 Hello and welcome to this session in which we will discuss S corporation taxes paid at a corporate level. Now, the first thing you're going to be asking yourself is, didn't we discuss that C Corp S corporation are flow through entities? In other words, the profit or the loss flow to these shareholders. Therefore, S corporation are not tax paying entities. And that is still true. S corporation as a corporation should not have any tax liabilities. However, under certain circumstances, the S corporation as a corporation as an entity might be responsible for some taxes. And you might be asking why? Well, quick review. All S corporation start as C corporation. Remember S corporation is an election. So the shareholders elect to be treated as an S corporation. So at some point they were a C corporation. Now they could have been a C corporation for one minute only or for one second. The corporation is created. We file our election and we want to be treated as an S corporation. Therefore we were a C corporation for a short period of time, a minute, right, or a day or whatever. The point is, instantaneously, we were an S corporation, but in certain circumstances, maybe we were a C corporation for several years, year one, year two, year three. Then we switch from C and we decided to be treated as an S corporation starting year four. So the C corporation existed prior to the S election for several years. Under those circumstances, because that happened, we could have some circumstances where we are responsible to pay taxes from an S corporation corporate level perspective. So there are four different taxes that might be imposed on the S corporation. Something called built in gains tax, passive investment income tax penalty, life or recapture and the general business credit recapture. So when we have those four circumstances, the S corporation will be responsible for paying taxes on a corporate level. And this is basically a violation of the concept of the S corporation. Because remember the S corporation generate revenues incur expenses and will have a profit. And this profit will go to the shareholders and the shareholders will pay taxes on the profit. That's what we know. Well, under those four circumstances, the corporation itself here will have to pay taxes on those four things. What are those four things we have to discuss them starting with the built in gains tax. Now, as you might know, once I have a list of things, I'll go over each section separately, starting with built in gains tax. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true faults questions, as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. So what is built in gains tax? Well, the built in gains tax may apply when a C corporation is converted to an S corporation. So this is what I just said. And at the time of the conversion, the fair value of the corporate assets exceeded the adjusted basis. So there we go, back to year one, year two, we were operating as a C corporation and life is good. In year three, we decided to be an S corporation. That's fine, life is good, too. But what happened is this, certain assets in the C corporation, the fair value of those assets are greater than the adjusted basis. What does that mean? It means we have a gain on these assets. And when we convert, think of it this way. It's as if we, it's as if we sold the asset and bought them again. If we sold them and bought the asset again, we're going to have a gain as if. We're not doing that. We're just transferring the asset from the C into the S. But since we have a gain, we have a built in gain. So what is the fear here? What is the IRS is concerned about? Remember under a C corporation, you are subject to double taxation. So what does double taxation means? It means if you sell those assets, if you sell those assets, the court, the corporation will pay taxes on those on the on the gain. Then the shareholder or the shareholders will pay taxes again. So we're paying taxes twice on these gains if we were a C corporation. Now what the, what the IRS is trying to avoid is you converting from a C to an S and doing what? Then selling those assets. And what happened under an S corporation? You are only subject to one tax, which is the gain flows to the shareholder and they'll pay the taxes once. So this is what they're trying to avoid. This is the big picture. So under those circumstances, the unrealized gain stemming from the increase in the value of the asset is referred to as built in gain and a subject to something called built in tax. If when, when does this build in tax kick in? If the appreciated asset was disposed within five calendar year from the date we selected. So how would you avoid this? You just wait five years being an S corporation, then you can sell it and you're no longer subject to that built in tax gain tax. So the IRS says if you're going to hold it for five years, your, your, your, your objective was not to avoid the taxes. They would let you go and you'll pay taxes once, which is the shareholder. Now what is the, what is the built in tax rate? The built in tax rate is, is equal to the highest corporate tax rate. And for our purposes today, this could be different into the future. We're using the 21%. So this could change. So if you're looking in 2025, 2026, you're looking at this recording and this changes just the highest corporate tax, whatever that highest corporate tax is on the date of the sale, not on the date of the conversion. The net gain after the tax is then passed to the shareholder as taxable gain. So it's passed also as taxable gain to the shareholder, the net gain. What are the exception? When does this built in gains don't apply? Well, let's go through it. And if you understand when it does not apply, you would know when does it apply? Well, if the S corporation was never treated as a C, simply put, you created the corporation and in instantaneously, you made the election, it's an S, therefore it was never a C corporation. Therefore this tax don't exist. The sale of the asset that was appreciated occur after the end of five years. I just told you, if you wait five years, this does not apply. The asset was acquired after the S status. Of course, if you purchase the asset after the S status took place and the asset appreciated, this does not apply. Also the appreciation of the value of the asset was due to an event after the S election. And this is what most people would argue that this increase in value occur after I selected my asset. That means I did not have a gain, an unrealized gain when I was a C corporation, it happened after. Let's take a look at an example to illustrate this concept. AP, a C corporation elected the S status during the current year. At that time of the election, they had assets with a fair value of 520 and adjusted gain of 325. Here we have the potential of built in gains. Now, if those assets were sold within five years of the election, a built in gain of 21% on the difference will apply. Therefore, we'll take 525, which is the fair market value, minus the adjusted basis, and we have a gain of 125. Additionally, the shareholders should report a taxable gain for the net gain of 195 or $154,050. Accordingly, a double taxation is imposed on the built in gains. So we did not get away with this built in gains. It was, it was taxed twice, the shareholders as well as the corporation. And this is what we're trying to avoid. Now how to determine the gain? How to determine the gain in order to pay the taxes? For the purpose of determining the built in gains, the gain is limited to the lesser of the entity's taxable income for the year. We have to look at the taxable income and the aggregate net built in gain for the corporation at the time, it converted to the S status. So we have to do what's called the netting process, net built in gain we have. Net means gains minus losses. The account of the unrealized gain is netted against the unrealized losses from the contributed asset. The net amount sets an upper limit on the tax base for the built in gain tax. So we have basically an upper limit. The built in gain may be offset also by any NOLs or unexpired capital losses carried forward from the C corporation. Also what's going to help us reduce the taxes, any NOL or unexpired capital losses because capital losses are carried from the C corporation, now we can use them to offset this gain. Let's take a look at an example to illustrate this concept. During the current year, Lili Inc. had an S corporation reported built in gain and losses of 95,000 and 20,000. What can we do? We can net them out. They net to 75,000. Lili also had an unexpired NOL of 12,000 carried forward from the years when it was a C corporation. Remember, at some point there was a C corporation. Lili's ordinary income for the current year is 68,000, determined the amount of any built in gain, if any. Well, the first thing is yes, there is a built in gain and it's going to be the lesser of the taxable income for the year, which is 68,000, or the net built in gain of 75,000, which is the difference between 90 and 75, which is the lesser, the lesser is 68. Now we're going to go a step further. The lesser amount is 68, however, before we apply the tax, we are allowed to deduct $12,000 from the NOL. Therefore we're going to take 68 minus 12, and what's left is 56, and that's subject to 21% tax, which is 11,760. Now also the gain will be applied to the shareholders as well. They'll have to pay taxes. It will pass through them, and therefore we had experience double taxation. What should you do now? You should go to Farhat Lectures and look at additional exercises, multiple choice, two falls. That's going to help you understand this topic. The CPA exam is important, good luck, study hard, stay safe.