When a business is converted from a C corporation to an S corporation, its owners sometimes encounter an unexpected—and unwelcome—tax liability in subsequent years. Often referred to by its unfortunate acronym, the “built-in gains” (BIG) tax can catch recently converted S corporation shareholders by surprise. Adding to the surprise, the liability associated with the BIG tax liability can be substantial, and is paid in addition to any tax paid by the shareholders on their S corporation income.

With today’s lower corporate tax rates, S corporation conversions are not as common as in years past. Nevertheless, many situations still warrant an S corporation election as part of a broader tax strategy. Before making such an election, owners should familiarize themselves with the BIG tax and take steps—in advance—to avoid or at least minimize their tax burden.

The BIG Tax at a Glance

The built-in gains tax was first introduced in the 1980s to prevent companies from avoiding corporate-level taxes when selling appreciated assets. By converting from C corporation to S corporation status before an asset sale, companies could pass unrealized gains through to shareholders, where they would be taxed at the individual level, often at lower capital gains rates.

The BIG tax eliminated this approach, ensuring that any gains a business accrued while it was still a C corporation do not escape corporate-level taxation. If an S corporation disposes of assets it owned when it was still a C corporation, it must pay taxes at the current corporate rate on any unrealized gains those assets had accumulated at the time of the conversion.

This requirement applies for the first five years after a company converts from a C corporation. If tax is owed, it is paid at the S corporation level at the current 21 percent federal corporate rate—one of the few times an S corporation must pay an entity-level tax. Many states have conforming provisions so state tax could be owed as well.

Unexpected Consequences and Complications

Company owners planning an S corporation conversion often assume the BIG tax will not affect them because they have no appreciated assets. They reason that, except for real estate, most corporate assets such as equipment and fixtures typically depreciate in value over time. But this assumption overlooks a crucial detail: for tax purposes, appreciation is calculated by comparing an asset’s fair market value against its tax basis—not its initial purchase price.

Companies often claim Section 179 deductions or bonus depreciation so the tax basis of those assets is significantly reduced—often to zero. This means a company disposing of such assets within five years of converting to an S corporation could owe taxes at the 21 percent corporate rate on most or all of the gain realized upon sale.

Another unforeseen complication affects companies that use the cash method of accounting, as many S corporations do. Because cash-method accounting does not recognize income until payment is actually received, any uncollected accounts receivable at the time of conversion are considered an appreciated asset as the value of these uncollected receivables exceeds their zero tax basis. The IRS regards this as a built-in gain as well, so those receivables are also subject to the 21 percent BIG tax if they are collected within five years after conversion.

If the sale is treated as an asset sale, the value of any goodwill or other intangibles that accrued while a C corporation would also be subject to BIG. An unexpected BIG tax liability can also impact shareholder distributions as funds used to pay the tax are not available for distributions.

Avoiding a BIG Tax Obligation

The simplest way to avoid incurring a BIG tax obligation is to defer the sale of any appreciated assets until five years have passed. Of course, this is not always feasible or desirable, particularly when it comes to collecting receivables.

In the case of an acquisition or outright sale of the entire company, structuring the transaction as a stock sale rather than an asset sale can avoid BIG tax complications. Buyers typically prefer an asset sale, however, so this approach also might not be acceptable (at least not without some price adjustment).

It is sometimes possible to mitigate the BIG tax by taking advantage of its limitations. For example, the amount of built-in gain that is subject to tax in any year is limited to the company’s taxable income in that year, as computed under C corporation rules. Any built-in gain that is not recognized because of this provision will carry forward through the remainder of the five-year recognition period. Nevertheless, when combined with strategies for delaying income or accelerating expenses, this provision can be helpful in avoiding or at least deferring the BIG tax. In addition, net operating losses carried over from when the entity was a C corporation can be used to offset the built-in gain.

Another rule limits the total amount subject to the BIG tax to the net unrealized built-in gain on all assets at the time of conversion. In other words, if the corporation also had some assets with built-in losses at the time of conversion these losses could offset the built-in gains from other assets. A complete and accurate appraisal of company assets at the time of conversion is essential to establish the net unrealized built-in gain.

Various other strategies are also available to avoid, mitigate, offset, or defer the effects of the BIG tax, but the key to all of them is to plan ahead. Careful consultation with your tax professional—before making the S corporation election—is crucial. Afterward, your available options could be severely limited.

Reach out to the Holbrook & Manter team with any questions you may have.