8.4.1 Measurement of the DTL for built-in gains
When there is a net unrealized built-in gain at the date of conversion, it might be necessary, as discussed in ASC 740-10-55-65, to continue to recognize a deferred tax liability after the change to S corporation status—the question is how to determine the amount, if any. Only the assets and liabilities that have temporary differences at conversion need to be considered. Even though the actual built-in gain is based on fair market value at the date of conversion, no consideration would be given to any appreciation above the book value as of the conversion date.
Under the tax law, any actual tax liability for built-in gains is based on the lower of the net recognized built-in gain and taxable income (computed as a C corporation) for the year. As such, there would be no built-in gain tax if a company has no taxable income in such year; however, tax may be assessed in a later year if the company has taxable income in any of the remaining years of the 5 year recognition period. Evenif a company expects future losses, a deferred tax liability on any built-in gains is recorded at the time of conversion because it is inappropriate to anticipate tax consequences of future tax losses under ASC 740-10-25-38. The tax benefit of the future losses should be recognized as incurred in future years to the extent that the built-in-gains are absorbed by those losses.
Any built-in losses may be used to reduce built-in gains. Thus, when calculating the net built-in gain deferred tax liability in accordance with ASC 740-10-55-65, the lesser of the unrecognized built-in gain (loss) or the existing temporary difference (on an asset-by-asset basis) as of the conversion date is used. That is, the unrecognized built-in gain (loss) for each asset is limited to the existing temporary difference as of the conversion date. At each financial statement date, the deferred tax liability should be remeasured until the end of the recognition period. Changes in the liability should be recorded in income tax expense (benefit) in the period of the change.
Example TX 8-5 illustrates recording deferred taxes for built-in gains.
EXAMPLETX 8-5 Recording deferred taxes for built-in gains
Assume that an entity’s S corporation election became effective on January 1, 20X2. On December 31, 20X1, the entity had the following temporary differences and built-in-gains:
Marketable securities | Inventory | Fixed assets | |
Expected to be used in operations and not sold within 5 years | No | No | Yes |
Fair market value [A] | $2,000 | $860 | N/A |
Tax basis [B] | 1,800 | 900 | |
Book value [C] | 1,900 | 850 | |
Built-in gain (loss) [A – B] | 200 | (40) | |
Existing taxable / (deductible) temporary difference [C – B] | 100 | (50) |
Assume that (a) the marketable securities and inventory will be sold the following year, (b) the entity has no tax loss or creditcarryforwardsavailable at December 31, 20X1 to offset the built-in gains, and (c) the applicable corporate tax rate is 21%.
How would the S corporation calculate the deferred tax liability for the built-in gain at the date of conversion?
Analysis
The deferred tax liability for the built-in gain at January 1, 20X2, would be calculated as follows:
Built-in gain on marketable securities | $100 | |
Built-in loss on inventory | (40) | |
Net unrecognized built-in gain | 60 | |
Applicable corporate tax rate | 21% | |
Potential deferred tax liability for built-in gain | $13 |
The net deferred tax liability for built-in gain is $13. This is the amount that should be reflected in the S corporation’s accounts (which would replace the deferred tax liability for marketable securities and inventory on the books of the C corporation at the date of conversion).
