Understanding the Built-In Gains (BIG) Tax for S Corporations

Converting a C corporation to an S corporation can offer significant tax advantages, including pass-through taxation and avoiding the corporate double tax. However, the IRS has measures in place to prevent corporations from avoiding taxes on appreciated assets through a quick conversion. One such measure is the Built-In Gains (BIG) Tax under IRC §1374.

This blog will explore the history, mechanics, example calculations, and strategic considerations surrounding the BIG tax to help businesses make informed decisions before converting to an S corporation.

Legislative History and Purpose of the BIG Tax

Before the BIG tax was introduced, some corporations converted to S corporation status simply to bypass corporate-level tax on unrealized gains. This allowed them to sell appreciated assets without paying the standard corporate tax at the time of sale.

To close this loophole, Congress enacted the Built-In Gains (BIG) Tax under IRC §1374 in the Tax Reform Act of 1986. The goal was to prevent tax avoidance by requiring newly converted S corporations to pay corporate-level tax on gains that existed before the conversion if those assets are sold within a certain period.

How the Built-In Gains (BIG) Tax Works

The BIG tax applies when:

1. A C corporation elects to become an S corporation.

2. The corporation owns appreciated assets (assets with a fair market value greater than their adjusted tax basis).

3. The corporation sells those assets within the five-year recognition period after conversion.

   
   

The tax is imposed at the highest corporate tax rate (currently 21%) on the lesser of:

• The built-in gains from assets sold during the five-year period.

• The total net unrealized built-in gain at the time of conversion.

  
  

The Five-Year Recognition Period

Initially, the recognition period was 10 years, but legislative changes reduced it to 5 years (under the PATH Act of 2015).

This means that if the S corporation holds its appreciated assets for at least five years after conversion, no BIG tax applies when those assets are later sold.

Example Calculation of the BIG Tax

Scenario: C Corporation Conversion to S Corporation

ABC Corp, a C corporation, elects to become an S corporation on January 1, 2024.

At the time of conversion, ABC Corp owns:

Asset	Fair Market Value (FMV)	Adjusted Basis	Built-in Gain
Equipment	$500,000	$200,000	$300,000
Real Estate	$800,000	$400,000	$400,000
Intellectual Property	$200,000	$100,000	$100,000
Total BIG	$1,500,000	$700,000	$800,000

• ABC Corp’s total built-in gain at conversion = $800,000.

• If the corporation sells assets worth $400,000 in built-in gains within five years, it must pay BIG tax at the 21% corporate tax rate.

  
  

BIG Tax Calculation

400,000×21%=84,000400,000 \times 21\% = 84,000400,000×21%=84,000

ABC Corp must pay $84,000 in BIG tax at the corporate level on the sold assets.

However, if ABC Corp waits five years before selling its assets, no BIG tax will apply, and gains will flow through to shareholders tax-free.

Key Considerations When Converting to an S Corporation

1. Timing Asset Sales to Avoid the BIG Tax

• If the business holds appreciated assets for five years, the built-in gains escape the corporate-level tax.

• This makes long-term planning crucial before conversion.

2. Understanding Which Assets Have Built-In Gains

• Conduct a thorough valuation of all corporate assets before conversion.

• This helps estimate potential BIG tax liability and determine the best tax strategy.

3. Offsetting Gains with Built-In Losses

• If a corporation has assets with built-in losses, selling them in the same tax year as built-in gains can offset BIG tax liability.

4. Business Model and Liquidity Needs

• If a corporation plans to sell major assets soon after conversion, it may want to delay S corporation election to avoid the BIG tax.

• Conversely, if the corporation intends to hold assets long-term, converting sooner may be beneficial.

  
  

Impact of the BIG Tax on Businesses

Pros of S Corporation Conversion Despite the BIG Tax

✅ Avoids double taxation on future earnings.

✅ Allows pass-through taxation after the five-year period.

✅ Reduces tax burdens for shareholders over time.

Cons of the BIG Tax

❌ Immediate asset sales trigger a 21% corporate tax.

❌ Limits flexibility to sell appreciated assets in the short term.

❌ Requires careful tax planning before conversion.

Final Thoughts

The Built-In Gains (BIG) Tax under IRC §1374 is an important factor when deciding whether to convert a C corporation to an S corporation. While the S corp election provides significant tax advantages, businesses must carefully plan for the five-year recognition period to avoid unnecessary taxation on built-in gains.

If your corporation is considering an S election, it is critical to assess your asset values, business goals, and liquidity needs before converting. A well-timed strategy can maximize tax savings and position the business for long-term growth.

Are you considering an S corporation election? What strategies have you used to navigate the BIG tax? Let’s discuss in the comments.