Considering converting your C corporation to an S corporation? You’ll want to understand and be aware of the built-in gains tax.

The Built-in Gains Tax

A built-in gains tax may apply when you dispose of appreciated assets held by the corporation (such as buildings, equipment, furniture) after the time of the conversion to an S corporation.

Although an S corporation is normally not subject to tax, when a C corporation converts to S corporation status the IRS imposes a tax at the highest corporate rate (35%) on the net built-in gains of the corporation when it disposes of appreciated assets held in the corporation. The idea is to prevent the use of an S election to escape tax at the corporate level on the appreciation that occurred while the corporation was a C corporation.

The Recognition Period

After the conversion to an S corporation, there is a holding period (called a “recognition period”) in which the IRS imposes the high tax rate on any appreciated assets that are sold, liquidated or disposed of. Though traditionally the recognition period has been 10 years, recently the laws have changed. Starting in 2009 and going through 2010, it became a seven-year holding period, and then a five-year period for the 2011-2014 tax years.

How the 35% Rate Applies

The 35% tax applies to the lowest of the following:

  1. the amount that would be the taxable income of the S corporation for the tax year taking into account only recognized built-in gains and recognized built-in losses;
  2. the corporation’s taxable income for that tax year; or
  3. the excess of the net unrealized built-in gain over the net recognized built-in gain for earlier tax years during the recognition period.

Depending on your accounting method – collecting an account receivable or disposing of inventory that accrued while your company was still a C corporation might be subject to the built-in tax.

Net Operating Losses Give You a Tax Break

C corporation net operating losses (which are otherwise not usable in an S corporation year) are allowed as a deduction against net recognized built-in gain. Where net recognized built-in gain is not taxed because of the taxable income limitation ((2) above), the gain is carried forward and may be taxed in later years.

The recognized built-in gain is passed through to the shareholders as income, in addition to being taxed at the corporate level (at a 35% rate). This unfortunate result is mitigated somewhat by treating the tax as a corporate loss which passes through to the shareholders.

Plan for the Impact of the Built-in Gains Tax

It’s important to plan for and establish the amount of built-in gains (and losses) at the time of the conversion to an S corporation. After the conversion, you can plan by timing the sale of assets, matching gains and losses, and so on. But right now the important thing is to value the corporation’s assets and inventory in order to ensure that appreciation that takes place after that conversion will not be subject to the built-in gains tax. In addition, depending on what state the Corporation conducts business in, there are additional built-in gains tax calculations.

Need Help?

PDM’s tax experts can assist you in getting the necessary appraisals, as well as in identifying any built-in losses that could reduce the effect of the built-in gain tax. Contact us; with our years of technical experience, advanced training, and cutting edge technology, we are your financial partner.