Al owns Service Corp whose assets consist of $100,000 of accounts receivable in

Question

Al owns Service Corp whose assets consist of $100,000 of accounts receivable in which Service Corp has a zero basis, and land held for investment worth $100,00 in which it has an adjusted basis of $10,000. C Corp E&P is $500,000 and there are no tax carryovers. Service elects S corp status on Jan 1 of the current year , and Service Corp collects the receivables in January but does not sell the land until the following year

a. What are the tax consequences to Service as a result of the collection of the receivables?

b. Is the collection taxable, if so to whom, what is the character of the income?

c. What are the tax consequences (is anyone taxed and if so who is it, and what is the amount and character of any income) if the land is sold for $90,000?

d. Assume that just prior to the S Corp election Service Corp had an NOL of $15,000. Would that change your answer to part (a), and if so how?

e. Is Service taxed as a result of the S Corp election?

Explanation / Answer

a. If C corp elects to convert in S corp and has zero basis in any asset then it simply means that any amount realized on sale of such asset or collection of receivables will be treated as income in the books of S corp only and therefore, whole amount of tax will be payable by S corp only. As a result, in the given case, Service Corp when collected such receivables is liable to pay income tax on such whole collection as it does not have any basis in such recevables.

b. As described in part a above, such collection of receivables is taxable in hands of S corp as it had no basis in such receivables. As per Section 1366(b), character of such income will be ordinary income and not capital gains.

c. If any property is sold by the S corp within five years of the transfer then it is required to pay additional built in tax on such sale as prescribed by IRS. Apart from such tax, shareholders will also be taxed on the amount of capital gain on such property. In the given case, amount of gain on sale of land is ($90,000 - $10,000 basis) = $80,000 which is less than the total depreciation of $90,000 claimed in earlier years. As a result, the same will be taxed as unrecaptured depreciation and $80,000 will be considered as ordinary income of the company and will be taxed at ordinary income tax to the shareholders.

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