Escaping the Built-In Gains Tax

Are you considering converting your C corporation to an S corporation?

If so, being aware of the built-in gains tax that may be assessed to your corporation is essential. With the proper planning, such as timing the sale of the built-in gain assets, you can escape paying the dreaded built-in gains tax.

What is built-in gains tax? Generally, an S corporation is not subject to tax. However, when a C corporation is converted to an S corporation status, the highest corporate tax rate (currently 35%), is imposed on the net built-in gains of the corporation, which is the excess of the fair market value of assets over the adjusted basis of assets. The built-in gains tax is only applied for assets that were in existence at the time of conversion and turned into cash or sold during the “recognition period,” which was normally a 10-year period. The good news is that on December 18, 2015, President Obama signed the “Protecting Americans from Tax Hikes” (PATH) Act, which retroactively and permanently extends, among other provisions, the 5-year built-in gains tax recognition period instead of the 10-year period.

For example, a C corporation was converted to an S corporation status on January 1, 2015. On the date of the conversion, it had assets with a fair market value of $3 million and adjusted basis of $2 million. The corporation’s net unrealized built-in gain would be $1 million. If the corporation had taxable income of $1.5 million and sold the built-in gain assets in 2017, the corporation would be subject to the built-in gains tax of $350,000 ($1 million X 35%). However, if the built-in gain assets were sold in 2020, the built-in gains tax would be a non-issue (zero built-in gain tax) since the fifth year of the recognition period ends on December 31, 2019.

Of course, there are other tax planning strategies to escape the built-in gains tax, such as selling accounts receivables before converting to an S corporation status, recognizing built-in losses in years when built-in gains are recognized, and so on. Before you make a decision to convert your C corporation to an S corporation status, you need to look closely at the real effect of the built-in gains tax and plan accordingly. By doing so, you may be able to reduce or escape paying the built-in gains tax that means a real tax savings for you.

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