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Valuation for Built In Gains

Tax considerations if you are switching your corporation to an S corporation

The only instance where corporate-level taxes are applicable to an S corporation, as if it were a C corporation, is when assets owned at the time of the S corporation conversion election are sold within the ten year time period after its conversion for C Corporation.

At the time of the election, the IRS requires that all assets of the company be valued at their fair market value. The difference between the fair market value and the historical cost basis, or income tax basis, of the company’s assets represents an unrealized built-in capital gain. If the S corporation sells any of these assets during the ten years, this gain will be realized and the company will be liable to pay corporate level taxes on the gain as if it were a C corporation.

In order to comply with IRS regulations, a valuation needs to be done in the event assets are sold during this timeframe. The IRS requires that this valuation be prepared by an expert with one of three designations, an ABV, a CVA or an ASA. Ann Paxton, a shareholder at PDR CPAs, prepares these reports. She holds both the ABV and the CVA designations.

According to IRS Regulation section 1.1374-3, the value is calculated as follows: The amount that would be realized if the taxpayer corporation had remained a c corporation and had sold all its assets at fair market value to an unrelated party that assumed all of its liabilities including a deduction for any federal tax due.

The valuator will consider 3 approaches to estimating the value of the entity’s assets at the time of the election. The three possible approaches include the asset approach, the income approach and the market approach.

Ann noted. “when these are operating companies, we stress the income approach to value using a capitalization of earnings approach. We focus on the anticipated benefits of investing in the business and determines the required rate of return based on the company’s unique risk factors. A common method under this approach estimates a business’s value by dividing its expected earnings by a capitalization rate”.

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