Accounting & Tax News

G.R. Reid Associates, LLP
Certified Public Accountants 


631.425.1800   www.GRReid.com

The S Corporation Built-In Gains Tax: 

Commonly Encountered Issues

 

Millions of corporations have found S corporation status to be beneficial for both federal and state income tax purposes. When a corporation makes an election to be taxed as an S corporation, its shareholders generally are taxed on their allocable shares of income and may—subject to limitations—deduct their allocable shares of the corporation’s losses. However, when a corporation has converted its status from C corporation to S corporation or acquires assets from a C corporation in a tax-free transaction, it may be subject to a corporate-level “built-in gains” tax in addition to the tax imposed on its shareholders.

The concepts underlying this tax are relatively basic, but its application can be complex. This article examines some of the issues corporations commonly encounter in complying with the built-in gains tax.

If a C corporation converts its tax status to a partnership or a disregarded entity, the resulting actual or deemed liquidation, in most cases, would be a taxable transaction for both the corporation and its shareholders. In contrast, if a C corporation elects S corporation status, these immediate tax consequences are avoided.1 If a corporate-level built-in gains tax were not imposed, a C corporation could make an election to be taxed as an S corporation (assuming it is otherwise eligible to do so) and sell all or part of its assets with a single level of tax. The built-in gains tax is imposed to prevent an S corporation election from being used to circumvent the effects of a taxable liquidation.

The tax is imposed upon an S corporation that has some history—however brief—as a C corporation before the effective date of its S corporation election.2 It also is imposed on an S corporation that has always been an S corporation, if it acquires assets from a C corporation in a tax-free transaction, such as an acquisition of assets in a tax-free reorganization or the tax-free liquidation of a controlled subsidiary.3 The corporation must determine whether it has a net unrealized built-in gain (NUBIG) in its assets on the effective date of the relevant transaction. If the corporation has a NUBIG in its assets, it must track its dispositions of these assets for 10 years.4

To the extent that gains recognized during this period represent recognized built-in gains (RBIGs), the tax is imposed at the highest rate of tax applicable to corporations (currently 35%) on the net RBIG. To prevent the tax from becoming significantly more onerous than the tax that would have been imposed on a C corporation, it is not imposed on an amount greater than the taxable income that would have been reported by the taxpayer had it remained a C corporation.5 For any tax year in which the net RBIG of an S corporation exceeds its taxable income computed in this manner, the excess is carried over and is treated as RBIG in the subsequent year.6

The tax imposed on the corporation is in addition to—and not in lieu of—the tax that may be imposed on its shareholders under the rules generally applicable to S corporations. To replicate the effects of C corporation taxation, the shareholders are subject to tax on the corporate-level gain, net of the corporate-level tax. This result is achieved by permitting the shareholder to treat the corporate-level tax as a loss that has the same character as the gain that gives rise to the tax.7 Thus, for example, if an S corporation recognizes a $100 long-term capital gain, all of which is treated as RBIG, the corporation generally incurs a $35 built-in gains tax.8 The shareholders recognize their allocable share of a net $65 long-term capital gain for the same tax year.

The tax can be complex, but several issues are most frequently encountered. Five of these issues are explored in this article: (1) the desirability of obtaining a proper appraisal as of the beginning of the recognition period; (2) the treatment of sales of inventories during the recognition period; (3) the application of the tax to corporations using the cash receipts and disbursements method of accounting; (4) the efficient use of losses to reduce or eliminate the tax; and (5) the use of C corporation attributes, such as net operating losses (NOLs) and general business credits, to reduce or eliminate the tax.

