Convert C to S and Cash to Accrual

Technical topics regarding tax preparation.
#1
Wiles  
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I have a cash basis C Corp that want to change to S Corp. They have $1 million on A/R. This is their primary built in gain on the conversion.

One of the ideas for dealing with this built in gain is to change to accrual basis. I believe this would defer the recognition over 4 years. Would we need to change the accounting method in the year prior to the S conversion? Or could we do it all in the same year?
 

#2
sjrcpa  
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Perhaps they will accrue some bonuses related to that $1 million AR.
 

#3
Wiles  
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Yes. That and managing taxable income going forward are other options.

But we are leaning towards this 4 year recognition deferral as they want to limit salaries and capture the QBID as an S-Corp.
 

#4
sjrcpa  
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Wiles wrote:managing taxable income going forward are other options.

That was going to be my next suggestion.
 

#5
Nilodop  
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From Rev Proc 2015-13 -
(3) Exception for conversion to or from S corporation status. A C corporation
electing to be treated as an S corporation or an S corporation terminating its S election that is then treated as a C corporation is not treated as ceasing to engage in a trade or business.


From Reg. 1.461-2(c)5(ii)
(ii) In the case of a change in method of accounting by an electing small business corporation under subchapter S, chapter 1 of the Code, the adjustments required by section 481 shall be made with respect to the taxable income of such electing corporation in the year of the change, but the limitations on tax under section 481(b) shall apply to the individual shareholders. Section 481(b) applies to a shareholder of an electing small business corporation whose taxable income is so increased by more than $3,000 as a result of such adjustments to such corporation's taxable income. It is not necessary for the shareholder to have been a member of the electing small business corporation, or for such corporation to have been an electing small business corporation, for the two taxable years immediately preceding the taxable year of the change of the corporation's accounting method in order to have the limitation provided by section 481(b)(1) apply. Further, a shareholder may apply section 481(b)(2), even though he was not a shareholder, or the corporation was not an electing small business corporation, for all the taxable years affected by the computation thereunder.

 

#6
Wiles  
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Also found this:

Reg §1.1374-4 (d) Section 481(a) adjustments
(1) In general. Any section 481(a) adjustment taken into account in the recognition period is recognized built-in gain or loss to the extent the adjustment relates to items attributable to periods before the beginning of the recognition period under the principles for determining recognized built-in gain or loss in this section. The principles for determining recognized built-in gain or loss in this section include, for example, the accrual method rule under paragraph (b) of this section.


Using the information in the OP, if taxpayer elects S status in same year they convert to accrual, the $1 million of A/R will be recognized over 4-years as a 481 adjustment. The recognized built in gain related to the A/R is the same $250K/year, subject to the taxable income limitation.
 

#7
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I've been in this same situation with a client before. It turned out that losing the deferral (by going cash to accrual) was much worse than recognizing the built-in gain. The company in my experience had more than $1M in receivables.
 

#8
Wiles  
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Thanks for that input. I have been flip flopping on whether to convert to accrual as part of this. My thinking, for this client, was to accelerate income with 4 years left of the QBI deduction.
 

#9
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I can't recall exactly how the situation played out, but if I remember correctly, the AR is subject to the C taxes in S corp Y1 and also included in the shareholder's pass-through income. However, the C corp taxes on the BIG are deductible by the S corp. This would allow a QBI deduction for the shareholder in Y1 on the receivables.

I was very surprised about the deferral issue. While it feels like you're accelerating income, you are actually maintaining the taxpayer's deferral. Income tax rates are higher than C corp rates. I would definitely look at that as it made a considerable difference in after-tax dollars by Y2/3/4.
 

#10
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Keep in mind that triggering the income allows the A/R to be received tax-free and that the stockholders' gain on conversation would be reduced by the corporate tax. A partial triggering could be done via a sale to an insider (e.g., a secured installment sale to an insider.) For an effective one year deferral you could conduct the sale on January 1 and elect S starting January 2.
Steve
 


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