The S Corporation Built-In Gains Tax: A Cost of Converting From C Corporation Status

An S corporation is generally a pass-through entity, but a corporation that previously operated as a C corporation may still owe an entity-level tax under IRC §1374. The built-in gains tax generally applies when gain that existed at the beginning of S corporation status is recognized during the five-year recognition period.

Net Unrealized Built-In Gain at Conversion

On the first day of the first S corporation year, the corporation determines its net unrealized built-in gain, generally by comparing the aggregate fair market value and adjusted basis of its assets, with statutory adjustments. This creates an overall ceiling on recognized built-in gain subject to tax; it is not simply an amount permanently allocated to each asset.

A valuation and detailed asset schedule are important because the corporation must later distinguish gain attributable to the C corporation period from appreciation arising after the S election.

The Five-Year Recognition Period

The recognition period generally covers the five-year period beginning with the first day of the first tax year for which the S election is effective. Gain recognized after that period generally is not subject to Section 1374 merely because the appreciation arose during the former C corporation years.

Waiting five years can reduce exposure, but the result depends on the transaction. Installment sales, deferred income, involuntary conversions, Section 338 elections, carryover-basis acquisitions, and other events can have special timing rules.

How the Taxable Amount Is Limited

The built-in gains tax is generally imposed at the highest corporate tax rate on the corporation's net recognized built-in gain, subject to multiple limitations. The taxable amount can be limited by the corporation's taxable income for the year and by the remaining net unrealized built-in gain limitation.

Recognized built-in losses, certain C corporation carryforwards, and other attributes may reduce the tax when the statutory requirements are met. A complete calculation therefore requires more than multiplying the gain on one asset by the corporate rate.

The tax is paid by the S corporation and reduces the income or cash remaining for shareholders. Shareholders generally report the pass-through items after the entity-level tax calculation; describing the same amount as automatically taxed twice can overstate the result.

Assets and Income Items That Commonly Create Exposure

Potential exposure can arise from appreciated real estate, equipment, inventory, securities, self-created goodwill, customer relationships, and other assets. For a cash-method former C corporation, collection of receivables or recognition of other deferred income may also produce recognized built-in gain under the applicable rules.

LIFO Recapture Is a Separate Conversion Cost

A C corporation using LIFO generally includes its LIFO recapture amount in income for its final C corporation year before the S election. The additional tax attributable to that recapture may generally be paid in four equal annual installments. This rule is separate from the Section 1374 built-in gains tax.

Other C Corporation Attributes Continue to Matter

Accumulated earnings and profits can affect the treatment of distributions and can create excess-net-passive-income concerns. C corporation net operating losses generally do not pass through to shareholders, although certain carryforwards may be relevant in computing the built-in gains tax.

Due Diligence Before the Election

Before converting, identify and value assets, review deferred income and receivables, estimate the likelihood of a sale during the recognition period, quantify LIFO recapture, analyze accumulated earnings and profits, and model both entity and shareholder consequences.

Section 1374 is highly fact-specific. This information is educational and is not a substitute for advice and valuation work based on a particular corporation and proposed transaction.