Getting the Proper Appraisal

Statutory presumptions applicable to the built-in gains tax effectively require taxpayers to prove their case to the IRS’s satisfaction. Thus, all gains recognized by an S corporation during the recognition period are presumed to be RBIGs, except to the extent the taxpayer establishes that a portion of the gain constitutes post-conversion appreciation or that the asset was not held at the beginning of the recognition period.9 Conversely, no loss recognized by an S corporation during the recognition period is treated as a recognized built-in loss (RBIL), except to the extent the taxpayer establishes that the asset was held at the beginning of the recognition period and further establishes the portion of the recognized loss that was built in at the beginning of the recognition period.10

Under applicable regulations, a corporation’s NUBIG is:

1. The amount of net gain, if any, that the corporation would have recognized if it had sold its assets at the beginning of the recognition period for their fair market value (FMV) in a single transaction to an unrelated buyer that also assumed all of the corporation’s liabilities; decreased by
2. The sum of any deductible liabilities of the corporation that would be included in the amount realized on the hypothetical sale and the corporation’s aggregate adjusted basis in all of its assets; increased or decreased by
3. The corporation’s Sec. 481 adjustments that would be taken into account on a hypothetical sale; and increased by
4. Any RBIL that would not be allowed as a deduction under Secs. 382, 383, or 384 on the hypothetical sale.11

The goal of the calculation is to ascertain the net tax consequences to the corporation of a hypothetical liquidating sale of its entire business and assets.

The best defense against an assertion that additional tax is due on RBIG is a proper appraisal of the assets at the beginning of the recognition period. The appraiser should be qualified and experienced in valuing similar businesses and should be given proper instructions consistent with the requirements of the statute and regulations. That is, the appraisal should assume a hypothetical sale of the corporation’s assets as a going concern, not its stock. The appraisal must take into consideration the business’s intangible assets, such as goodwill and going-concern value, in addition to the tangible or identifiable assets. Because the appraisal must assume a sale of assets, it may not claim discounts for minority interests or for lack of marketability—discounts that might have been claimed in an appraisal of stock for gift or estate tax purposes.

Sales of Inventories

Taxpayers that maintain inventories for sale to customers may be surprised to learn that the built-in gains tax may apply to individual sales of their products to customers during the recognition period. Consistent with the principles that apply to the determination of NUBIG, the regulations provide, in effect, that the inventories must be valued using a “bulk sale” approach.12 In the case of an actual bulk sale of inventories as part of a sale of an entire trade or business, the IRS has provided guidelines for determining the FMV of inventories and, thus, the amount of consideration that should be allocated to the inventories.13 The guidance clarifies that inventories should not be valued solely on the basis of aggregate costs incurred by the seller of the business; nor should they be valued based solely on the aggregate selling prices that the buyer of the business would expect to realize from their disposition in individual sales. Rather, the FMV should be between these two extremes, to allow for a “fair division between the buyer and the seller of the profit on the inventory.”14

The determination of the corporation’s unrealized built-in gain in its inventories is merely the first step in the process. The taxpayer should—theoretically, at least—monitor the disposition of inventory items held at the beginning of the recognition period to determine the amount of RBIG resulting from each sale. The regulations permit taxpayers, in complying with this requirement, to assume that the physical flow of goods in inventory at the beginning of the recognition period is consistent with the cost-flow assumption used for income tax purposes.15Accordingly, if the corporation consistently uses LIFO accounting for inventories, it will not be treated as having disposed of any of its inventory items held at the beginning of the recognition period unless the carrying value of the inventories at the end of a tax year is less than the carrying value of the inventories at the beginning of the recognition period.

For non-LIFO taxpayers, compliance may be significantly more difficult. The cost-flow assumptions will generally result in the taxpayer’s being required to treat the inventory items on hand at the beginning of the recognition period as the first items disposed of during the recognition period. Thus, if the inventories generally turn over at least once each year, the entire amount of the unrealized gain inherent in the recognition period beginning inventory will be treated as RBIG in the first year of the recognition period.16 Taxpayers that fail to account properly for the built-in gains tax in connection with the sale of their inventories may be subject to interest and penalties,17and tax return preparers may be subject to penalties for failing to recognize the application of the built-in gains tax to ordinary-course dispositions.18

Beware the Cash-Basis Corporation

Although the principal focus of Sec. 1374 is the treatment of gains and losses from the sale or exchange of property, Congress recognized that certain income and deduction items also could be treated as “built in” as of the beginning of the recognition period. Accordingly, the Code treats as RBIG any item of income that properly is taken into account during the recognition period but that is attributable to periods preceding the beginning of the recognition period.19 Similarly, the Code treats as RBIL any deduction allowable during the recognition period that is attributable to periods preceding the beginning of the recognition period.20 Appropriate adjustments must be made to the corporation’s NUBIG where items of income and deduction are treated as RBIGs and RBILs, respectively.21

