On December 18, 2015, President Obama signed the Consolidated Appropriations Act, 2016 (the Act), which makes permanent the five-year recognition period under Section 1374 relating to the built-in gains tax imposed on S corporations, and the provisions relating to charitable contributions of property by an S corporation.

Reduction in S corporation recognition period

An S corporation that was previously a C corporation may be subject to the built-in gains tax imposed under Section 1374 if the corporation has net recognized built-in gain during its recognition period. In general, prior to amendment, the recognition period meant the 10 years following a corporation's conversion to S status. Various legislative provisions temporarily reduced the recognition period, however, including a reduction to five years for tax years beginning in 2011, 2012, 2013 or 2014 (see Tax Alert 2013-71).

The Act makes permanent the five-year recognition period for purposes of the built-in gain tax.

Basis adjustment to stock of S corporations making charitable contributions of property

The Pension Protection Act of 2006 (the 2006 Act) amended Section 1367(a)(2) to provide that a decrease in shareholder basis in the stock of an S corporation under Section 1367(a)(2)(B) by reason of a charitable contribution equals the shareholder's pro rata share of such property's adjusted basis in the hands of the corporation. In addition, the 2006 Act amended Section 1366(d) to provide that, for charitable contributions to which the amendment to Section 1367(a)(2) applies, the basis limitation under Section 1366(d)(1) does not apply to the excess of the shareholder's pro rata share of the charitable contribution over the shareholder's pro rata share of the adjusted basis of such property. The provision, originally applicable to contributions made by S corporations in tax years beginning after December 31, 2005, and before January 1, 2008, was subsequently extended to include contributions made in tax years beginning before January 1, 2015.

The Act makes these amendments permanent.

Implications

The built-in gains tax may have significant implications in planning for a conversion to or from S corporation status. By making the five-year recognition period permanent, the Act eliminates some uncertainty in planning for a conversion. The reduction of the recognition period from 10 years to five years may make a conversion to S corporation status more attractive under certain circumstances, for example, when it is likely that an exit strategy will be implemented within six to 10 years after the conversion. In addition, since the expiration of the Bush tax cuts in 2013, many S corporations have considered whether C corporation status might be more tax advantageous. One significant disadvantage in converting from S corporation to C corporation status is that if, the corporation later decides to convert back to S corporation status, its recognition period starts over. By permanently reducing the recognition period from 10 years to five years, this disadvantage may be diminished.

Furthermore, by making the reduction in the recognition period permanent, there should be more certainty in planning for sale or exchange transactions involving S corporations because it should now be possible to determine with certainty if an S corporation is within its recognition period at the time of a proposed transaction. In this regard, for qualified stock purchases of S corporation stock that occurred during 2015, when a Section 338(h)(10) or Section 336(e) election was not made because of uncertainty about whether the recognition period for tax years beginning in 2015 was five years or 10 years, reconsideration of the advisability and availability of making such an election may be warranted. Note that the due date of a Section 338(h)(10) election is the 15th day of the 9th month following the month of acquisition. A Section 336(e) election requires the S corporation and all its shareholders to enter into a written, binding agreement to make the election on or before the due date (including extensions) of the federal income tax return of the S corporation target for the tax year that includes the disposition date.Making the charitable contribution provisions permanent should facilitate the ability to plan for charitable giving of appreciated property by an S corporation.

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