Chapter 8:
Change in the Tax Status of an Entity
Chapter Summary
An entity’s tax status may change from nontaxable to taxable, or vice versa. For instance, some entities, such as partnerships, certain limited liability companies, and Subchapter S corporations, which are generally not subject to income taxes, may change from nontaxable to taxable status, or vice versa, as a result of changes in tax laws or changes in elections. ASC 740-10-25-32 though 25-33 and ASC 740-10-40-6 provides guidance for reflecting the tax effects of changes in tax status.
8.1 General Rule for Changes in Tax Status
ASC 740-10-45-19 requires that the deferred tax effects of a change in tax status be included in income from continuing operations at the date the change in tax status occurs. Deferred tax assets and liabilities should be recognized for existing temporary differences when an entity changes its tax status to become subject to income taxes. Similarly, deferred tax assets and liabilities should be eliminated when a taxable entity ceases to be taxable. In both cases, the resulting adjustment is included in income from continuing operations.
ASC 740-10-25-33 and 25-34 require that an election for a voluntary change in tax status be recognized in the financial statements on the approval date, or on the filing date if approval is not necessary. Alternatively, a change in tax status that results from a change in tax law is recognized on the enactment date, similar to other tax law changes.
Example 8-1: Accounting for Deferred Taxes on an Available for Sale Security When a Change in Tax Status Occurs
Background/Facts:
Company A, a U.S. entity with a December 31 fiscal year-end, filed a “check-the-box” election to convert Company B, its foreign subsidiary, into a U.S. branch operation. The election is effective beginning on July 1, 20X2. During the first half of 20X2, Company B experienced an unrealized loss on an available-for-sale (AFS) security it held in the local country. The unrealized loss was recognized in other comprehensive income (OCI). The unrealized loss has no impact on Company B’s local country taxes as Company B is located in a zero-rate jurisdiction, but will result in a tax deduction in the U.S. when the loss is ultimately realized since Company B is now a branch of Company A. Should the tax benefit associated with establishing the U.S. deferred tax asset related to the unrealized loss on the security on July 1, 20X2, be recorded in OCI or income from continuing operations?
Analysis/Conclusion:
The tax benefit should be recognized in income from continuing operations. In this situation, even though the pretax event (i.e., the unrealized loss) was recognized in OCI, the initial tax effect from the unrealized loss was the direct result of the election made by Company A to convert Company B to a U.S. branch operation and thereby change its tax status. In accordance with ASC 740-10-45-19, when deferred tax accounts are adjusted as a result of a change in tax status, the effect of recognizing or eliminating the deferred tax liability or asset shall be included in income from continuing operations.
Once the deferred tax asset is established, upon the change in tax status, the tax effect of any subsequent changes in the value of the AFS security would be subject to normal intraperiod allocation rules. The impact of that may result in a disproportionate effect being lodged in OCI (since the establishment of the deferred tax asset was reflected in continuing operations). As described in Section TX12.2.3.2.2.3 there are two approaches for clearing disproportionate tax effects within the context of AFS securities. Each individual investment could be considered a separate component (i.e., single unit of measure), or investments within a single portfolio could be aggregated into one component (i.e., aggregate portfolio approach).
In the remainder of this chapter, the term nontaxable status is used to refer to entities such as S corporations, partnerships, and limited liability companies, which generally are not subject to income taxes. The term taxable status is used to refer to entities such as C corporations, which generally are subject to income taxes.
8.2 Loss of Nontaxable Status
If an entity either initiates an action or fails to initiate an action that results in a change in its tax status, the effect of the change in status should be recognized in the period in which the change occurs. However, if an entity has begun taking the necessary steps to cure a violation, careful consideration is required in determining whether a change in tax status has occurred.
