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a cash-basis taxpayer to be taxed as if collected in the last year of corporate taxation, thus adding to
the cost of Morris‟s subchapter S conversion.
Of course, the greatest source of untapped corporate tax potential lies in corporate assets that have
appreciated in value while the corporation was subject to corporate tax, but are not sold by the
corporation until after the subchapter S election is in place. In the worst nightmares of the IRS,
corporations that are about to sell all their assets in a corporate acquisition first elect subchapter S
treatment and then immediately sell out, avoiding millions of dollars of tax liability.
Fortunately for the IRS, Congress has addressed this problem by imposing taxation at the corporate
level of all so-called built-in gain realized by a converted S corporation within the first 10 years after
its conversion. Built-in gain is the untaxed appreciation that existed at the time of the subchapter S
election. It is taxed not only upon a sale of all the corporation‟s assets, but anytime the corporation
disposes of an asset it owned at the time of its election. This makes it advisable to have an appraisal
done for all the corporation‟s assets as of the first day of subchapter S status, so that there is some
objective basis for the calculation of built-in gain upon sale somewhere down the line. This appraisal
will further deplete Morris‟s coffers if he adopts the subchapter S strategy. However, despite these
complications, it is still likely that Morris will find the subchapter S election to be an attractive
solution to his family and compensation problems.
Just in case Morris is thinking in this direction, converting his corporation to an LLC has even more
dire tax consequences. Such a transaction is treated, for tax purposes, as a dissolution of the
corporation and the formation, by its shareholders, of the LLC by contribution of the dissolved
corporation‟s assets and liabilities to the new entity. This will cause the immediate recognition of all
built-in gain at the corporate level in addition to capital gain for the shareholders as their shares are
constructively redeemed.
Pass-Through Entity
Consider how a subchapter S corporation might operate were the corporation to experience a period
during which it was not so successful. Subchapter S corporations (as well as most LLCs, partnerships,
and limited partnerships) are known as pass-through entities, because they pass through their tax
attributes to their owners. This not only operates to pass through profits to the tax returns of the
owners (whether or not accompanied by cash), but also results in the pass-through of losses. As
discussed earlier, these losses can then be used by the owners to offset income from other sources
rather than having the losses frozen at the corporate level waiting for future profit.
The Internal Revenue Code, not surprisingly, places limits on the amount of loss that can be passed
through to an owner‟s tax return. In a subchapter S corporation, the amount of loss is limited by a
stockholder‟s basis in his or her investment in the corporation. Basis includes the amount invested as
equity plus any amount the stockholder has advanced to the corporation as loans. As the corporation
operates, the basis is raised by the stockholder‟s pro rata share of any profit made by the corporation
and lowered by the pro rata share of loss and any distributions received.
These rules might turn Morris‟s traditional financing strategy on its head the next time he sits down
with the corporation‟s bank loan officer to negotiate an extension of the corporation‟s financing. In the