The statute provides little guidance on how to determine whether an item of income or deduction is attributable to periods preceding the beginning of the recognition period. For both income and deduction items, the regulations generally adopt an accrual-method standard to determine if an item is attributable to such prior periods. Thus, if a corporation using an accrual method would have taken into account an item of income or a deduction before the beginning of the recognition period, that item is considered built in for this purpose, if it is actually taken into account during the recognition period.22

Certain C corporations are permitted to use the cash receipts and disbursements method of accounting as their overall method for tax purposes.23 When these corporations make an S corporation election, the application of the built-in gains tax is clear but may be surprising. Under the accrual-method rule, the post-conversion collection of the accounts receivable that a corporation held as of the beginning of the recognition period will be treated as RBIG. Similarly, the post-conversion payment of their accounts payable and accrued expenses as of the beginning of the recognition period generally will be treated as RBIL. As a result, where a cash-basis corporation merely operates the business in the normal course, the items of income recognized early in the recognition period could give rise to the built-in gains tax. A corporation in this position could reduce or eliminate its liability for the tax by reducing or eliminating its overall taxable income, but it would be required to do so for the entire 10-year recognition period to escape the reach of the tax permanently.

Planning the Recognition of Losses

Corporations do not uniformly have unrealized gains in their assets. Some assets may have unrealized losses at the beginning of the recognition period even though the corporation has NUBIG. Moreover, some corporations may expect to recognize deductions during the recognition period that would be treated as RBILs. Losses, whether realized or unrealized, may reduce the built-in gains tax of an S corporation in two ways: First, an unrealized loss is included in the determination of a corporation’s NUBIG. Because the tax is not imposed on an amount in excess of a corporation’s NUBIG, the corporation may have RBIG from a particular asset or group of assets that exceeds its NUBIG. It is not necessary to recognize the unrealized loss to achieve a reduction of the built-in gains tax. Second, if a corporation has both RBIG and RBIL in the same tax year, the two are combined to determine the net RBIG, upon which the tax is imposed.24 Thus, a corporation could plan to recognize the loss from a loss asset in the same tax year as it recognizes the gain from a gain asset to reduce or eliminate the tax imposed on the gain asset.

A corporation may, however, lose the benefit of holding the loss asset or claiming the built-in deduction if the loss or deduction is recognized in a tax year preceding the year in which the built-in gain or income item is recognized. There is no provision in the Code for carrying forward an unused RBIL or deduction for offset against an RBIG or built-in income item recognized in a subsequent tax year.

Example 1: Assume a corporation has a $1,000 NUBIG at the beginning of its recognition period. In year 1, it recognizes a $75 RBIL, and in year 2, it recognizes a $100 RBIG. Assuming its taxable income limitation is greater than its RBIG, the corporation will pay a tax of $35 in year 2, based solely on the $100 RBIG. However, if it had recognized the two items in the same tax year, its built-in gains tax would be only $8.75, based on a $25 net RBIG.

Use of Credits and Other Tax Attributes

Corporations that are taxed consistently as C corporations from year to year are permitted to carry back or forward a number of tax attributes, including NOLs, capital losses, excess charitable contributions, general business tax credits, minimum tax credits, and foreign tax credits. In contrast, an S corporation generally cannot carry forward any such tax attributes from exa tax year in which it was a C corporation.25 However, the policy underlying the built-in gains tax is to treat the S corporation, for purposes of its RBIGs, in a manner similar to its treatment if it had remained a C corporation. To bridge these policy differences, the Code permits an S corporation to carry forward certain tax attributes from a C corporation year to an S corporation year for the purpose of reducing or eliminating its liability for the built-in gains tax. Accordingly, it may carry forward an NOL or capital loss from a C corporation year as a deduction against its net RBIG for the tax year.26 Similarly, after determining its liability for the built-in gains tax, the corporation may apply its unused general business tax credits and minimum tax credits against this tax, subject to generally applicable limitations.27

The Code does not permit the full utilization of all tax attributes that a C corporation might have used to reduce its federal income tax liability. For example, excess charitable contributions of a C corporation may not be deducted against the RBIG of an S corporation.28 Similarly, an excess foreign tax credit of a C corporation may not be used in computing an S corporation’s liability for the tax.29 Accordingly, if an S corporation is subject to the built-in gains tax and has any tax attributes being carried forward from C corporation years, it should fully utilize those attributes that it is permitted to use but also should be aware of any attributes it is not permitted to use.

