Under the old law, farmers who had regular C corporations could convert to an S corporation tax-free. However, if the corporation had appreciated assets at the time of the conversion, then a "built-in gains" (BIG) tax would apply on that appreciation if the property was sold within a certain period of time.
For many years, you had to wait 10 years, however starting about three years ago, this period was permanently reduced to five years. If the BIG tax applied to the sale, the S corporation would pay a 35% tax on the gain and then the shareholder would only be taxed on 65% of the gain. The reason for 65% is the assumption is that the corporation would have paid the 35% tax and then the corporation would only be able to distribute 65% to the shareholder.
Starting in 2018, the BIG tax rate is now 21%, thus a 40% tax savings on any BIG. We believe for those few fiscal S corporations that realize a BIG tax in 2018 that the rate may be allocated partly at the 35% level and partly at the 21% level. However, very few S corporations have both a fiscal year and recognize BIG.
Many farmers assume that converting to an S corporation will create a lot of BIG tax since all of their cash basis grain inventories, prepaids, deferred payment contracts have no tax basis. This is actually not true for most farm corporations. As long as the S corporation keeps it taxable income at zero for 5 years, there is no BIG tax owed on these types of assets even though the BIG was recognized in year one.
One trap for some farmers is if they sell an asset on the installment method during that five year period, the BIG gain will carryover for the life of that contract. This is the only time the BIG tax can exceed five years.
Also, some states also tax BIG and those rates likely have remained the same.
Let's look at few examples:
Farmer Jack converts to an S corporation on January 1, 2018. His total BIG is $1 million for cash/accrual items and $1 million for equipment. During 2018, he recognizes all of the $1 million cash/accrual items and the corporation's taxable income for 2018 is zero and will be zero for 2019-2022. The corporation will not owe any BIG tax.
Now let's assume taxable income over the five year period is $500,000. In this case, the corporation will pay $105,000 of BIG tax, but Jack will only pay tax on $395,000 of ordinary income.
Now, Jack in year five sells a tractor for a $200,000 gain and reports $100,000 of income in that year. His BIG tax will $21,000 since he kept his income at $100,000. The BIG tax on the remaining $100,000 of gain will disappear in year 6.
Converting to an S corporation can make a lot of sense and if you report BIG in years 1-5, it will hurt but not as bad as before 2018.