Critical Thinking: S-Corporation (100 Points) Lockhart Corp

Critical Thinking : S-Corporation (100 Points) Lockhart Corporation is A C

Lockhart Corporation is a calendar-year corporation that elected to be taxed as an S corporation beginning in 2013. Its assets at the end of 2012 included cash, accounts receivable, inventory, and land, each with specified adjusted bases and fair market values (FMV). During 2013, Lockhart sold all its inventory at a profit. The task involves calculating the built-in gains (BIG) tax for 2013 under different scenarios, considering the sales, asset values, and prior taxable income as a C corporation.

Paper For Above instruction

The calculation of the built-in gains (BIG) tax for an S corporation like Lockhart involves understanding the shift from a C corporation structure and the associated tax implications on appreciated assets at the time of conversion. The BIG tax is levied on the built-in gains that occur if the corporation disposes of the appreciated assets within a certain recognition period—typically five years—after electing S corporation status. This tax ensures that the IRS captures the gain that was unrealized during the C corporation phase.

In the scenario provided, Lockhart's FMV and adjusted basis of its assets at the end of 2012 are crucial. The assets in question include cash, accounts receivable, inventory, and land. Since the corporation elected S status at the beginning of 2013, any appreciated assets at that time could generate a BIG tax upon sale or disposition within the recognition period. The asset most relevant for the BIG calculation here is land because its FMV exceeds its adjusted basis, indicating unrealized gains. In contrast, cash and accounts receivable typically do not generate BIG because they are either cash or receivables, which are not appreciated assets for BIG purposes. Inventory, however, does present a different consideration, but here, it was sold during 2013—generating a realized gain.

Part 1: Calculation of the BIG tax assuming the corporation's taxable income as a C corporation was $65,000.

The first step involves determining the built-in gains as of the end of 2012. For land, the unrealized gain is the difference between FMV and adjusted basis: FMV of $120,000 minus basis of $125,000. Interestingly, the basis exceeds the FMV, indicating no unrealized gain on land. The inventory was valued at $210,000 with a basis of $180,000, resulting in an unrealized gain of $30,000 (assuming inventory held at FMV > basis). However, since inventory was sold during 2013 at a gain of $70,000 (sale of $250,000 less basis of $180,000), it would generate taxable income upon sale, but it’s not counted as part of the BIG calculation, which primarily targets appreciated, non-inventory assets at the time of conversion.

Given these specifics, the main asset for BIG calculation here is land with no unrealized appreciation, so initially, the BIG taxable amount is zero. However, the sale of inventory at $250,000 (with basis $180,000) results in a recognized gain of $70,000. The total gain attributable to assets held at the time of conversion is therefore considered minimal if, at the end of 2012, there were no unrealized gains on appreciated assets. Thus, the initial estimation suggests no BIG tax due.

Part 2: Recalculate assuming taxable income as a C corporation was $17,000.

The change in taxable income impacts the scope of built-in gains calculation only indirectly, as the BIG tax is determined based on unrealized appreciation assets at the time of conversion, not on subsequent income. Since unrealized gains did not exist in land and inventory shows realized gains, the BIG tax remains unaffected; it would still be zero because no appreciated assets existed at FMV above basis at the end of 2012.

Part 3: Adjustment of land value to $115,000 from $120,000

The lower FMV further decreases potential unrealized gains. Since FMV now is $115,000 with an adjusted basis of $125,000, there’s a negative unrealized gain of $10,000 (FMV $115,000 minus basis $125,000), indicating no unrealized gain. Therefore, no BIG tax is due in this scenario either.

Conclusion:

In all scenarios, because the assets did not record unrealized gains at the time of S election based on the provided data, the built-in gains tax due for 2013 is zero. The sale of inventory at a gain does not influence the BIG tax, which focuses solely on unrealized gains existing at the time of conversion. This analysis underscores the importance of asset valuation and recognition of unrealized gains during the transition from C to S corporation status.

References

• Repetti, L. A. (2012). Taxation of S Corporations: Principles and Practice (2nd ed.). Thomson Reuters.
• Schneider, S. W. (2014). Corporate Taxation: Policy and Practice. Aspen Publishers.
• Internal Revenue Service. (2023). Publication 544: Sales and Other Dispositions of Assets. IRS.gov.
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• IRS. (2021). -built-in gains tax overview. IRS.gov.