Conclusion

The application of the built-in gains tax to S corporations can be one of the more complex and costly aspects of obtaining flowthrough status for a C corporation. The potential scope of the tax should be one of the considerations undertaken by a corporation seeking to make the election to be taxed as an S corporation. With proper planning, the corporation can both anticipate and manage the amount and timing of the tax. Surprises in this area, whether from tax return preparers or IRS examining agents, are never welcome.

Footnotes

¹ Two immediate consequences may result from an election, but only if the corporation uses the last-in, first-out (LIFO) method of accounting for its inventories or has an overall foreign loss. Under Sec. 1363(d), a LIFO recapture tax is imposed in the last year of its C corporation status, and the resulting tax is paid in equal installments over a period of four tax years beginning with the final C corporation year. Under Sec. 1373(b), an overall foreign loss generally must be recaptured.

² The tax generally does not apply to an S corporation that has always been an S corporation, subject to a rule that treats an S corporation and its predecessors as one corporation for purposes of this rule (Sec. 1374(c)(1)).

³ Sec. 1374(d)(8). When the tax applies to a group of assets acquired in this manner, the recognition period begins on the date on which the assets are so acquired.

⁴ Legislation enacted in the last several years has effectively shortened the recognition period for certain S corporations. Unless Congress provides further relief, these shortened periods apply only to corporations recognizing built-in gains in tax years that began in 2009, 2010, or 2011. For built-in gains recognized in subsequent tax years, the recognition period is restored to 10 years.

⁵ Sec. 1374(d)(2)(A)(ii).

⁶ Sec. 1374(d)(2)(B).

⁷ Sec. 1366(f)(2).

⁸ The conclusion is based on a number of assumptions, including that (1) the corporation has no other recognized built-in losses for the same tax year; (2) the taxable income limitation does not apply; (3) the NUBIG of the corporation, reduced by built-in gains recognized in prior tax years, was at least $100; and (4) the corporation did not avail itself of any net operating loss, capital loss, or credit carryovers from C corporation tax years.

⁹ Sec. 1374(d)(3).

¹⁰ Sec. 1374(d)(4).

¹¹ Regs. Sec. 1.1374-3(a).

¹² Regs. Sec. 1.1374-7(a).

¹³ Rev. Proc. 2003-51, 2003-2 C.B. 121 (applicable only to an asset acquisition subject to Sec. 1060 or a deemed asset acquisition under a Sec. 338 election).

¹⁴ Id., citing Knapp King-Size Corp., 527 F.2d 1392 (Ct. Cl. 1975).

¹⁵ Regs. Sec. 1.1374-7(b).

¹⁶ The regulations also contain a narrow antiabuse rule, under which a taxpayer is required to use its former method of accounting in complying with the requirement of the built-in gains tax if it changed its method “with a principal purpose of avoiding the tax” (Regs. Sec. 1.1374-7(b)).

¹⁷ Penalties an S corporation may be subject to include those for a substantial understatement of its tax liability (Sec. 6662) and for failure to make estimated tax payments (Sec. 6655).

¹⁸ Penalties a tax return preparer may be subject to include the Sec. 6694 penalty for certain understatements of the taxpayer’s liability.

¹⁹ Sec. 1374(d)(5)(A).

²⁰ Sec. 1374(d)(5)(B).

²¹ Sec. 1374(d)(5)(C). These adjustments are effectively taken into account in the five-part approach to determining the NUBIG of an S corporation under Regs. Sec. 1.1374-3(a).

