What is Built-In Gains Tax and How is it Calculated?

Small businesses, including employee-owned companies, have a few different business entity options to choose from. Among the choices are C corporations and S corporations. The standard corporate entity is a C corp, while an S corp holds a special tax status.

Built-in gains (BIG) tax can apply when a C corp elects to become an S corp, and for a five-year period following the conversion, starting on the first day of the first tax year after making the S corp election.

This points to a couple of key questions. First, why would a business elect S corp status? Second, what are built-in gains, and should they be a major cause for concern?

In this article, we’ll take a closer look.

C Corp and S Corp: How Do They Differ?

The default, standard tax status for a corporation under the Internal Revenue Code is the C corporation. C corps file a tax return and pay federal taxes. When business owners receive dividend payments from the corporation, these payments are considered personal taxable income. This situation is often referred to as “double taxation,” since both the corporation and the individual pay taxes on the income.

An S corp, on the other hand, is a pass-through taxation entity. It also files a return, but the corporation pays no federal income tax. All of the business’s profits (and/or losses) “pass through” and are reported on the owner’s personal income tax return. The owners are responsible for paying any income tax due—but the income is taxed only once, at the individual level. That special tax treatment can make S corp status pretty attractive, so it makes sense there are restrictions to which businesses can and cannot become an S corp, and how an S corporation values its inventory.

There are also rules in place to prevent a corporation from switching back and forth between C corp and S corp merely as it suits their immediate tax circumstances. An S corp that terminates its election to revert to a C corp is required to wait five tax years before it can re-elect S corp status. For this and other reasons, the tax status election of a small business can have a big impact.

What Are Built-In Gains?

Built-in gains tax was established in 1986. It’s a special federal tax imposed on an S corporation after conversion from a C corp. An S corp’s built-in gains tax applies to appreciated assets and profit attributable to assets received by the S corporation on the date of conversion. The assets of the C corp retain their tax basis, and the carryover basis is used to calculate taxable gains or losses on the sale of those assets.

Currently in 2022, the corporate tax rate is 21%, though that’s certainly subject to change—before the Tax Cuts and Jobs Act of 2017, the highest corporate tax rate was 35%, and according to U.S. Code 1374, built-in gains tax is imposed at the highest corporate tax rate.

Built-in gains can be recognized and taxed not only in the first tax year after conversion; currently, the built-in gains recognition period is five tax periods. This means that, for a period of five years after conversion, if the S corp sells any asset that it held on the day of S corp election, the S corp will owe BIG tax on that transaction.

Built-in gains tax only applies to an S corp for that five-year period after conversion. Corporations that elected S corp status upon incorporation aren’t subject to built-in gains tax. Gains recognized on assets acquired after becoming an S corp are not subject to built-in gains unless they have a carryover basis from a C corp.

The S corp reports built-in gains on Form 1120-S and provides an attachment showing its total net recognized built-in gain, along with a list of any capital gains and/or losses, and ordinary gains and/or losses.

How is Built-In Gains (BIG) Tax Calculated?

To calculate built-in gains tax, determine fair market value (FMV) of corporate assets (such as real estate or equipment). Next, determine the adjusted basis of the assets, and subtract the adjusted basis from FMV. If the adjusted basis is higher than FMV, the difference qualifies as built-in gains.

For example, let’s say a business converts from a C corp to an S corp, and on the conversion date, it owns a building with a fair market value of $750,000 and an adjusted basis of $500,000. After the conversion, the S corporation sells the building for a million dollars. The building had a built-in gain of $250,000.

The S corp is therefore on the hook for built-in gains tax on the $250,000 difference between the adjusted basis and FMV, at a tax rate of 21%. That means, when it files Form 1120-S, it owes $52,500 in federal built-in gains tax.

As a pass-through entity, the S corp is not required to pay tax on the net gain after built-in gains tax. Therefore, $1,000,000 – $250,000 – 52,500 = 697,500 in net gain is passed through to shareholders, each of whom pays their portion in personal income tax on long-term capital gains. In the case of S corporations that are only partially owned by an ESOP, non-ESOP owners would pay their tax liabilities associated with the taxable gain on asset sales from the prorated distributions they receive.

Of course, tax laws are complex, and leadership should consult with a tax professional about tax strategies, filing, and responsibilities. 

Understand how selling to an ESOP can affect a business.

Get the guide: What to Expect After the Transition to an ESOP Company.