1. Built-In Gains Tax
2. Net Unrealized Built-In Gain
3. Recognized Built-In Gain
4. Overview of Entity Taxation 
5. Overview of S Corporation Taxation 
6. Planning Opportunities 

The S corp built in gains tax is imposed to prevent taxable liquidation. This tax is charged when a C corporation becomes an S corporation. The built-in gains tax may also be imposed when an S corporation receives assets in a tax-free transaction. 

Built-In Gains Tax

For those who own and operate an S corporation, the built-in gains tax is essentially a tax that you may face if:

  • You were formally a C corporation 
  • You disposed of assets from that C corporation through a sale (which was subject to sales tax)

This holds true if this sale was completed during the official recognition period, which is a period of five years that begins once a C corporation officially converts into an S corporation. You would also be subject to this tax when you receive assets from a C corporation due to a carryover transaction. 

Currently, the built-in gains tax is set at an incredibly high corporate tax rate of 35 percent. The amount that is taxed will generally be reduced based on any losses. Net losses from a C corporation could also help minimize the amount you would be taxed. 

Net Unrealized Built-In Gain

Here are some things to consider in terms of unrealized net gain:

  • If you have any net gain, this would be represented if your corporation sold assets at the start of the recognition period. This would have been done within a single transaction.
  • Also, be mindful of the sum of any deductible liabilities. 
  • Refer to Section 481 in terms of your corporation's adjustments based on a hypothetical sale. 
  • In addition, any recognized built-in loss would not be allowed as a deductible. Please refer to Section 382, 383, or 384.

Recognized Built-In Gain

Recognized built-in gains are any gains within the recognition period that an S corporation has deemed:

  • An asset that wasn't held at the start of the first taxable year 
  • As any gain that is beyond the excess of the fair market value

Overview of Entity Taxation 

Different entities face varying tax rules. This is why many business owners consider the perks of S corporations. By seeking S corporation election, shareholders pay taxes based on their shares. However, the company is not taxed at the corporate level. In addition, shareholders may also be able to deduct their shares of corporate losses. 

In contrast, C corporations are taxed at both the entity and shareholder levels. For those who own a limited liability company, you can choose to be taxed as a C corporation or become a pass-through entity. 

Overview of S Corporation Taxation 

If you are planning to form an S corporation, you need to understand what this means in terms of requirements and limitations. 

  • When forming an S corporation, the business cannot have more than 100 shareholders. The company can also have only one class of stock. 
  • In order to become a shareholder, you must be a U.S. citizen, tax-paying resident, or specific trust/estate.
  • Any eligible entity can seek S corporation status, and all eligible C corporations can seek S corporation election in regards to taxation. 
  • In a case where S corporate election is terminated, the corporation will not be eligible for five years, unless consent is granted by taxing authorities. 
  • Although S corporations are not typically taxed at the entity level, this excludes the built-in gains tax. The same is true in terms of excess net passive income. 

Planning Opportunities 

As an S corporation, you could hold off until the set recognition period expires. At this point, you could sell off the assets which would have triggered the built-in gains tax. This is because corporations and taxpayers as a whole are now protected by the PATH Act. You could also dispose of all built-in loss assets during the year that you dispose of built-in gain assets. This would help minimize the overall taxable gains. 

Before you convert your business into an S corporation, make sure you discuss the built-in gains tax with your attorney. This can help you better plan for the future, ensuring the sustained growth and success of your business. After all, due diligence at this stage can make or break your company. 

If you need help understanding the S corp built-in gains tax, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.