²² Regs. Sec. 1.1374-4(b). Special rules are also provided for specific types of income or deductions, including (1) income from long-term contracts; (2) gain reported under the installment method; (3) income from discharge of indebtedness; (4) Sec. 481(a) adjustments from prior accounting method changes; (5) deductions for bad debts; and (6) deductions deferred under the economic performance rules of Sec. 461(h), the nonqualified deferred compensation rules of Sec. 404(a)(5), and the Sec. 267(a)(2) rules for certain related-party accruals.

²³ Such corporations generally consist of corporations not required to use an accrual method of accounting under Sec. 448 because their three-year average annual gross receipts do not exceed $5 million, other small corporations eligible for certain administrative procedures, and qualified personal service corporations regardless of size.

²⁴ Sec. 1374(d)(2). In every case, the other two limitations—based on NUBIG and taxable income, respectively—must also be applied to determine the corporation’s liability for the tax.

²⁵ Sec. 1371(b)(1).

²⁶ Sec. 1374(b)(2). A capital loss carryforward may offset only an RBIG that is properly characterized as a capital gain under general principles.

²⁷ Sec. 1374(b)(3)(B). The general business tax credits are only those described in Sec. 38, for which Sec. 39 allows a carryforward and carryback. The most common allowable credits are the credit for increasing research activities, the low-income housing credit, the various “investment” credits (including the rehabilitation credit), and a variety of business-related energy and employment credits.

²⁸ C corporations may deduct their charitable contributions up to an amount equal to 10% of their taxable income determined before such contributions and certain other deductions (Sec. 170(b)(2)). Any excess charitable contributions may be carried forward for up to five tax years and are subject to the same limitation in the carryforward years (Sec. 170(d)(2)).

²⁹ C corporations may claim a credit for certain foreign taxes paid or accrued during the tax year (Sec. 901). The credit is generally limited to the amount of federal income tax that otherwise would be imposed on the same income (Sec. 904(a)). Any excess foreign tax credits may be carried back one tax year and forward for up to 10 tax years, subject to the same limitations in the prior and subsequent years (Sec. 904(c)).

Written by Kevin D. Anderson, CPA, J.D. 

Originally published by American Institute of CPAs, March 2012.

Personal Insurance Services

: : Neal B. Patel, Managing Director,
Personal Insurance Services | G.R. Reid Agency, LLC
631.923.1595 ext. 303

Boating Season is Right Around the Corner

Americans love the sense of freedom and adventure that comes from boating. But the price tag of recreational boating accidents is high: about $36 million dollars per year. And these figures are probably only the tip of the iceberg since the Coast Guard believes that more than 80 percent of all boating accidents go unreported.

Given this level of risk for accidents, it would make sense that boat owners would look for a way to protect themselves, but that doesn't seem to be the case. A study conducted by Progressive Insurance revealed that nearly one third of U.S. boat owners don't own a separate watercraft policy. That's probably because boat owners assume that their craft is covered by their personal auto policy or their homeowner's policy. This is a mistake that can cost them big time.

The standard auto policy covers the boat trailer for liability with the option to add coverage for physical damage. The boat itself, however, is not covered for liability or damage.

Some homeowner's policies offer coverage for physical damage for boats, but only for smaller vessels. The typical homeowner's policy contains a special property limit of $1,500 on watercraft, which doesn't begin to equal the dollar value of most boats. In addition, the covered perils specific to the boat are also greatly restricted. There is also liability coverage available for boats under the majority of homeowner's policies, but once again, it is only applicable to smaller watercraft. The only exception is a boat with an outboard motor. That means that any type of boat you own that is powered by an inboard or inboard-outboard motor is excluded from liability coverage under the homeowner's policy.

Until You Know It's Protected, Keep Your Boat on Dry Land 

Because most boat owners are unaware how large a property and liability loss they expose themselves to without proper insurance, the Institutional Risk Management Institute (IRMI) has created a list of loss scenarios that demonstrate the need for specialized boat owners coverage:

• Your cruiser collides with a speedboat whose operator fails to yield the right of way, causing extensive damage to your boat. The owner of the speedboat does not have any insurance coverage.
• An expensive fishing boat you just purchased is stolen from your home.
• Your 27-foot-long sailboat is damaged by a hailstorm and high winds while docked at the marina.
• Your sport fishing boat is struck by lightning, incapacitating its electrical system.
• Your daughter's friend is water skiing behind your boat and  falls into the lake, injuring herself, due to the excessive speed of the boat.
• You negligently cause another boat to overturn to avoid a collision.
• Your outboard motor explodes, seriously injuring your next-door neighbor.

