Built-In Gains Tax: The Five-Year Catch After S Election
Why a C corporation that becomes an S corporation can still owe corporate tax on gains it had before the switch.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
The built-in gains tax is a corporate-level tax on an S corporation that used to be a C corporation. If it sells or collects on assets within five years of becoming an S corporation, gain that existed at conversion is taxed at the 21 percent corporate rate — on top of the tax shareholders pay on the same gain.
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Why does the tax exist?
Without it, a C corporation about to sell appreciated assets could elect S status the day before the sale and avoid corporate tax entirely. Section 1374 closes that door: appreciation that built up during the C corporation years stays exposed to corporate tax for a recognition period after conversion.
How is it calculated?
| Step | What happens |
|---|---|
| 1. Net unrealized built-in gain | On the first day as an S corporation, fair market value of all assets minus their tax basis, netted for built-in losses |
| 2. Recognized built-in gain | Gain on assets sold, or income collected (such as receivables of a cash-method company), during the five-year period, to the extent it existed at conversion |
| 3. Limits | The yearly amount cannot exceed what the company's taxable income would be as a C corporation, and the total cannot exceed the net unrealized built-in gain |
| 4. Tax | 21 percent (the top corporate rate under Section 11(b)) of the net recognized built-in gain after C corporation net operating loss and capital loss carryforwards, less any C corporation business credit carryforwards |
| 5. Pass-through | The tax paid reduces the gain passed through to shareholders |
Amounts held back by the taxable income limit carry forward within the five-year period.
What assets cause the most trouble?
- Receivables of a cash-method company. Services performed before conversion and collected after are built-in income.
- Goodwill. A business with valuable customer relationships often has large built-in gain in self-created goodwill.
- Real estate and equipment that appreciated or was depreciated below value.
- LIFO inventory. A separate rule (Section 1363(d)) requires a C corporation using LIFO to include its LIFO reserve in income for its last C year; the resulting tax is paid in four equal installments — the first with the final C corporation return, the rest with the next three Form 1120-S returns.
How do you plan for it at conversion?
Get an appraisal as of the conversion date. Without one, the IRS can argue that gain on a later sale existed all along. Document the value of goodwill, equipment, and real estate. If a sale is likely within five years, compare the built-in gains tax against waiting, structuring part of the sale as personal goodwill owned by the shareholder, or selling stock instead of assets.
Frequently asked questions
Does the tax apply to a company that was always an S corporation?
No. It applies only to former C corporations and to assets an S corporation acquired from a C corporation in a carryover-basis transaction — for those assets, the five-year period starts on the acquisition date.
Is the recognition period still five years?
Yes. The PATH Act of 2015 made the five-year recognition period permanent; it runs from the first day of the first tax year the S election is in effect.
Can old C corporation losses offset the gain?
Yes. Net operating loss and capital loss carryforwards from C corporation years can reduce net recognized built-in gain, and some credits can reduce the tax.
Does every asset sale in the five years trigger it?
Only the part of the gain that existed on the conversion date. Appreciation after conversion is outside the tax, which is why the appraisal matters.
Official sources
The IRS explains: “An S corporation may owe the tax if it has net recognized built-in gain during the applicable recognition period.” — Internal Revenue Service, Instructions for Schedule D (Form 1120-S) (2025), https://www.irs.gov/instructions/i1120ssd
Federal law provides: “If for any taxable year beginning in the recognition period an S corporation has a net recognized built-in gain, there is hereby imposed a tax (computed under subsection (b)) on the income of such corporation for such taxable year.” — U.S. Government Publishing Office, 26 U.S.C. 1374 — Tax imposed on certain built-in gains (United States Code, 2024 Edition), https://www.govinfo.gov/content/pkg/USCODE-2024-title26/html/USCODE-2024-title26-subtitleA-chap1-subchapS-partIII-sec1374.htm
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Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk documents asset values at conversion and models the built-in gains exposure before any sale. See pricing or book a free fit call.
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