When a C-corporation elects S-corporation status, it does not escape the corporate-level tax on appreciation that accrued while it was a C-corp. IRC §1374 imposes a built-in gains (BIG) tax at the highest corporate rate (21%) on any net recognized built-in gain during the recognition period - generally the first five years after the S election. This tax prevents C-corps from escaping corporate-level tax by electing S-corp status just before a major asset sale. Understanding §1374 is essential for any C-to-S conversion analysis and for planning asset sales by former C-corps during the recognition period.
Who it applies to: S-corporations that were formerly C-corporations (or that acquired assets from a C-corp in a carryover basis transaction like a §381 reorganization).
Recognition period: 5 years following the date of the S election. Gains recognized on assets owned at conversion that were sold within this period may be subject to BIG tax. After 5 years, §1374 no longer applies to subsequent dispositions.
The tax: 21% corporate tax on the lesser of (a) the net recognized built-in gain for the year, or (b) the taxable income of the S-corp computed as if it were a C-corp. This is a corporate-level tax paid by the S-corp - in addition to the shareholder's pass-through income tax on the same gain.
Net Unrealized Built-In Gain (NUBIG): The total BIG tax exposure is capped at the NUBIG - the excess of fair market value over adjusted basis of all assets at the time of conversion. Once cumulative recognized built-in gains equal the NUBIG, no further BIG tax applies.
A built-in gain is any item of income or gain that would have been includible in the C-corp's gross income had the S election not been made and the asset sold on the conversion date. The most common built-in gains: appreciation in real estate owned by the C-corp at conversion, goodwill that has been depreciated or was never recognized in the C-corp's accounts but exists at FMV, accounts receivable on a cash-basis C-corp (which had not yet been recognized as income), and deferred income items that would have been taxable to the C-corp had it remained a C-corp.
Built-in losses also exist - the BIG tax is applied to the net recognized built-in gain. A built-in loss (FMV below basis at conversion) offsets built-in gains recognized in the same year. The NUBIG calculation at conversion should capture all assets, including intangibles, to establish the ceiling on total BIG tax exposure.
The most straightforward §1374 planning strategy is timing. If a former C-corp S-corp can wait until after the 5-year recognition period to sell appreciated assets that existed at conversion, no BIG tax applies. For a C-corp that converts in January 2026, assets owned at conversion can be sold BIG-tax-free beginning in January 2031. For long-lived assets like real estate, waiting 5 years is often feasible.
For assets that must be sold within the recognition period, installment sales provide partial relief. Under the installment method, gain is recognized as payments are received. If an installment sale is structured with payments extending beyond the recognition period, gain recognized in years after the recognition period ends is not subject to BIG tax - even though the sale occurred within the recognition period. The installment payments trigger gain recognition, and §1374 only applies to gain recognized during the recognition period, not to gain from a contract entered during the period if the recognition falls after.
The §1374 BIG tax is a corporate-level tax. It reduces the S-corp's taxable income passed through to shareholders - the shareholder's pass-through income is the gain net of the BIG tax. But the BIG tax does not eliminate the shareholder's income tax on the pass-through. A $1 million built-in gain in an S-corp within the recognition period: $210,000 in BIG tax (21%) paid by the corporation; $790,000 passes through to the shareholder, who pays income tax at their marginal rate. Total tax rate on the built-in gain exceeds the corporate rate alone.