Apportionment of net recognized built-in gains in California
S-corporations doing business in California and that have net recognized built-in gains (NRBIG) are required to apportion those gains to California. However, taxpayers and tax professors had questions. What apportionment factors does the S corporation use: the factors in the year of sale or the year of conversion?
On April 3, 2017, the Franchise Tax Board (FTB) released Technical Advice Memorandum (TAM): 2017 -02, providing guidance on the S corporation net recognized built-in gains tax and whether or not the built-in gains (or losses) are attributed to California using the apportionment factors in the year of sale or the year of conversion.
California conforms to IRC section 1374(a), under California Revenue and Taxation Code section 23809, which states:
“If for any taxable year beginning in the recognition period an S corporation has a net recognized built-in gain, there is hereby imposed a tax (computed under subsection (b)) on the income of such corporation for such taxable year.”
In general, the recognition of income or loss occurs at the time of realization, such as the sale of property, followed by the recognition of gain or loss. The applicable apportionment factors to be used in a transaction are the ones related to the business activities from the year of realization. The FTB compared the NRBIG to that of an installment sale transaction, in which realization and recognition occur in different years but the applicable apportionment factors to be used are the ones related to the business activities from the year of realization. The factors must reflect the business activities for the year in which the income was realized. When an apportioning s-corporation sells property generating NRBIG, the income (or loss) should be apportioned according to the factors in the year of the sale and not the apportionment factors in the year of the S corporation conversation.
The FTB has now issued guidance on a matter that was previously unclear. The FTB's methodology is consistent with other transactions in which realization and recognition occur in different years. Examples include installment sales, completed contract method of accounting and the post-apportionment utilization of the net operating loss carrybacks and carryforwards. Accordingly, taxpayers should be using the apportionment factors for the year in which the built-in gains (or losses) were realized.