Author: Leon Clinton

As you consider converting your C corporation into an S corporation, understand and plan for the built-in gains (BIG) tax. 

The tax code imposes the BIG tax on S corporations that recognize gains on assets that the C corporation held at the time of S corporation conversion. Some gains can surprise you because on the date of conversion, the law makes you convert your accounting to the accrual method. 

Example. Your C corporation operates on a cash basis and has receivables at the time of conversion. Your new S corporation operates on a cash basis. But as it collects the receivables, it faces the BIG tax.

Here’s a breakdown of the BIG tax: The first tax is 21 percent—the C corporation rate. The S corporation passes the remaining 71 percent of profits to you, where they are subject to individual income tax rates, which can be as high as 40.8 percent.

To help you navigate and potentially avoid the BIG tax, here are five strategic approaches:

1. Avoid selling the S corporation during the five-year BIG tax penalty period.
2. Identify personal goodwill, which is not a corporate asset, and get a proper appraisal to prove this to the IRS.
3. Reduce building appreciation with an accurate appraisal.
4. Give yourself a bonus.
5. Establish any unpaid compensation from previous years as a liability, and have the S corporation pay it within two and a half months after conversion. This creates a built-in loss to offset other built-in gains.

If you want to discuss the BIG tax, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• September 13, 2024

If you run your business through a regular “C” corporation, beware of the accumulated earnings tax (AET). 

The IRS can use the AET to penalize C corporations that retain earnings in the business rather than pay them to shareholders as taxable dividends. To retain earnings, the C corporation first pays the corporate tax of 21 percent on those earnings.

When the corporation distributes those already taxed earnings to shareholders, the shareholder includes those distributed earnings as dividends in taxable income, where they are taxed again at the shareholders’ capital gains rate.

The AET is a flat 20 percent tax. The AET is a penalty tax imposed after an audit in which the IRS concludes that the corporation paid out insufficient dividends compared to the amount of income accumulated by the corporation. 

You have AET exposure when your C corporation has large balances in retained earnings, cash, marketable securities, or loans to shareholders reported on a corporation’s balance sheet on IRS Form 1120, Schedule L.

The IRS can impose the AET on any C corporation, including public corporations. However, closely held C corporations are the most likely targets because their shareholders have more influence over dividend policy than public corporations’ shareholders.

Historically, IRS auditors have not prioritized the AET, but anecdotal evidence suggests this may change.

Fortunately, there are many ways to avoid problems with the AET—for example:

• Elect S corporation status
• Retain no more than $250,000 in earnings ($150,000 for corporations engaged in many types of personal services)—all C corporations are allowed to retain this much AET free.
• Establish that the corporation needs retained earnings above $250,000/$150,000 for its reasonable business needs—for example, to provide necessary working capital, fund expansion needs, pay debts, or redeem stock 

The key to avoiding the AET is to document the reasons for accumulating earnings beyond $250,000/$150,00 in corporate minutes, board resolutions, business plans, budget documents, or other contemporaneous documentation.

If you want to discuss the accumulated earnings tax, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• September 10, 2024

Consider this happy scenario: You purchased one Bitcoin for $15,000 14 months ago and another six months later for $40,000. Today, you sell one Bitcoin for $60,000. You’re a genius! But is your taxable gain $45,000 or $20,000? 

It all depends on your crypto accounting method.

Many crypto owners are enjoying substantial gains at a time of surging cryptocurrency prices. When you sell multiple crypto units in the same year, you reduce your taxable gains using a crypto accounting method that provides the highest possible tax basis for each unit sold, resulting in the lowest taxable profit.

As you might expect, the default method approved by the IRS doesn’t always provide the highest basis, resulting in higher taxes. The IRS made FIFO (first in, first out) the default method. It requires you to calculate your basis in chronological order for each crypto unit sold. With FIFO, your basis in the above example is $15,000, and your taxable profit is $45,000.

You can use a method other than FIFO. The other methods are called “specific identification methods” and include HIFO (highest in, first out) and LIFO (last in, first out). With HIFO, you are deemed to sell the crypto units with the highest cost basis first; your basis in the above example would be $40,000, and your taxable profit only $20,000.

Because HIFO sells your crypto with the highest cost basis first, it ordinarily results in the lowest capital gains and the largest capital losses. But using HIFO can cause loss of long-term capital gains treatment if you have not held the crypto for more than one year.

Using HIFO or LIFO is more complicated than FIFO. You must keep records showing

• the date and time you acquired each crypto unit,
• your basis and the fair market value of each unit at the time it was acquired,
• the date and time each unit was sold or disposed of, and
• the fair market value of each unit when sold or disposed of.

If you lack adequate records, the IRS will default to the FIFO method during an audit, which could result in more taxable profit.

It’s next to impossible to manually create the needed crypto records, particularly if you have many trades. Most crypto owners use specialized crypto tax software that automates the basis and gain/loss calculations and can even fill out the required tax forms.

You can change your crypto accounting method from year to year without obtaining IRS permission—for example, you can change from FIFO to a specific identification method such as HIFO. You don’t have to disclose which method you use on your tax return.

If you want to discuss crypto accounting, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• September 3, 2024