8.3 Switching Tax Status
8.3.1 Switching to Nontaxable Status
In the United States, an election to change to nontaxable status can be effective as of the beginning of the entity’s next fiscal year, or retroactively to the beginning of the current year if the election is filed within two and one-half months of the beginning of the year. Nontaxable status may be terminated by revocation or by the entity ceasing to qualify as a nontaxable entity. An election to revoke nontaxable status can be effective either for a specified prospective date, or retroactively to the beginning of the year if the election is filed within two and one-half months of the beginning of the year. Nontaxable status automatically terminates effective on the first day that the entity ceases to qualify as a nontaxable entity.
When a taxable entity switches to nontaxable status and the filing date precedes the effective date (e.g., a calendar-year entity files on March 31, 2008, to be effective January 1, 2009), the deferred taxes that will not be required after the effective date should be released to income at the filing date, if approval is not necessary. At this time, the entity will need to evaluate the expected reversal pattern of its temporary differences. Temporary differences that are expected to reverse prior to the effective date, while the entity is still taxable, should continue to be reflected in the financial statements. On the other hand, temporary differences that are expected to reverse subsequent to the effective date, when the entity will no longer be taxable, should be derecognized at the filing date, if approval is not necessary. Deferred tax balances also may be required after the effective date if the entity is subject to the built-in gains tax (see Section TX 8.4).
8.3.2 Switching to Taxable Status
When a nontaxable entity switches to taxable status, or nontaxable status is retroactively revoked, the change in status should be reflected at the filing date, if approval is not necessary. If approval is necessary, the change in status should be reflected on the approval date. Deferred taxes should be provided at the date of change for temporary differences (at that date) that will reverse after the effective date.
Example 8-2: Retroactive Switch from Nontaxable Status
On February 28, 20X1, Omega Corp. revoked its nontaxable status, changing to taxable status retroactive to January 1, 20X1. No approval is required for this change. The following information relates to temporary differences at February 28, 20X1:
It is not expected that a valuation allowance will be needed for the deductible temporary differences at December 31, 20X1. Assuming an applicable rate of 35 percent, at February 28, 20X1, Omega Corp. would record a net deferred tax liability of $385 ($1,100 at 35 percent) and a $385 deferred tax provision to income from continuing operations. Further, a current tax provision for the taxable income for the two months ended February 28, 20X1, would be accrued at February 28, 20X1. It may be useful to disclose the current and deferred components of the total tax provision in discussing the effect of the change to taxable status.
Another disclosure to consider is the amount of the net deferred tax liability that would have been recognized at January 1, 20X1, if Omega Corp. had been taxable at that date. Also, if Omega Corp. had not yet issued its 20X0 financial statements by February 28, 20X1, those statements should disclose the change in tax status and the effects of that change, if material.
Example 8-3: Prospective Switch from Nontaxable Status
On September 30, 20X1, Company A revoked its nontaxable status, thereby changing to taxable status to be effective January 1, 20X2. No approval is required for this change. The information below relates to temporary differences that existed at September 30, 20X1, and that will reverse after January 1, 20X2. It is not expected that a valuation allowance will be needed for the deductible differences. An applicable rate of 35 percent has been assumed.
As a result of the revocation, Company A would record a net deferred tax liability of $350 ($1,000 at 35 percent) as of September 30, 20X1, and a $350 deferred tax provision to income from continuing operations.
The following information relates to temporary differences at December 31, 20X1.
A net deferred tax liability of $385 ($1,100 at 35 percent) would result. Because the net deferred tax liability increased from September 30 to December 31, a $35 deferred tax provision would be required, even though Company A remained, in terms of actual tax status, a nontaxable entity during that period. There would be a total tax provision of $385 (all deferred) for the year ended December 31, 20X1.
8.4 Post-1986 S Corporation Elections/Built-in Gains
If a U.S. entity converts from C corporation status to S corporation status (taxable to nontaxable), the IRS will impose a tax on any “built-in gain” recognized on the sale of assets that occurs within 10 years after the conversion date. (The American Recovery and Reinvestment Act of 2009 shortened the recognition period to 7 years for elections made in 2002 and 2003.) A built-in gain represents the excess of the fair market value over the tax basis of the entity’s assets as of the conversion date. If an asset is sold within 10 years after the conversion date, the portion of any gain recognized that is attributable to the built-in gain would be subject to income tax. Alternatively, if an asset is sold after the 10-year period, no tax related to the built-in gain would be due.
