A ‘BIG’ tax relief

The deal US Congress passed to prevent the country from going over the so-called 'fiscal cliff’ included a raft of different measures. One that hasn’t gotten much attention – and should be of note to US fund managers – is a reduced time window in which certain S-corps are subject to “built-in gains” (or BIG) tax.

The built-in-gains tax was created to prevent your everyday C-corp from avoiding corporate level tax by converting to a tax flow-through S-corp (similar to a limited liability partnership) before selling its assets or liquidating.

Generally S-corps, which were once C-corps, must wait 10 years (starting from the time of conversion) before they can avoid a 35 percent built-in gains tax on the appreciated value of assets previously held by the converted C-corp.

Recent law changes however have shortened that 10-year “recognition period” for existing S-corps to varying degrees depending on the tax year in question. The Small Business Jobs Act of 2010 for example reduced the built-in gain capture period to a five year window in 2011. What the fiscal cliff deal does is bring that shorter five-year recognition period for assets sold by an S-corp in taxable years beginning in 2012 or 2013 as well.

US fund managers, particularly those focused on the mid-market, should see this as significant. The change in law makes it more likely that private equity funds will be able to obtain certain tax advantages with respect to S-corps purchased in 2013 that were, at one time, C-corps. Pepper Hamilton tax partner Steve Bortnick explains that a key benefit of an S-corp target is the ability of the fund to accelerate its assets to fair market value (and thus capturing an increase in tax-advantageous depreciation and amortization deductions) without paying any corporate-level tax.

And the deal opportunities can be significant. There are some 4.5 million S-corps in the US today, according to various estimates. S-corps may generate revenues in the tens of millions of dollars, meaning their tax advantageous status should not fool one into thinking their use has been restricted to mom and pop shops. S-corps can be of any size, so long as the number of shareholders is kept below 100 and limited to US stakeholders, among other requirements.

Now it’s true that when analysts review the numerous deal opportunities that come their way on a weekly basis, tax considerations are not usually front of mind during the early stages of due diligence. Only until tax experts are brought into the fold can factors like amortization or depreciation deductions really become food for thought. But the fact that the built-in gains tax will be less of a hit for thousands of small businesses is a fact worth remembering when scanning targets with S-corp status. Or said in another way, it’s a seldom discussed tax victory worth being mindful of as carry tax debates continue to beg for your attention.