Lockhart Corporation Is A Calendar Year Corporation

Lockhart Corporation Is A Calendar Year Corporation At The Beginning

Lockhart Corporation is a calendar-year corporation. At the beginning of 2013, its election to be taxed as an S corporation became effective. Lockhart Corp.'s balance sheet at the end of 2012 reflected the following assets (it did not have any earnings and profits from its prior years as a C corporation): Asset Adjusted Basis FMV Cash $35,000 $35,000 Accounts receivable 25,000 25,000 Inventory 180,000 210,000 Land 125,000 120,000 Totals $365,000 $390,000 Lockhart's business income for the year was $65,000 (this would have been its taxable income if it were a C corporation). During 2013, Lockhart sold all of the inventory it owned at the beginning of the year for $250,000.

What is its built-in gains tax in 2013? Be sure to show your work. Assume the same facts as in part (1), except that if Lockhart were a C corporation, its taxable income would have been $17,000. What is its built-in gains tax in 2013? Be sure to show your work. Assume the original facts except the land was valued at $115,000 instead of $120,000. What is Lockhart's built-in gains tax in 2013? Be sure to show your work.

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The calculation of the built-in gains (BIG) tax in the context of a corporation transitioning from a C corporation to an S corporation involves a careful analysis of the assets’ current fair market values (FMV) and adjusted basis at the time of conversion, as well as the taxable income and gains realized during the year. In the case of Lockhart Corporation, understanding how to determine the built-in gains tax requires examining these components and applying relevant tax rules specified by the Internal Revenue Service (IRS).

Initially, the concept of built-in gains pertains to the appreciation in the fair market values of assets that occurred while the corporation was taxed as a C corporation. When the corporation converts to an S election, any recognized gains from these appreciated assets during the recognition period are subject to the built-in gains tax. The IRS mandates a recognition period, typically five years, during which these gains are taxed if the assets are sold or otherwise disposed of at a profit.

For Lockhart Corporation, the key assets at the end of 2012 include cash, accounts receivable, inventory, and land. Since cash and accounts receivable are generally not subject to built-in gains, the focus is primarily on inventory and land, which have appreciated in value since their basis was established during the C corporation period.

The initial step is calculating the total built-in gains by comparing the FMV of these appreciated assets at the time of conversion with their adjusted basis. For inventory, the FMV at the end of 2012 was $210,000 with an adjusted basis of $180,000, resulting in a gain of $30,000. For land, the FMV was $120,000 with an adjusted basis of $125,000, which indicates a loss, hence no built-in gain is recognized from the land in this scenario.

However, in the second scenario where the C corporation’s taxable income would have been $17,000, the analysis of the built-in gains remains essentially the same because taxable income does not directly influence the gain calculation but is relevant in assessing overall tax liability. The difference in taxable income figures primarily affects the overall tax liability but does not alter the calculation of the built-in gains tax itself.

In the third scenario, where the land’s FMV is adjusted to $115,000 instead of $120,000, the recalculation of potential gain from land does not produce a gain, as the FMV is less than the basis, indicating a loss position. Therefore, no built-in gains tax applies to land, and the only relevant gain remains from the inventory sale.

To calculate the actual built-in gains tax, the IRS prescribes applying the highest corporate-tax rate to the recognized gains attributable to the appreciation of assets held at the time of conversion during the recognition period. In this case, assuming a 35% tax rate, the gain from the inventory ($30,000) would be taxed accordingly, resulting in a built-in gains tax of $10,500. The gains from the land are not taxable in this context due to no appreciation.

In summary, the primary consideration involves recognizing the appreciated assets’ FMV versus basis, applying the appropriate tax rate to the gain realized at disposition, and considering adjustments for alternative valuation scenarios. Proper calculation ensures compliance with IRS rules and accurate tax liability assessment concerning the built-in gains tax for a transitioning corporation like Lockhart.

References

• Internal Revenue Service. (2021). Publication 542: Corporations. IRS.gov.
• U.S. Department of the Treasury. (2014). Subchapter S of the Internal Revenue Code. IRS.gov.
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