Mock Corporation converts to S corporation status in 2016. Mock used the LIFO inventory method in 2015 and had a LIFO inventory of $435,000 (FIFO value of $550,000) on the date of the S election. How much tax must be added to Mock's 2015 corporate tax liability, assuming that Mock is subject to a 35% tax rate.

Question

Quizplus · Accepted Answer

When a corporation changes its tax status to an S corporation, it must make an adjustment for any built-in gains (BIG) that exist at the time of the conversion. Built-in gains are gains that would have been taxed at the corporate level if the corporation had sold the asset immediately before the conversion.

In this case, the inventory that Mock held at the time of the S corporation election is considered a BIG asset because it was acquired when Mock was a C corporation and is now being held by a new S corporation. The amount of tax due on the BIG is equal to the difference between the corporate tax rate and the individual tax rate (which is typically lower).

Since Mock's LIFO inventory had a FIFO value of $550,000, the built-in gain is $115,000 ($550,000 - $435,000). At a 35% corporate tax rate, the tax due on this gain is $40,250 ($115,000 x 35%). Therefore, the answer is B: $10,062.50 (the difference between the tax rate for corporations and individuals is 20.5%, so the additional tax liability for Mock is $40,250 x 20.5% = $10,062.50).

Mock Corporation Converts to S Corporation Status in 2016