How to Calculate Built-In Gains Tax for S Corporations
Navigate the built-in gains tax for S corporations. This guide details the layered calculation method and factors that limit your final tax liability.
The built-in gains tax is a corporate-level tax designed to prevent a specific tax avoidance strategy. When a C corporation converts to an S corporation, its profits are passed to its shareholders. This tax ensures that if the new S corporation sells assets that appreciated during its time as a C corporation, the government can still collect the corporate-level tax that would have been due on that appreciation.
Determining Applicability and Net Unrealized Built-In Gain
The built-in gains tax applies to S corporations that were formerly C corporations or acquired assets from a C corporation in a tax-free transaction. A key component is the “recognition period,” a five-year timeframe starting on the first day the S corporation election takes effect. Any sale of an appreciated asset owned at the time of conversion, if sold within this five-year window, can trigger the tax.
This rule extends to installment sales. If an asset is sold via an installment sale during the recognition period, the gains remain subject to the tax, even if payments are received after the five-year period expires.
At the date of the S corporation conversion, a one-time calculation must be performed to determine the Net Unrealized Built-In Gain (NUBIG). This figure is the total potential gain subject to the tax over the five-year recognition period. To calculate NUBIG, the corporation must subtract the aggregate adjusted basis of all its assets from their fair market value (FMV).
The NUBIG acts as a ceiling, as the total built-in gains tax paid over the five years cannot exceed the tax on this amount. For example, if a company’s assets have a total FMV of $2 million and an adjusted basis of $1.2 million on the conversion date, the NUBIG is $800,000. An independent appraisal is often used to establish a defensible FMV for assets like real estate or intellectual property.
The Annual Built-In Gains Tax Calculation
Each year during the recognition period, the S corporation must identify its Net Recognized Built-In Gain (RBIG). This is the net gain from the sale of assets during the tax year that were on hand when the S corporation election became effective. It includes gains from inventory sales and collections on accounts receivable attributable to the prior C corporation period.
Next, the corporation must calculate its taxable income for the year as if it were still a C corporation. Certain deductions available to S corporations might be disallowed for this calculation. This can result in a higher taxable income figure than what is reported for regular S corporation pass-through purposes.
The amount subject to the built-in gains tax is determined by a three-part limitation test. The taxable amount is the lesser of three figures: the Net RBIG for the year, the corporation’s taxable income calculated under C corporation rules, or the remaining NUBIG. The remaining NUBIG is the original NUBIG less any recognized built-in gains from previous years.
Once the lowest of these three amounts is identified, that figure is multiplied by the highest federal corporate income tax rate (currently 21%) to determine the preliminary tax. For instance, if an S corporation has a Net RBIG of $100,000, C corp taxable income of $120,000, and a remaining NUBIG of $300,000, the tax is based on the $100,000 Net RBIG. The preliminary tax would be $21,000 before any credits are applied.
Applying Carryforwards and Credits
After calculating the preliminary built-in gains tax, the S corporation can reduce this liability using certain carryforwards from its time as a C corporation. These tax attributes can be applied to offset the built-in gains tax.
Net Operating Loss (NOL) carryforwards from prior C corporation years can directly reduce the taxable base. For example, if the amount subject to tax is $100,000 and the corporation has a $30,000 NOL carryforward, it can reduce the taxable amount to $70,000. This lowers the amount upon which the 21% tax is calculated.
Business tax credit carryforwards, such as the general business credit from C corporation years, can also be used. These credits reduce the final tax liability on a dollar-for-dollar basis. If the calculated tax is $21,000 and the corporation has a $5,000 business tax credit carryforward, the final tax owed would be reduced to $16,000.
Reporting and Paying the Tax
The built-in gains tax is reported and paid through the corporation’s annual income tax return, Form 1120-S, U.S. Income Tax Return for an S Corporation. The tax is reported in Part II of the form on a line designated for “other taxes.”
A corporation paying this tax must attach a statement to its Form 1120-S. This attachment should detail the calculation, showing the net recognized built-in gain for the year and how the final tax amount was determined, including any limitations or carryforwards.
Payment is handled in the same manner as other corporate income taxes. The corporation is generally required to make quarterly estimated tax payments throughout the year if it anticipates a built-in gains tax liability. This helps avoid potential underpayment penalties.