Choice "D" is correct. A distribution or a sale of an S corporation's assets may result in a tax on any "built-in gain" at the corporate level. An unrealized "built-in gain" results when the following two conditions occur: (1) a C corporation elects S corporation status, and (2) the fair market value of the corporate assets exceeds the adjusted basis of corporate assets on the election date. The two conditions exist in the facts of the question. The net unrealized built-in gain is the excess of the fair market value of corporate assets over the adjusted basis of corporate assets at the beginning of the year in which the S corporation status is elected.
FMV at January 1 | $ 85,000 |
Adjusted basis at January 1 | (40,000) |
Excess | 45,000 |
× 35% tax rate | 35% |
Corporate tax liability | $ 15,750 |
Note: The gain to the corporation is a total of $55,000 ($95,000 − $40,000). An S corporation generally does not pay tax at the corporate level; however, in this case, there was built-in gain of $45,000 upon the election to become an S corporation, so the related C corporation tax must be paid upon the sale of the asset.Choice "c" is incorrect. The gain to the corporation is a total of $55,000 ($95,000 − $40,000). An S corporation generally does not pay tax at the corporate level; however, in this case, there was built-in gain of $45,000 upon the election to become an S corporation, so the related C corporation tax must be paid upon the sale of the asset.Choice "a" is incorrect. This choice incorrectly assumes that the tax is calculated as 35% of the difference between the sales price of the asset ($95,000) and the fair market value at the effective date of the S election ($85,000). [$95,000 − $85,000=$10,000; $10,000 × 35%=$3,500]Choice "b" is incorrect. This choice incorrectly uses the actual total gain on the sale (the sales price of $95,000 less the basis of $40,000) and then calculates the tax liability as 35% of that amount. [$95,000 − $40,000=$55,000; $55,000 × 35%=$19,250]