If income tax is due upon the sale of an asset, the entity should consider whether any net operating loss carryforwards or capital loss carryforwards could be utilized to offset any tax due.
In ASC 740-10-55-64, the FASB stated that an entity converting from C corporation to S corporation status should continue to record a deferred tax liability to the extent it will be subject to the built-in gains tax. As the timing of realization of a built-in gain determines whether it is taxable, actions and elections that are expected to be implemented should be considered and could have a significant impact on the deferred tax liability to be recorded. For example, if an entity expects that depreciable fixed assets will be retained in the operations of the business, no amount would be subject to the built-in gains tax.
Additionally, when calculating the built-in gains tax on an asset-by-asset basis, the lesser of the unrecognized built-in gain (loss) or the existing temporary difference as of the conversion date is used. That is, the unrecognized built-in gain (loss) is limited to the existing temporary difference as of the conversion date.
8.4.1 Deferred Tax Liability after the Change to S Corporation Status
When there is a net unrealized built-in gain at the date of conversion, it might be necessary, as discussed in ASC 740-10-55-65, to continue to recognize a deferred tax liability after the change to S corporation status—the question is how to determine the amount, if any. Only assets and liabilities that have temporary differences at conversion need to be considered. Essentially, the question is what impact the temporary differences for these assets will have on the built-in gains tax that is expected to be paid. Even though the actual built-in gain is based on fair market value at the date of conversion, no consideration would be given to any appreciation above the book value as of the conversion date.
Under the tax law, any actual tax liability is based on the lower of the net recognized built-in gain and C corporation taxable income for the year. However, in the calculation of the deferred tax liability, it may be appropriate to ignore the limitation based on C corporation taxable income if it would be operative only if there were future book losses. It is inappropriate to anticipate the benefit of future book losses under ASC 740-10-25-38. The tax benefit of the future book losses should be recognized by releasing the deferred tax liability if and when such losses are recorded.
Example 8-4: Recording Deferred Taxes for Built-in Gains
Assume that an entity’s S corporation election became effective on January 1, 20X6. On December 31, 20X5, the entity had the following temporary differences and built-in-gains:
Assuming that (a) the marketable securities and inventory will be sold in the following year, (b) the entity has no tax loss or credit carryforwards available at December 31, 20X5, to offset the built-in gains, and (c) the applicable corporate tax rate is 35 percent, the deferred tax liability for the built-in gain at January 1, 20X6, would be calculated as follows:
Note: At subsequent financial statement dates until the end of the 10 years following the conversion date, the entity should remeasure the deferred tax liability for net built-in gains based on the provisions of the tax law. Deferred tax expense or benefit should be recognized for any change in the deferred tax liability.
8.4.2 Tax-Planning Actions
As further described in Section TX 5.4.3, anticipated tax-planning actions should be considered in determining the deferred tax liability. However, in assessing whether an action will be economically advantageous, its effect on the built-in gains tax is not the only factor considered. The effect on taxable income (loss) to be reported by the shareholders is also important, as any corporate-level tax reduces the built-in gain included in taxable income by the shareholders.
8.4.3 Financial Statement Reporting
The calculation would be made initially and reflected in the financial statements as of the date the election is made, if approval is not necessary (i.e., the date of the change in tax status). When the election precedes the effective date of the change, projections of assets on hand and estimates of their fair market values at the effective date are necessary. The analysis has to be updated in preparing subsequent balance sheets through the effective date.
The deferred tax liability will have to be reassessed at each balance sheet date subsequent to the conversion date. In addition to changes in the deferred tax liability that result from changes in expectations, the financial statements will reflect tax expense in the year(s) when the dispositions take place for differences between the built-in gains tax paid and the amount previously provided, including the tax applicable to unrecognized appreciation at the conversion date.