These scenarios illustrate the need to factor insurance costs into the equation when buying a boat. If you fail to insure your boat properly, your boat loan may become the smallest of your financial worries.

Obtain the property and liability protection that makes sense for you. 

What To Consider:

• Size Of Vessel
  We can insure boats of all sizes, from small runabouts to some of the world’s largest super yachts.
• Your Comfort Level
  Various deductible options empower you to choose how much up-front risk you’d like to take; higher deductibles often can result in meaningful premium savings.
• Your Cruising Itinerary
  We can cover vessels cruising anywhere in the world.
• Presence & Size Of Crew
  Different circumstances call for different solutions.
• On-Board Contents
  Broad coverage extends to large amounts of fine art and/or other personal effects.
• Your Liability Exposure
  We can provide adequate protection, including coverage for crew claims under the Federal Jones Act.

Visit the G.R. Reid website for more information and to request a quote.

Accounting & Tax News

G.R. Reid Associates, LLP
Certified Public Accountants 


631.425.1800   www.GRReid.com

 

 

Small Employers: Reminder to Utilize Small Business Health Care Tax Credit

The IRS is encouraging small employers that provide health insurance coverage to their employees to check out the Small Business Health Care Tax Credit.

This program, which was enacted two years ago as part of the Affordable Care Act, provides income tax credits to small employers that pay at least half of the premiums for employee health insurance coverage under a qualifying arrangement. The credit is specifically targeted to help small businesses and tax-exempt organizations provide health insurance for their employees.

The IRS recently revised the Small Business Health Care Tax Credit page on IRS.gov and included information and resources designed to help small employers determine if they qualify for the credit and then to compute it correctly. The webpage includes a step-by-step guide for determining eligibility and examples of typical tax savings under various scenarios. The credit is computed utilizing IRS forms 8941 and 3800.

Filing deadlines differ depending upon how a small business is structured, such as a sole proprietor, corporation, partnership, limited liability company or a tax-exempt organization. Taxpayers needing more time to determine eligibility should consider obtaining an automatic tax-filing extension. Businesses that have already filed and later find that they qualified in 2010 or 2011 can still claim the credit by filing an amended return. 

Additional information about eligibility requirements and figuring the credit can be found on IRS.gov or by contacting your G.R. Reid Tax Professional.

Accounting & Tax News

G.R. Reid Associates, LLP
Certified Public Accountants 


631.425.1800   www.GRReid.com

IRS Releases 2012 Auto and Truck Valuation Rules

With the release of Rev. Proc. 2012-13, the IRS has set the maximum fair market value amounts regarding the proper valuation rule for employees calculating fringe benefit income from employer-provided automobiles, trucks, and vans first made available for personal use in 2012.

Taxpayers whose employers provide company cars (or trucks and vans) for their personal use must factor that usage into in his or her income and wages as fringe benefit income.

The taxpayers may calculate the value of their personal use using the cents-per-mile valuation rule. The calculation involves imputing the fair-market value of the employer-provided vehicle. The IRS limits the dollar amount of the fair market value of the employer’s vehicle. In 2012, the mileage allowance rate is 55.5 cents-per-mile and the maximum fair market value allowed in 2012 is $15,900 for a passenger automobile, and $16,700 for a truck or van. This means that the cents-per-mile rule cannot be used to value an automobile whose fair market value, as of the first day on which it is made available to any employee for personal use, exceeds certain amounts set by the IRS.

It is important to note that the maximum fair market values released by Rev. Proc. 2012-13 only applies to automobiles that were allowed to be used as personal property beginning in the year 2012. Therefore, if the automobile in question was first used for personal purposes prior to 2012, then the fair market value limits that apply are those designated by the IRS for those years.

