There are many instances in which a corporation might decide to convert from a C corporation to an S corporation. Various federal and state tax opportunities arise out of a switch like this one. The built-in gains tax, however, is something to consider when debating whether to change to an S corporation. Since C corporations are essentially double-taxed – at both the shareholder and entity level – the government won’t permit companies to switch to an S corporation, which doesn’t face this extra level of taxation, without paying an additional fee.
The built-in gains tax is one levied against an S corporation that used to be a C corporation, or received assets from a C corporation. Also, the S corporation must dispose of the assets that had built-in gains in a taxable sale or exchange during a time known as the recognition period. The recognition period lasts for five years, and it begins when the C corporation changes over to an S corporation. As of 2018, the built-in gains tax is levied at the highest corporate rate.
The built-in gains tax is covered in U.S. Code 1374. This code states that if, for any taxable year, an S corporation has a built-in gain, that corporation’s income will be taxed for that year. In general, the code explains, this tax will be levied according to the highest available corporate rate. An important component of this code is that an S corporation and its predecessors will always be viewed as one entity going forward, from the perspective of the tax code.
To calculate the built-in gains tax, you will need to determine both short-and-long-term C corporation assets. You may use these to determine the fair market value of these assets. Next, you'll need to calculate the adjusted basis of the assets. Subtract the adjusted basis of the assets from their fair market value. Only if the adjusted basis number is higher than the fair market value will you have to pay the built-in gains tax. Any built-in gain that you do calculate must be reported on Form 1120-S at the close of the first tax year of the S corporation.
In addition to dealing with built-in capital gains, companies thinking of becoming S corporations must consider how they will deal with being unable to produce earnings and profits. Under current tax law, S corporations are not permitted these, known as E&P. Only C corporations may have earnings and profits. However, if your S corporation used to be a C corp, you may have accumulated E&P over the years.
According to U.S. Code 1374, if a company’s gross passive investment income exceeds 25 percent of its gross receipts, this income may be subject to tax at the highest corporate income tax rate. If your S corporation has no accumulated E&P, this won’t come into play. However, if it does have both E&P and excess passive investment income, some of the excess net passive investment income may be taxed. You should seek the assistance of a lawyer and accountant if you are considering this conversion.