S Corporation Built-In Gains Tax: Section 1374 CPA REG Guide
Comprehensive guide to the built-in gains tax under IRC Section 1374 for CPA REG candidates. Covers the recognition period, NUBIG calculation, and planning strategies.
The Built-In Gains Tax Under IRC Section 1374
When a C corporation elects S corporation status, the built-in gains (BIG) tax under Section 1374 may apply to gains recognized on assets that had appreciated while the entity was a C corporation. This entity-level tax is designed to prevent corporations from avoiding the corporate-level tax on appreciated assets by converting to S status before selling those assets. For CPA REG candidates, understanding the mechanics of the BIG tax, the recognition period, and the available offsets is essential.
When Does the BIG Tax Apply?
Triggering Events
The BIG tax applies when an S corporation recognizes gain on the disposition of an asset during the recognition period, and the gain is attributable to appreciation that existed on the date the corporation converted from C to S status. The tax also applies when an S corporation acquires assets from a C corporation in a tax-free transaction under Section 381 (such as a merger), and those assets had built-in gains at the time of acquisition.
The Recognition Period
The recognition period is the five-year period beginning on the first day the S election is effective. Any built-in gains recognized during this period are subject to the BIG tax at the entity level. After the recognition period expires, any remaining appreciation on assets held since the conversion date is taxed only at the shareholder level when recognized, at the applicable individual rates.
The five-year recognition period was permanently set by the Protecting Americans from Tax Hikes (PATH) Act of 2015. Previously, the period had been temporarily reduced to seven years and then five years during the financial crisis.
Calculating the BIG Tax
Net Recognized Built-In Gain (NRBIG)
The BIG tax is imposed on the "net recognized built-in gain" for the taxable year. This is computed as the lesser of: (1) the net gain recognized during the year that is attributable to built-in gain (i.e., the gain that existed on the conversion date), and (2) the taxable income of the S corporation as if it were a C corporation. This second limitation prevents the BIG tax from exceeding what the corporate tax would have been.
Additionally, the cumulative NRBIG over the entire recognition period cannot exceed the "net unrealized built-in gain" (NUBIG), which is the total built-in gain in all assets at the conversion date minus the total built-in loss in all assets at that date. This ceiling ensures that the total BIG tax does not exceed the tax on the net appreciation that existed at conversion.
Built-In Gains vs. Post-Conversion Gains
Only the built-in portion of a gain is subject to the BIG tax. If an asset had a fair market value of $100,000 and a basis of $60,000 on the conversion date, and the S corporation sells it for $130,000 during the recognition period, only $40,000 (the built-in gain) is subject to BIG tax. The remaining $30,000 of post-conversion appreciation is taxed only at the shareholder level.
Tax Rate
The BIG tax is imposed at the highest corporate tax rate, which is currently 21% (the flat rate enacted by the TCJA). The tax is computed at the entity level and reduces the amount of income that passes through to the shareholders.
Offsets and Reductions
- Built-in losses: Built-in losses recognized during the recognition period offset built-in gains in computing NRBIG.
- NOL carryforwards: The S corporation can use NOL carryforwards from its C corporation years to offset NRBIG.
- Business credit carryforwards: C corporation business credit carryforwards can offset the BIG tax.
- Capital loss carryforwards: C corporation capital loss carryforwards can offset built-in capital gains.
Shareholder-Level Effects
After the BIG tax is paid at the entity level, the net income passes through to shareholders. The BIG tax paid reduces the amount subject to shareholder-level tax, preventing full double taxation. The character of the gain (ordinary or capital) passes through to shareholders based on the nature of the underlying asset.
CPA Exam Tips
- The BIG tax applies only to C-to-S conversions (or S corps acquiring C corp assets in tax-free transactions).
- The recognition period is five years from the first day of S status.
- NRBIG is capped by taxable income and cumulative NUBIG.
- C corporation NOLs, capital loss carryforwards, and credit carryforwards can offset the BIG tax.
- Only built-in gain (appreciation existing at conversion) is subject to BIG tax; post-conversion appreciation is not.
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