Last week, in a post titled “Secrets of the Fiscal Cliff,” I set about identifying six of the lesser publicized tax aspects of the American Taxpayer Relief Act of 2012 (ATRA). In the final item, I wrote the following:

Ask a C corporation shareholder why he hasn’t converted to an S corporation, and the most common response is “the built-in-gains tax.” As a reminder, the built-in-gains tax prevents a C corporation from circumventing double taxation by converting to an S corporation and then immediately selling its assets or liquidating. In simple terms, it does so by requiring an S corporation to pay corporate level tax on any gains that were inherent in the assets of the S corporation on the date of the election and that are recognized within the first 10 years after the S election is effective.

Recent law changes, however, have provided for truncated recognition periods for existing S corporation that have reached certain landmarks in their 10-year period. For example, the 2009 Recovery Act provided that for S corporation tax years beginning in 2009 and 2010, no tax would be imposed on the net unrecognized built-in gain of an S corporation if the seventh tax year in the recognition period preceded the 2009 and 2010 tax years.

Note, however, that these law changes merely abbreviated the recognition period for certain existing S corporations that have already begun their recognition periods. For newly electing S corporations, the recognition period has always remained 10 years. Until now. The fiscal cliff deal surprisingly calls for only a 5-year recognition period for corporations that elect S status in 2012 or 2013.

I reached this conclusion based on the language of Section 326 of the ATRA, which reads:

EXTENSION OF REDUCTION IN S-CORPORATION RECOGNITION PERIOD FOR BUILT-IN GAINS TAX.

IN GENERAL.—Paragraph (7) of section 1374(d) is amended by inserting after subparagraph (B) the following new subparagraph:

(C) SPECIAL RULE FOR 2012 AND 2013.—For purposes of determining the net recognized built-in gain for taxable years beginning in 2012 or 2013, subparagraphs (A) and (D) shall be applied by substituting ‘5-year’ for ‘10-year’.’’

For a point of reference, pre-ATRA  Section 1374(d)(7)(A) read:

(7) Recognition period.

(A) In general. The term “recognition period” means the 10-year period beginning with the 1st day of the 1st taxable year for which the corporation was an S corporation.

Putting it all together, I concluded that Section 326 of the ATRA provided a different type of relief from previous amendments to Section 1374. The fiscal cliff deal, it appeared to me, was abbreviating the typical 10-year recognition period for newly electing S corporations in 2012 and 2013 on a prospective basis. Why did I reach this conclusion, particularly in light of the fact that previous amendments to the recognition period had all been made on a retroactive basis?

For starters, the previous changes to Section 1374(d)(7) used very specific language to indicate the effect of a truncated recognition period. Consider Section 1374(d)(7)(B), which was added in 2009:

(B) Special rules for 2009, 2010, and 2011. No tax shall be imposed on the net recognized built-in gain of an S corporation—

(i) in the case of any taxable year beginning in 2009 or 2010, if the 7th taxable year in the recognition period preceded such taxable year, or

(ii) in the case of any taxable year beginning in 2011, if the 5th year in the recognition period preceded such taxable year.

Looking at it logically, I assumed that if Congress intended Section 326 of the ATRA to simply exclude from built-in-gains any gain recognized in 2012 or 2013 by an S corporation that had reached the five-year point in its recognition period, it would have written the proposed Section 1374(d)(7)(C) in the same manner as Section 1374(d)(7)(B). More to the point, Congress could have avoided adding a new subparagraph and simply amended Section 1374(d)(7)(B)(ii) by adding 2012 and 2013.

Adding a differently worded new subparagraph didn’t make sense, which is why I concluded that the language of new Section 1374(d)(7)(C) was meant to accomplish something else: to shorten the recognition period to five years for corporations electing S status in 2012 or 2013.

But over the weekend, something gave me pause, and it wasn’t just the fact that such an approach would be a departure from previous Congressional motives; it was the language of the title to Section 326 of the ATRA. As indicated above, it reads:

EXTENSION OF REDUCTION IN S-CORPORATION RECOGNITION PERIOD FOR BUILT-IN GAINS TAX.