What Are the S Corp Capital Gains Tax Rates?

An S corporation features a pass-through tax status, meaning it does not pay corporate income tax. Instead, the income, losses, deductions, and credits flow directly to the shareholders’ personal tax returns, where they pay tax at their individual rates. A capital gain occurs when a capital asset, like property or stock, is sold for a profit. These gains are short-term if the asset was held for one year or less, or long-term if held for more than one year. The tax implications depend on whether the corporation sells an asset or a shareholder sells their stock.

Capital Gains from S Corp Asset Sales

When an S corporation sells a capital asset like real estate or equipment, the transaction is first analyzed at the corporate level. The gain or loss is calculated by subtracting the asset’s adjusted basis from its sale price. The adjusted basis is the original cost of the asset, adjusted for factors like depreciation. The character of this gain, whether short-term or long-term, is determined by how long the corporation held the asset.

This calculated gain is passed through to the shareholders. Each shareholder is allocated a portion of the gain based on their percentage of stock ownership in the company. This allocation is detailed on a Schedule K-1 form that the corporation provides to each shareholder.

Shareholders are responsible for reporting their allocated share of the capital gain on their personal tax returns. The gain retains its character, meaning if it was a long-term gain for the corporation, it is a long-term gain for the shareholder. Shareholders will then pay tax on this gain at their individual capital gains tax rates, which are 0%, 15%, or 20% for long-term gains, depending on their total taxable income. Short-term gains are taxed at the shareholder’s ordinary income tax rate.

For example, if an S corporation sells a building it has owned for five years for a $200,000 long-term capital gain, and there are two equal shareholders, each receives a Schedule K-1 showing a $100,000 long-term capital gain. Each shareholder would then report this on their personal tax return and pay the corresponding long-term capital gains tax.

Not all profit from an asset sale is treated as a capital gain. Proceeds allocated to assets like inventory or accounts receivable are taxed as ordinary income. The allocation of the purchase price among the various assets sold determines the character of the income passed through to the shareholders.

Capital Gains from Selling S Corp Stock

When a shareholder sells their personal shares in an S corporation, it is a private transaction distinct from the corporation’s business operations. The tax consequences of this sale are personal to the selling shareholder. The gain or loss is calculated by subtracting the shareholder’s stock basis from the sale price, and its character as short-term or long-term depends on how long the shareholder held the stock.

A shareholder’s basis starts with their initial investment, which is the cash or property contributed to acquire the stock. This initial basis is then adjusted annually. It is increased by the shareholder’s pro-rata share of corporate income and any additional capital contributions they make, and it is decreased by corporate distributions and the shareholder’s share of corporate losses.

Consider a shareholder who initially invested $50,000 for their stock. Over the years, their allocated share of profits was $30,000, and they received distributions totaling $10,000. Their adjusted stock basis would be $70,000. If they sell their stock for $120,000, their capital gain is $50,000.

If the stock was held for more than one year, the gain is taxed at the long-term capital gains rates. If held for one year or less, it is taxed at the shareholder’s ordinary income tax rate. Additionally, shareholders who are not actively involved in the business may be subject to the 3.8% Net Investment Income Tax (NIIT) on their gain.

The Built-In Gains Tax Exception

An exception to the pass-through nature of S corporations is the Built-In Gains (BIG) tax. This is a corporate-level tax that applies to S corporations that were previously C corporations. The purpose of the BIG tax is to prevent C corporations from avoiding double taxation on appreciated assets by converting to an S corporation shortly before a sale.

A “built-in gain” is the unrealized appreciation in the value of an asset that occurred while the company was a C corporation. This is the difference between the asset’s fair market value and its adjusted basis on the first day of the S corporation election. The BIG tax is triggered if the S corporation sells such an asset within a five-year “recognition period” from the date the S election took effect.

The BIG tax is calculated at the highest corporate tax rate, which is 21%. This tax is paid by the S corporation itself, not the shareholders directly. The amount of the built-in gain recognized from the sale is then reduced by the corporate-level tax paid, and the remaining gain is passed through to the shareholders on their Schedule K-1s.

For instance, imagine a C corporation converts to an S corporation. At the time of conversion, it owns land with an adjusted basis of $100,000 and a fair market value of $300,000, resulting in a built-in gain of $200,000. If the S corporation sells the land for $350,000 two years later, the recognized built-in gain is $200,000. The corporation would pay a BIG tax of $42,000 (21% of $200,000).

The remaining gain, plus the additional $50,000 of appreciation that occurred during the S corp years, would pass through to the shareholders. This tax does not apply to corporations that have always been S corporations or to assets acquired after the S corporation election was made. Asset appraisals at the time of conversion are necessary for managing potential BIG tax liability.

Reporting Capital Gains on Tax Forms

Reporting capital gains involves specific tax forms for both the S corporation and its shareholders, who have distinct filing responsibilities.

For the S Corporation (Form 1120-S)

When an S corporation sells a capital asset, the transaction is reported on Schedule D of Form 1120-S, U.S. Income Tax Return for an S Corporation. This schedule is used to detail the sale and calculate the net capital gain or loss. If the Built-In Gains tax applies, it is also calculated on Schedule D and reported as a tax liability on Form 1120-S.

For the Shareholder (Schedule K-1)

The S corporation must prepare a Schedule K-1 (Form 1120-S) for each shareholder. This form breaks down the shareholder’s individual share of the corporation’s income, deductions, and credits. Capital gains passed through from the corporation are specifically reported on the Schedule K-1, with short-term and long-term gains listed separately.

For the Shareholder’s Personal Return (Form 1040)

Shareholders take the capital gain information from their Schedule K-1 and report it on their personal tax return, Form 1040. These gains are reported on Schedule D (Form 1040), which is used to calculate their overall capital gains and losses for the year. The details of the transactions may also need to be reported on Form 8949, which then feeds into Schedule D. In the case of a personal sale of S corporation stock, the shareholder reports the transaction directly on their own Schedule D and Form 8949.