By: John S. Morlu II, CPA
Businesses often need to reassess their tax structure to align with changing goals or financial strategies. One common change is converting a C corporation (C corp) into an S corporation (S corp) or vice versa. While these transitions can provide tax benefits, they also come with specific rules, including potential tax liabilities. Here’s a closer look at what happens when a business switches from a C corp to an S corp, with a focus on the Built-In Gains (BIG) Tax, and some practical tips to manage the process.
Switching from a C Corporation to an S Corporation
What Is the Built-In Gains (BIG) Tax?
When a C corporation converts to an S corporation, any increase in the fair market value (FMV) of the corporation’s assets over their tax basis is referred to as a Built-In Gain (BIG). Under Section 1374 of the Internal Revenue Code, this gain is subject to a corporate-level tax if certain conditions are met.
The BIG tax is triggered if:
1. The S corporation sells or exchanges these assets, or
2. A deemed sale occurs, such as during a liquidation distribution.
The tax is assessed at 21%, which is the highest corporate tax rate.
Key BIG Tax Rules
1. Recognition Period:
- The BIG tax applies only to sales or exchanges of assets within five years of the S election. After this period, the corporate-level BIG tax no longer applies.
2. Tax Calculation Limits:
- The BIG tax cannot exceed the net unrealized built-in gain that existed on the date of the S election.
- Assets with unrealized losses on the election date reduce the total amount subject to the BIG tax.
Example: Calculating the BIG Tax
Consider the following example:
| Asset | Basis | Fair Market Value (FMV) | Built-In Gain/Loss |
| Machine 1 | $50,000 | $75,000 | $25,000 |
| Machine 2 | $250,000 | $210,000 | ($40,000) |
| Machine 3 | $40,000 | $75,000 | $35,000 |
| Total | $340,000 | $360,000 | $20,000 |
- On the S election date, the total net unrealized built-in gain is $60,000.
- If Machine 1 is sold during the five-year recognition period, the BIG tax applies only to the gain that existed on the election date: $25,000.
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Reducing the BIG Tax Liability
Here are strategies to minimize the impact of the BIG tax:
1. Wait Out the Recognition Period:
Avoid triggering the BIG tax by delaying asset sales or liquidations until the five-year period expires.
2. Offset Gains with Losses:
Unrealized losses on the election date reduce the taxable built-in gains. For instance:
| Asset | Basis | Fair Market Value (FMV) | Built-In Gain/Loss |
| Machine 1 | $50,000 | $75,000 | $25,000 |
| Machine 2 | $250,000 | $210,000 | ($40,000) |
| Machine 3 | $40,000 | $75,000 | $35,000 |
| Total | $340,000 | $360,000 | $20,000 |
- The net BIG is reduced to $20,000 because Machine 2’s unrealized loss offsets the gains.
3. Accrue Reasonable Bonuses Before Election:
Accruing but not paying bonuses to shareholder-employees before the S election reduces accumulated earnings and profits (E&P), which can lower the taxable amount during the BIG period.
Practical Tax Tips
- Consider asset sales strategically, focusing on those with the lowest built-in gains during the recognition period.
- Maintain detailed records of asset bases and fair market values at the time of conversion to ensure accurate BIG tax calculations.
- Work with a tax advisor to explore timing strategies for capital expenditures or distributions.
Switching Back from S Corporation to C Corporation
While this article focuses on switching from a C corp to an S corp, it’s worth noting that transitioning back to a C corporation has its own complexities, including restrictions on when a new S election can be made. Additionally, the treatment of previously taxed income, distributions, and retained earnings should be carefully analyzed to avoid unexpected tax liabilities.
Conclusion
Switching from a C corporation to an S corporation can provide significant tax benefits, particularly for owners who want to avoid double taxation. However, the Built-In Gains (BIG) Tax is a key consideration, as it imposes a corporate-level tax on asset gains recognized within the five-year window following the S election.
By understanding the rules and implementing smart tax strategies, business owners can minimize the impact of the BIG tax and maximize the advantages of the S corporation structure. As always, consulting with a qualified tax professional is essential to navigating these transitions effectively and aligning them with your long-term business goals.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
The firm’s groundbreaking innovations include:
• ReckSoft (www.ReckSoft.com): AI-driven reconciliation software revolutionizing financial accuracy and efficiency.
• FinovatePro (www.FinovatePro.com): Advanced cloud accounting solutions empowering businesses to thrive in the digital age.
• Fixaars (www.fixaars.com): A global handyman platform reshaping service delivery and setting new benchmarks in convenience and reliability.
Under his strategic vision, JS Morlu continues to set the gold standard for technological excellence, efficiency, and transformative solutions.
