Converting to an S Corporation can be a super powerful strategy and one that we talk about with business owners on a daily basis. However, if you are converting from a C Corporation, there is one "BIG" tax you need to consider.

For those of you who do not know what an S Corp even is or how it can be a powerful strategy to save on self-employment taxes, check out our entire series of blogs and podcast episodes here:

Everything You Need To Know About S Corporations

What Is the Built-In Gain (BIG) Tax?

The built-in gains tax, also known as the BIG tax, specifically applies to C Corporations that have converted to an S Corporation. This tax was put into place to prevent C Corp owners from electing S Corp right before a liquidation or asset sale event and avoid double tax. Let's explain that further:

• C Corporation Asset Sale: If you sell an asset as a C Corp, you will pay corporate taxes on that sale, and then you'll also pay taxes at the shareholder level for any funds dispersed (double taxation).
• S Corporation Asset Sale: The gain is taxed just once at the shareholder level due to the passthrough treatment of an S Corp.

This really comes into play when the fair market value (FMV) of the corporate assets is greater than their adjusted basis on the books. Let's go through a quick example:

• FMV of Vehicle: $50,000
• Adjusted Basis: $0 (Fully Depreciated)
• FMV > Adjusted Basis

If you were a C Corp and sold that vehicle for $50,000, you would have a corporate tax that you would pay on that gain at the corporate level, and if you then paid those funds out to the shareholders, there would be an additional tax on that. If you were organized as a S Corp and sold that vehicle for $50,000 you would avoid the corporate level tax and just pay taxes on the gain at the shareholder level. 

A smart tax play could be to convert to an S Corp prior to the sale of that vehicle and avoid double taxation, right? Wrong, and that is exactly what the BIG tax was created for.

When Does the Built-In Gain (BIG) Tax Apply?

There are a few main items when the BIG tax comes into play:

1. Conversion From C Corp to S Corp: The business must have previously been a C Corp that converted to an S Corp.
2. Built-In Gain Was Present: At the time of conversion, there were assets that had a fair market value (FMV) greater than the adjusted basis of that asset.
3. Sale of Appreciated Asset During Recognition Period: The asset was sold in the S Corp within 5 years of the conversion to an S Corp.

Alright, so with that in mind, let's look at some scenarios where the built-in gain tax does NOT apply.

1. S Corp Never Treated As C Corp: If the S Corp were never treated as a C Corp, then there would be no built-in gain tax.
2. Instant Conversion: If you created a C Corp and instantly converted to an S Corp, there would be no built-in gain tax because there were no assets in the C Corp yet. 
3. Asset Purchased After Conversion: If you purchase an asset within the S Corp after any type of conversion, there would be no BIG tax on that because that asset was never inside the C Corp.
4. Sell Asset After 5-Year Holding Period: If you hold on to an asset and sell it after 5 years from the conversion to an S Corp, there is no BIG tax.

How Do I Calculate the Built-In Gain (BIG) Tax?

When the BIG tax has been triggered, you calculate it as follows:

1. Identify Built-In Gain Amount: This would be the unrealized gain at the time of converting from C Corp to S Corp. Essentially FMV less adjusted basis. Accurate asset valuation as the time of conversion is crucial.
2. Calculate Gain on Sale: Determine the gain that was realized from the sale of the asset(s) that qualifies for the BIG tax.
3. Apply Tax: Apply the highest corporate tax rate to that gain and pay the tax. Currently, this is 21%.

Let's go through an example:

Let's assume on the date you converted a C Corp to an S Corp; you had a vehicle with an FMV of $50,000 and an adjusted basis of $0 because you fully depreciated it. You would have an unrealized built-in gain of $50,000 on the date of conversion.

Now let's assume 3 years into the S Corp, you sell that vehicle for $35,000. That entire amount would be subject to the BIG tax at 21%.  Thus, you would have to pay $7,350 in BIG tax as well as the tax that flows through to you as the shareholder of the S Corp.

How Do I Avoid the Built-In Gain (BIG) Tax?

This is where some planning can come into play. 

• Wait 5 Years: This is the most straightforward way to avoid the BIG tax. Simply avoid selling any appreciated assets during the 5-year period after conversion. Once the period expires, you can sell the assets, and it will no longer trigger the BIG tax.
• Sell in Loss Years: The BIG tax is limited to the taxable income of the company. Therefore if you sell the asset in a year that you are going to be facing a loss, there would be no BIG tax to recognize. Be aware, though, that this unrecognized gain would carry forward to a year where there would be taxable income.
• Use C Corp Carryovers: If you have NOLs, capital losses, etc that were carried over from the C Corp, you can utilize those to reduce the BIG tax.
• Stock Sale vs. Asset Sale: If you were to sell the entire S Corp within the 5-year period, you might want to negotiate a stock sale versus an asset sale to avoid the BIG tax.

In some cases, starting a new S Corp entity rather than converting an existing C Corp can make more sense. This strategy avoids potential BIG Tax implications but may involve additional costs or operational restructuring.

What Steps Should I Take Before Converting C Corporation to S Corporation?

This is exactly why we wrote this article; we see far too many business owners not even realize the BIG tax was a thing. The BIG tax is not necessarily in itself a reason not to convert to an S Corp, but you do want to be aware of it and understand what it would mean if you dispose of assets within the 5-year period.

If you have assets that would be subject to BIG tax, you should do a full review of them prior to the conversion to understand what your unrecognized gain will be on those assets at the time of conversion. You will want to keep this report on file so you can reference it in the event you sell one of those assets.

Again, to be clear, the BIG tax is definitely not a reason to avoid an S Corp election because an S Corp election can be extremely powerful. It is just one piece you want to consider and understand if you are planning the election, especially if you have intentions of selling assets from the C Corp in the next 5 years.