8.5 Increase in Tax Basis upon the Conversion of a Partnership to
a Corporation
As part of a plan to go public, an entity currently organized as a partnership effects a transaction that will result in its conversion to a C corporation. This transaction generally would be recorded at predecessor basis for both book and tax purposes. In addition, the change in tax status would require the recognition of a deferred tax asset or liability for the initial temporary differences at the time of the change in status. The recognition of initial temporary differences is recorded in income from continuing operations. However, no current tax expense would result as of the date of the change in status.
If, however, the partnership had net liabilities for tax purposes, a gain, calculated based on the net liabilities that were assumed by the corporation, would be currently taxable to the individual former partners upon conversion. The new C corporation would obtain a step-up in tax basis in an amount equivalent to the gain. The question arises whether this step-up in tax basis is considered a result of the change in tax status (to which the guidance in ASC 740-10-25-32, applies) or a result of a transaction “with or among shareholders” (ASC 740-20-45-11).
We believe that the additional taxable gain recognized by the former partners, which prompted the step-up in tax basis, is a direct consequence of the change in tax status. Therefore, the benefit should be recorded in income from continuing operations, in accordance with ASC 740-10-45-18. In other words, the impact of the change in tax status that is recognized in continuing operations is determined after taking into account the step-up in basis that results from payments made by the individual partners. While an argument could be made for equity treatment in accordance with ASC 740-20-45-11, the consensus in that issue specifically excludes from its scope changes in tax status. We also believe that ASC 225-10, Income Statement would not apply in this situation, because the tax liability is imposed directly on the individual partners and not on the entity itself.
8.6 Business Combination Considerations
8.6.1 S Corporation Election Invalidated by Acquisition by C Corporation
If a C corporation acquires an S corporation in a transaction that will be accounted for as a business combination for financial reporting purposes, ownership by the C corporation may make the S corporation’s election void. This raises the question about the appropriate deferred tax accounting for this event—the change in the tax status guidance in ASC 740-10-25-32, or the business combination guidance in ASC 805-740-25-3 through 25-4, Business Combinations.
We believe that if the S corporation election is invalidated by the acquisition of the entity, then business combination accounting is appropriate. Therefore, deferred tax assets and liabilities are recorded in acquisition accounting for the differences between the assigned values for financial reporting and the tax bases of the assets acquired and liabilities assumed.
However, if the S corporation issued stand-alone financial statements without the application of “pushdown” accounting, the effect of the business combination (i.e., loss of S status) should be accounted for as a change in the tax status of the entity. Accordingly, in the separate financial statements of the acquired entity, the effect of recognizing a deferred tax liability or asset should be included in income from continuing operations at the business combination date.
In some situations, the deferred taxes of the acquired entity are affected not only by the change in tax status, but also by changes in the individual tax bases of its assets and liabilities. This situation could arise where the acquiring entity made a IRC Section 338(h) (10) election under the U.S. tax code. In the separate financial statements of the acquired entity, the tax effect of changes in the tax bases of the assets and liabilities are recorded in equity pursuant to ASC 740-20-45-11, while the tax effect of the change in tax status is recorded in continuing operations. The application of ASC 740-20-45-11 on separate financial statements of a subsidiary is discussed further in Section TX 14.6.
8.6.2 Common-Control Merger Involving an S Corporation
If a C corporation acquires an S corporation in a transaction that will be accounted for as a merger of entities under common control, the combined financial statements for periods prior to the transaction should not be adjusted to include income taxes for the S corporation.
ASC 740-10-25-32 requires the recognition of deferred taxes at the date a nontaxable entity becomes a taxable entity, which is the date of the business combination. This adjustment should be included in income from continuing operations.
Although historical financial information cannot be tax-effected, it is generally appropriate to include pro forma historical financial information that includes taxes for the S corporation as though it had been combined with the C corporation for all periods presented.
