What Is the S Corp Built-In Gains Tax?

The built-in gains (BIG) tax is a corporate-level tax under Internal Revenue Code Section 1374, designed to prevent a specific type of tax avoidance. It applies when a C corporation with appreciated assets converts to an S corporation. In a C corporation structure, profits from selling an asset are taxed at the corporate level and again at the shareholder level when distributed as dividends. S corporations, as pass-through entities, normally avoid this double taxation because income and gains flow directly to shareholders. The BIG tax ensures that the appreciation in asset value that occurred during the C corporation years remains subject to a corporate-level tax if the asset is sold after the conversion, preserving the integrity of both tax structures.

Determining Applicability of the Tax

For the built-in gains tax to apply, a specific set of conditions must be met. The primary requirement is that the corporation must have previously operated as a C corporation before filing an election, using Form 2553, to change its status to an S corporation. A business that has been an S corporation since its inception is not subject to this tax. The tax is also only triggered if, on the first day the S corporation election is effective, the aggregate fair market value of the corporation’s assets is greater than their aggregate adjusted basis. The adjusted basis is the original cost of an asset adjusted for factors like depreciation.

A key element is the “recognition period,” a defined timeframe during which the sale of an appreciated asset can trigger the tax. Under current federal law, this period is five years, beginning on the first day of the first tax year the corporation operates as an S corporation. If the corporation sells an asset that had a built-in gain during this five-year window, it must “recognize” that gain, and the tax may apply. If the S corporation holds onto the appreciated assets and sells them after the period has expired, any gain from the sale is not subject to the built-in gains tax.

Identifying Assets and Net Unrealized Built-In Gain

At the time of converting from a C corporation to an S corporation, a calculation must be performed to determine the total potential exposure to the tax. This involves identifying the “built-in gain” or “built-in loss” for every individual asset the corporation owns on the conversion date. A built-in gain exists if an asset’s fair market value is higher than its adjusted basis, while a built-in loss exists if the asset’s basis is higher than its fair market value. Common sources of built-in gains include appreciated real estate, securities, and inventory. Accounts receivable for a company that used the cash method of accounting as a C corporation can also create a built-in gain, as they have a fair market value but a zero basis.

After assessing every asset, the corporation calculates its Net Unrealized Built-In Gain (NUBIG). This is a one-time calculation determined by subtracting the aggregate adjusted basis of all assets from their aggregate fair market value on the conversion date. This NUBIG figure acts as a ceiling on the total amount of built-in gains that can be taxed over the entire five-year recognition period. If a company’s NUBIG is $500,000, the total amount of gains subject to the BIG tax over the next five years cannot exceed this amount.

Calculating the Annual Tax Liability

Each year during the five-year recognition period, a corporation must determine its tax liability by calculating its Net Recognized Built-In Gain (NRBIG). This is the total of gains from the sale of qualifying assets during that tax year, reduced by any built-in losses from assets sold in the same year. The actual amount subject to tax is the lesser of three figures: the NRBIG for the current year; the S corporation’s taxable income for that year, calculated as if it were a C corporation; and the remaining NUBIG from the conversion date, reduced by any NRBIG taxed in prior years.

Once the taxable amount is determined, the tax is calculated using the flat corporate tax rate of 21%. This rate is applied directly to the lesser of the three limitation amounts.

A company can reduce its annual tax liability using certain tax attributes carried forward from its C corporation years. Unexpired Net Operating Loss (NOL) carryforwards and capital loss carryforwards can be used to offset the NRBIG. These deductions are applied against the recognized gain, which can lower or eliminate the tax due for that year.

Reporting the Tax and Shareholder Impact

The built-in gains tax for a given year must be reported on the S corporation’s annual income tax return. The tax is computed and detailed on Schedule D of Form 1120-S, U.S. Income Tax Return for an S Corporation. The final tax amount is then carried to the main form and included in the corporation’s total tax liability for the year.

The payment of the BIG tax occurs at the corporate level, making it one of the few instances where an S corporation pays federal income tax directly. This corporate-level tax payment has a direct consequence for the shareholders. The amount of the tax paid by the corporation is not simply a business expense; it flows through to the shareholders and affects their individual financial positions.

The total gain from the asset sale that is passed through to shareholders is reduced by the amount of the BIG tax the corporation paid. This tax is treated as a loss that is allocated among the shareholders based on their ownership percentages. This pass-through loss, in turn, reduces each shareholder’s stock basis in the corporation, which impacts the shareholder’s taxable gain or loss on a future sale of their stock or on distributions received from the corporation.