible for and what actions to take in order to secure them.