What Is Net Unrealized Built-In Gain?

Net unrealized built-in gain (NUBIG) represents the total potential profit on a company’s assets if they were sold at fair market value on the day the company transitions from a C corporation to an S corporation. This concept is linked to the built-in gains (BIG) tax, governed by Internal Revenue Code Section 1374. The purpose of this tax is to prevent a business from accumulating value as a C corporation and then converting to an S corporation just before selling assets to avoid corporate-level income tax.

An S corporation is a pass-through entity where profits are taxed once at the shareholder level, while a C corporation faces two layers of tax: at the corporate level and again at the shareholder level when profits are distributed. The BIG tax ensures that the appreciation in asset value that occurred while the company was a C corporation is still subject to a corporate-level tax, even if the assets are sold after the S corporation election.

Determining Applicability of the Built-In Gains Tax

The built-in gains tax applies to corporations that were once C corporations and have elected to be taxed as S corporations. This tax is not a concern for businesses that have operated as S corporations since their inception. The tax is triggered when an asset owned by the corporation on the day of its conversion is sold or disposed of within a specific timeframe known as the recognition period.

The recognition period is the first five years beginning on the first day the S corporation election is effective. If a company converts to an S corporation on January 1, 2025, its recognition period runs until December 31, 2029. Any asset owned on the conversion date that is sold after this five-year window expires is not subject to the BIG tax.

The tax applies only to the gain that existed at the time of the conversion. Any appreciation in value that occurs after the company becomes an S corporation is not part of the built-in gain and is treated under the normal pass-through rules of an S corporation.

Calculating Net Unrealized Built-In Gain

The calculation of net unrealized built-in gain is a one-time event that occurs at the moment of conversion from a C corporation to an S corporation. It establishes the maximum potential gain that could be subject to the BIG tax over the recognition period. The calculation is a comprehensive appraisal of all the company’s assets and liabilities on the first day of its first year as an S corporation.

The formula for NUBIG is the aggregate fair market value (FMV) of all assets owned by the corporation on the conversion date, less the aggregate adjusted basis of those same assets. The adjusted basis is typically the original cost of an asset minus any depreciation taken. A positive result indicates a net unrealized built-in gain, while a negative result means the company has a net unrealized built-in loss, in which case the BIG tax would not apply.

Certain assets commonly contribute to built-in gains. For a cash-basis taxpayer, accounts receivable are a prime example; since no income has been recognized, their adjusted basis is zero, and the full fair market value is considered a built-in gain. Inventory that has been produced but not yet sold may have a fair market value higher than its carrying cost, creating a built-in gain.

Appreciated property, such as real estate or machinery that is worth more than its depreciated value, is another source of built-in gains. For instance, if a building was purchased for $500,000 and has been depreciated to an adjusted basis of $300,000, but its current fair market value is $800,000, it has a built-in gain of $500,000. It is also important to account for assets that have decreased in value, as these create built-in losses that can offset built-in gains in the overall NUBIG calculation.

The Built-In Gains Tax Calculation and Payment

The BIG tax is triggered when an asset with a built-in gain is sold during the five-year recognition period. The sale makes a portion of the unrealized gain a “recognized” built-in gain for that tax year.

The annual tax is computed on the lesser of three figures for the tax year:

• The net recognized built-in gain for that year.
• The S corporation’s taxable income calculated as if it were still a C corporation.
• The remaining NUBIG from the start of the year (the original NUBIG figure reduced by any recognized built-in gains from prior years).

The tax rate applied to this calculated amount is the highest prevailing federal corporate income tax rate for that year, currently 21%. For example, if a company sells an asset and recognizes a $100,000 built-in gain, and this amount is the lowest of the three limitations, the BIG tax would be $21,000.

This tax is reported and paid with the S corporation’s annual income tax return, Form 1120-S, with the detailed calculation performed on Schedule D. Any business tax credits carried forward from the C corporation years may be used to reduce the calculated BIG tax liability.

Limitations and Carryforwards

A limitation in the annual built-in gains tax calculation involves the corporation’s taxable income. If an S corporation’s net recognized built-in gain for a year is more than its taxable income for that same year (calculated using C corporation rules), the BIG tax is only applied to the amount of the taxable income.

When the taxable income limitation is triggered, the excess recognized built-in gain is not forgiven. This untaxed portion is treated as a net recognized built-in gain carryforward. This amount is carried over to the following tax year and is treated as if it were a recognized built-in gain occurring in that next year.

This carryforward mechanism ensures that the gain is eventually taxed, provided the company generates sufficient taxable income within the original five-year recognition period. The carryforward does not extend the recognition period itself. If the company cannot generate enough taxable income to absorb the carryforward amount by the end of the five-year window, any remaining carryforward expires and is no longer subject to the BIG tax.