8.6.3 Change in Tax Status as Part of a Business Combination
Section TX 8.6.1 discusses the accounting for a change in tax status that is directly caused by an acquisition (e.g., an S corporation election is invalidated by its acquisition by a C corporation). In addition to that situation, the acquirer may choose to change the tax status of the acquired entities. The question arises whether the tax effects of a “voluntary” status change of acquired entities (e.g., an election to change from a C corporation to an S corporation) should be recorded as part of the acquisition accounting or in continuing operations in accordance with
ASC 740-10-40-6.
In general, a voluntary change in tax status of an acquired entity following an acquisition (even when occurring during the measurement period) should be accounted for in continuing operations in accordance with ASC 740-10-40-6. However, there may be circumstances where we believe it would be appropriate to account for a voluntary change in tax status as part of the acquisition. Items to consider when making this determination include whether:
1. As of the acquisition date, the entity qualified for and intended to make the election. (The acquirer should be able to demonstrate that the status change was part of the plans for acquiring the target and not based on factors occurring after the entities were acquired.)
2. The election is effective at (or applied retroactively to) the acquisition date.
3. Consideration is paid to the taxing authority to effectuate the change in tax status.
PwC engagement teams should consider consulting with the Accounting Services Group within PwC’s National Professional Services Group when accounting for a voluntary change in tax status as part of an acquisition.
8.7 REIT Conversion
8.7.1 Effective Date of a REIT Conversion
Example 8-5: Effective Date of a REIT Conversion
Background/Facts:
Company A, a C corporation, plans to convert into a real estate investment trust (REIT) effective as of January 1, 2006. A REIT is not required to file an election to effect the change in tax structure; rather, the REIT first reports the conversion to the IRS by filing a specific tax form (1120-REIT) several months after the end of its initial tax year as a REIT. Further, such change does not require preapproval by the IRS.
Requirements for Company A’s REIT status to become effective include:
Setting up the legal entity structure of the REIT,
Purging accumulated earnings and profits from its operations as a C corporation through a distribution to shareholders (E&P Purge), and
Filing its initial tax return as a REIT on Form 1120-REIT.
Company A is assessing the impact of this event, and trying to determine when to adjust its deferred tax accounts to reflect its new REIT status. This fact pattern does not seem to be addressed by ASC 740 or any other literature and there appears to be diversity in practice. In particular, is the conversion from a C corporation to a REIT considered a change in tax status as discussed in ASC 740-10-25-33 (which can’t be reflected until the REIT election has been made—presumably when the tax return for the initial tax year is filed) or is this an event that should be reflected in an earlier period, perhaps when Company A has committed to a course of action? Further, if it is not treated as a change in tax status, when is the REIT conversion effective, given that approval is not required, nor does any sort of election need to be filed, to convert to a REIT?
Analysis/Conclusion:
In our view, the conversion of a C corporation to a REIT is not a “change in tax status” as described in ASC 740-10-25-33. This is because a REIT is still technically a taxable entity under the Internal Revenue Code. A REIT’s earnings are taxable (although the amount subject to income taxes is reduced by a deduction for the amount of REIT income distributed to shareholders).
Because we do not view the REIT conversion to be a change in tax status, we believe it would
be appropriate to reflect the effects of the REIT conversion at the date when Company A
(1) completed all significant actions necessary to qualify as a REIT and (2) committed to that course of action. This is consistent with the guidance in ASC 740-10-05-9 which addresses situations where companies have “control” over the outcome of whether certain temporary differences will result in taxable amounts in future years.
In this example, Company A should account for the conversion to a REIT when it:
1. Has committed itself to this course of action in such a way that it would be impossible or practically impossible to not convert to REIT status. Approval by the appropriate parties within Company A (e.g., board of directors) and a public announcement of the change might produce this result, provided that this truly constituted a commitment.
2. Has obtained financing for the E&P purge (if necessary and considered significant).
3. Is “REIT-ready” in all material respects such that the only legal and administrative actions necessary to qualify for REIT status is to file its tax return on Form 1120-REIT (i.e., any remaining steps are considered perfunctory).
At that time, tax assets or liabilities should be adjusted to reflect the change to REIT structure.