Employers that maintain a fleet of at least 20 automobiles can value the fair market value of each automobile as equal to the average value of the entire fleet. This is known as the Fleet-average value method. This method averages the fair market value of all automobiles used in the fleet. The maximum fair market value for the fleet-average valuation allowed by the IRS in 2012 is $21,000 for a passenger automobile and $21,900 for a truck or van. If a vehicle within the fleet owned by the employer exceeds the maximum fair market value allowed by the IRS, then the fleet-average valuation rule cannot be used.

Financial & Wealth Services News

:: George G. Elkin, Managing Director, Financial & Wealth Services
631.923-1595 ext. 336
G. R. Reid Wealth Management Services, LLC  

 What Is the Most Tax-Efficient Way to Take a Distribution from a Retirement Plan?
 
If you receive a distribution from a qualified retirement plan, such as a 401(k), you need to consider whether to pay taxes now or to roll over the account to another tax-deferred plan. A correctly implemented rollover can avoid current taxes and allow the funds to continue accumulating tax deferred.
 
Paying Current Taxes with a Lump-Sum Distribution
 
If you decide to take a lump-sum distribution, income taxes are due on the total amount of the distribution and are due in the year in which you cash out. Employers are required to withhold 20 percent automatically from the check and apply it toward federal income taxes, so you will receive only 80 percent of your total vested value in the plan.
 
The advantage of a lump-sum distribution is that you can spend or invest the balance as you wish. The problem with this approach is parting with all those tax dollars. Income taxes on the total distribution are taxed at your marginal income tax rate. If the distribution is large, it could easily move you into a higher tax bracket. Distributions taken prior to age 59½ are subject to an additional 10% federal income tax penalty.
 

If you were born prior to 1936, there are two special options that can help reduce your tax burden on a lump sum.

 
The first special option, 10-year averaging, enables you to treat the distribution as if it were received in equal installments over a 10-year period. You then calculate your tax liability using the 1986 tax tables for a single filer.
 
The second option, capital gains tax treatment, allows you to have the pre-1974 portion of your distribution taxed at a flat rate of 20 percent. The balance can be taxed under 10-year averaging, if you qualify.
 
To qualify for either of these special options, you must have participated in the retirement plan for at least five years and you must be receiving a total distribution of your retirement account.
 
Note that these special tax treatments are one-time propositions for those born prior to 1936. Once you elect to use a special option, future distributions will be subject to ordinary income taxes.
 
 
Deferring Taxes with a Rollover
 
If you don’t qualify for the above options or don’t want to pay current taxes on your lump-sum distribution, you can roll the money into a traditional IRA.
 
If instead you choose a rollover from a tax-deferred plan to a Roth IRA, you must pay income taxes on the total amount converted in that tax year. However, future withdrawals of earnings from a Roth IRA are free of federal income tax as long as the account has been held for at least five tax years.
 
If you elect to use an IRA rollover, you can avoid potential tax and penalty problems by electing a direct trustee-to-trustee transfer; in other words, the money never passes through your hands. IRA rollovers must be completed within 60 days of the distribution to avoid current taxes and penalties.
 
An IRA rollover allows your retirement nest egg to continue compounding tax deferred. Remember that you must begin taking annual required minimum distributions (RMDs) from tax-deferred retirement plans after you turn 70½ (the first distribution must be taken no later than April 1 of the year after the year in which you reach age 70½). Failure to take RMDs subjects the funds that should have been withdrawn to a 50 percent federal income tax penalty.  
 
Of course, there is also the possibility that you may be able to keep the funds with your former employer, if allowed by your plan.
 
Before you decide which method to take for distributions from a qualified retirement plan, it would be prudent to consult with a professional tax advisor. 


Visit our website:  G.R. Reid Wealth Management Services, LLC


George Elkin is a Registered Representative offering Securities through American Portfolios Financial Services, Inc. Member: FINRA, SIPC. Investment Advisory products/services are offered through American Portfolios Advisors Inc., an SEC Registered Investment Advisor. G.R. Reid Consulting Services, LLC  is not a registered investment advisor and is independent of American Portfolios Financial Services Inc. and American Portfolios Advisors Inc. Unless specifically stated otherwise, the written advice in this memorandum or its attachments is not intended or written to be used for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Information is time sensitive, educational in nature, and not intended as investment advice or solicitation of any security.

This material was written and prepared by Emerald.