Category: Corporations
Subject: S Corporation Liquidation
Title: S Corporation Built-In Gains Tax
IRC Sections: 1374, 1375
Filename: 1323.html
Date Produced: 05/94

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The taxpayer is an S corporation which is in the process of liquidation. The S election was made in December or 1988 such that the taxpayer is subject to the transition rules for the built-in gains tax. In addition to the assets being sold as part of the liquidation, there are leasehold improvements that will be abandoned. The leasehold improvements relate to real estate owned by the controlling shareholder of the taxpayer and leased to the corporation.

Issues
Can the loss on the abandonment of the leasehold improvements offset the amounts subject to the built-in gains tax?

Does the fact that the leasehold improvements relate to property leased by a related party affect the answer?

Conclusions
There is nothing to per se prevent an abandonment loss from offsetting gains subject to the built-in gains tax. However, certain measurement requirements for built-in losses in all probability eliminate the abandonment loss from the built-in gains tax computation and effectively render the loss unavailable for offset purposes.

Given the answer to the first issue, the second issue is moot.

Discussion
The built-in gains tax is imposed by §1374(a) on the net recognized built-in gain as defined by §1374(d)(2). The net recognized built-in gain is the difference between all recognized built-in gains and the recognized built-in losses. It follows that the abandonment loss must be considered a built-in loss in order to be eligible to offset existing built-in gains.

A loss produced by the disposition of an asset can be a built-in loss only if the asset was held by the corporation on the date of its conversion to S corporation status. §1374(d)(4)(A). The amount of the built-in loss is limited to the excess of the adjusted basis of the asset at the time of conversion over the fair market value of the asset at the time of conversion. §1374(d)(4)(B).It seems to me that the limitation based on date-of-conversion measurements may effectively exclude the abandonment loss from built-in loss status. The taxpayer suffers a loss on abandonment of leasehold improvements due to the events of the present. The leasehold improvements are worthless now because they will be abandoned now. Assuming these assets were in place at the time of conversion, the leasehold improvements were in all probability worth something close to their adjusted tax bases at the time of conversion. If that is indeed the case, there is no built-in loss from the abandoned leasehold improvements. In any event, the measurement of the built-in loss, if there is one at all, is entirely different from the abandonment loss in existence at this moment.

It is also worthy of note that under § 1374(d)(2) the net recognized built-in gain subject to the built-in gains tax is the lesser of a) the sum of all recognized built-in gains and losses; or b) taxable income computed under §1375(b)(1)(B). In the event that taxable income of the S corporation (which would naturally take into account the abandonment loss) is less than the sum of all recognized built-in gains and losses, the abandonment loss could in effect provide tax benefit against the existing built-in gains. See also the carryover provision of §1374(d)(2)(B).