What Is the Built-In Gains Tax for S Corporations?
When a C corp becomes an S corp, a special tax may apply to the appreciated value of assets that existed at the time of the business's conversion.
The built-in gains (BIG) tax is a corporate-level tax designed to prevent a specific type of tax avoidance. When a C corporation becomes an S corporation, it may have assets that have increased in value over time. The BIG tax ensures that appreciation that occurred while the company was a C corporation is still taxed at the corporate level if those assets are sold shortly after the conversion. This prevents businesses from using the S corporation structure to escape taxes on gains accrued during their time as a C corporation.
Think of it as a “toll” for bringing the appreciated value of assets from a C corporation into the S corporation framework. S corporations generally pass their income, losses, and credits through to their shareholders. The built-in gains tax is an exception, imposing a direct tax on the corporation itself under specific circumstances.
Identifying Net Unrealized Built-in Gain at Conversion
The built-in gains tax applies specifically to C corporations that make an election to be taxed as an S corporation. It also applies if an S corporation acquires an asset from a C corporation in a transaction where the asset’s tax basis carries over. The tax is calculated based on the value of assets at the moment of conversion.
To understand this calculation, one must be familiar with Fair Market Value (FMV) and adjusted basis. FMV is the price an asset would sell for on the open market, while the adjusted basis is an asset’s original cost, adjusted for factors like depreciation. The process begins by calculating the Net Unrealized Built-in Gain (NUBIG).
This is a one-time calculation performed on the first day of the corporation’s first tax year as an S corporation. To determine the NUBIG, the corporation must assess the aggregate FMV of all its assets and subtract the aggregate adjusted basis of those same assets.
For example, imagine a C corporation owns a building with an FMV of $1 million and an adjusted basis of $400,000 when it converts. The unrealized built-in gain on this asset is $600,000. If this were the only asset, the corporation’s NUBIG would be $600,000, which sets the maximum potential built-in gains tax liability.
Calculating the Annual Built-in Gains Tax
Once the S corporation election is effective, the company enters a “recognition period.” This is a five-year window, starting on the first day of the first tax year as an S corporation, during which the built-in gains tax can be triggered. If the corporation sells an asset that had a built-in gain at conversion within this period, it has a “recognized built-in gain.” The tax is on the gains recognized from asset sales each year, not the entire NUBIG at once.
When an asset with a pre-existing gain is sold, the corporation must determine its Net Recognized Built-in Gain (NRBIG) for that tax year. The NRBIG is the lesser of the gains recognized during the year from selling these assets or the total NUBIG established at conversion, less any built-in gains taxed in previous years.
The actual built-in gains tax payable for any given year is the lowest of three specific amounts. The first is the NRBIG for that year. The second is the corporation’s taxable income for the year, calculated as if it were still a C corporation. The third is the remaining NUBIG from the original conversion, reduced by any net recognized built-in gains from prior years.
Consider an S corporation that sells an asset and has an NRBIG of $100,000. Its taxable income for the year is $80,000, and its remaining NUBIG is $300,000. The corporation would compare these three figures and use the lowest amount, $80,000, to calculate its built-in gains tax. The tax is then calculated by multiplying this amount by the highest corporate tax rate, which is currently 21%.
Reporting and Paying the Tax
After determining the final taxable amount of the built-in gain for a year, the corporation must report and pay the associated tax. This process is handled on the S corporation’s annual income tax return, Form 1120-S. The specific calculations for the built-in gains tax are performed on Schedule D (Form 1120-S). The form guides the preparer through the limitations discussed previously, and the resulting tax amount is then entered on the main Form 1120-S as part of the corporation’s total tax liability.
The payment is subject to the same rules and deadlines as other corporate income taxes. This means the corporation will likely need to make estimated tax payments throughout the year to cover its anticipated built-in gains tax liability, with the final amount due by the regular due date of the corporate tax return.