What Is the Built-in Gains Tax for S Corporations?

The built-in gains tax is a corporate-level tax designed to prevent tax avoidance when a C corporation becomes an S corporation. C corporations pay taxes at the corporate level, while S corporations are pass-through entities where profits are passed directly to shareholders. This tax ensures that if the company sells assets that appreciated in value during its time as a C corporation, it cannot use the S corp status to avoid tax on that pre-conversion gain. The tax targets the “built-in gain” that existed in assets at the moment of conversion and is paid by the S corporation itself, separate from the income taxes paid by its shareholders.

Determining Applicability and the Recognition Period

The built-in gains (BIG) tax applies exclusively to S corporations that were previously C corporations or those that acquired assets from a C corporation in a tax-free transaction. A business that has operated as an S corporation since its formation is not subject to this tax. The tax is triggered when an asset held by the company on its S corp conversion date is sold at a gain, while assets acquired after the conversion date are typically exempt.

A key component is the “recognition period,” a fixed five-year timeframe during which the sale of an appreciated asset is subject to the BIG tax. This period begins on the first day the S corporation election is effective. For example, if a C corporation’s election is effective on January 1, 2025, its recognition period ends on December 31, 2029, and a sale after that date would not trigger the tax.

Calculating the Built-in Gains Tax

The calculation begins by determining the Net Unrealized Built-in Gain (NUBIG). This is the hypothetical gain the corporation would have realized if it sold all of its assets at fair market value on the first day of its S corporation status, minus the assets’ adjusted basis. NUBIG represents the maximum total gain that can be subject to the BIG tax over the entire five-year recognition period.

When an asset is sold during the recognition period, the gain is known as a Recognized Built-in Gain (RBIG). For any given year, the amount of gain that is actually taxable is the lowest of the following:

• The RBIG for that year
• The remaining NUBIG limit
• The S corporation’s taxable income for that year, calculated as if it were a C corporation

This taxable portion of the gain is taxed at the highest prevailing corporate income tax rate, which is currently 21%. Corporations can reduce this taxable amount using net operating loss (NOL) and capital loss carryforwards from their C corporation years. Business tax credit carryforwards can also be used to directly offset the calculated tax liability. Inventory sold and accounts receivable collected during the recognition period that are attributable to the C corporation years are also considered built-in gains.

Reporting and Paying the Tax

The built-in gains tax liability is reported in Part III of Schedule D (Form 1120-S), “Capital Gains and Losses and Built-in Gains.” The final tax amount is then carried to the main Form 1120-S. The corporation itself is responsible for paying the tax. If the corporation anticipates its total tax for the year will be $500 or more, it must make quarterly estimated tax payments.

Failure to make these required payments on time can result in penalties. After the corporation pays the BIG tax, the amount paid reduces the income that flows through to the shareholders, preventing the same gain from being taxed twice. This reduction is allocated proportionally among the gains that generated it and is reflected on the Schedule K-1s issued to each shareholder.