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46 MoldMaking Technology —— OCTOBER 2017 THE BOTTOM S Corporations Provide Flexibility with Profit Taxes By Michael J. Devereux II, CPA, CMP The Protecting Americans from Tax Hikes Act ("PATH Act"), which Congress passed in December 2015, permanently short- ened the S Corporation "built-in gain holding period," mak- ing it more attractive for corporations to elect status as an S Corporation and the treatment that such a status incurs. In order to be treated as an S Corporation, a company must file Form 2553 with the IRS with the full consent of all sharehold- ers. Someone authorized to sign the S Corporation's tax return must sign the form. What does this mean for mold shops? Let's back up a bit and review some basics. When a company elects to be treated as an S Corporation, the company must determine the fair mar- ket value of each asset and determine the amount by which the fair market value exceeds the tax basis in the asset. This amount is the built-in gain. At this point, the built-in gain on each asset is calculated but not paid. The built-in gain tax is paid if the company sells or oth- erwise disposes of an asset within the recognition period, which the PATH Act shortened from 10 years to five years. For example, if a tool shop owned a piece of equipment that had a fair market value of $100,000 at the time that the tool shop elected to be an S Corporation, but the piece of equip- ment was fully depreciated (and therefore had a $0 tax basis), the built-in gain would be equal to $100,000. If the piece of equipment was sold dur- ing that five-year recogni- tion period, the company would pay a built-in gains tax of $35,000. That figure is calculable by taking the fair market value ($100,000) and mul- tiplying it by 35 percent, which is the rate at which S Corporations are taxed. S Corporations are generally not subject to income tax. Instead, items of income, gain, loss and credits are passed to the shareholders of the S Corporation, who pay income tax on their pro-rata share of those items of income and loss. For instance, if an individual owns 50 percent of an S Corporation, the individual must pay tax on 50 percent of the ordinary income and other items of income and loss that the S Corporation reports. When a C Corporation elects to become an S Corporation, it must pay tax at the highest corporate rate, which, again, is currently 35 percent. The S Corporation must pay tax on all gains that were built-in at the time of filing Form 2553 if the asset with the built-in gain is sold or otherwise disposed of during the recognition period. For example, a C Corporation mold shop elects to become an S Corporation on January 1, 2016, and has one asset in which the fair market value exceeds its basis in the asset. If the shop sells or otherwise disposes of the asset before December 31, 2020, it must pay the built-in gain tax in the tax year in which the asset was sold. However, if the shop sells or disposes of the asset after January 1, 2021, the shareholders do not pay a built-in gain and instead pay any gains on the sale of the asset. When applicable, the built-in gain tax is paid at the S Corporation level (35 percent of the built-in gain). The share- holders do not pay the built-in gain tax. In addition, if the company has net operating losses (NOLs) or general business tax credit carryforwards, it may use those tax assets to offset the built-in gain. S Corporation Requirements Companies interested in filing as an S Corporation must meet all of the following requirements: Limited number of shareholders. The company may not have more than 100 shareholders (the number of people who are shareholders at any given time throughout the tax year). However, the company can have more than 100 shareholders throughout the taxable year, as long as there are no more than 100 shareholders at one time. All family members and their estates are treated as a single shareholder. Domestic corporations only. The company must be a domestic corporation, created or organized in the United States. Years ago, the IRS allowed companies to "check the box" as a means of determining how the company would be taxed. "Check the box" refers to the Entity Classification Election part of Form 8832, which allows companies to elect their classification for Federal income tax purposes. This election has allowed some Limited Liability Companies (LLCs) to become S Corporations. That is, they may "check the box" to be a C Corporation, then timely file Form 2553 to become an S Corporation. However, to do this, the LLC operating agreement must be compliant with the S Corporation rules. Eligible corporations only. The company may not be a finan- cial institution, insurance company, domestic international sales corporation (DISCs) or taxable mortgage pool. Eligible shareholders only. Nonresident aliens may not be shareholders. Only individuals, decedents' estates, estates of individuals in bankruptcy and certain trusts can be share- holders of an S Corporation. Corporations, partnerships and numerous types of trusts cannot be shareholders either. One exception is that S Corporations may own qualified Subchapter S subsidiaries (QSubs) if the proper filings occur. The built-in gain tax is paid if the company sells or otherwise disposes of an asset within the recognition period, which the PATH Act shortened from 10 years to five years.