United States: How S Corporations Can Minimize The Built-In Gains Tax

An S corporation that was previously taxed as a C corporation, or that received assets from a C corporation in a carryover-basis transaction, can be subject to the built-in gains tax. Fortunately, there are several planning techniques for minimizing or entirely avoiding the built-in gains tax. Some of these techniques received a significant boost from the Protecting Americans from Tax Hikes Act (the "PATH Act"), enacted on Dec. 18, 2015.

Overview of Entity Taxation

Different types of entities are subject to different tax rules. Income earned by C corporations is subject to two levels of tax, at the entity level (when the income is earned) and at the shareholder level (when the earnings are distributed to the shareholders). By contrast, income earned by pass-through entities, including S corporations, partnerships and disregarded entities, is generally not subject to tax at the entity level. (Limited liability companies can choose to be taxed as C corporations or as pass-through entities.) Instead, a pass-through entity's items of income and loss pass through to its owners.

Shareholders of a C corporation that want to change it to a pass-through entity generally have two alternatives: (1) convert the C corporation to a limited liability company taxed as a partnership (or a disregarded entity in the case of a single owner), or (2) elect to treat the C corporation as an S corporation (assuming the requirements for S corporation treatment, discussed below, are satisfied). The first alternative would result in entity-level taxable gain, generally in the amount of the fair market value of the assets of the C corporation, reduced by the assets' aggregate tax bases. By contrast, the second alternative can avoid the entity-level taxable gain unless the built-in gains tax applies.

Overview of S Corporation Taxation

A corporation can be taxed as an S corporation if it satisfies certain requirements. First, an S corporation cannot have more than 100 shareholders. Second, an S corporation cannot have more than one class of stock, provided, however, that it can have stock with differing voting rights. Third, the only permitted shareholders are (1) individuals that are U.S. citizens or tax residents, and (2) certain trusts and estates.

An eligible entity can elect to be taxed as an S corporation since its formation. Alternatively, an eligible C corporation may generally elect to be taxed as an S corporation in any year after its formation. If an S election is terminated, the corporation and any successor corporation could not elect to be taxed as an S corporation for five years, without the consent of taxing authorities.

An S corporation is generally not subject to entity-level tax. Instead, items of income and loss pass through to the S corporation's shareholders, based on their respective ownership interests. Whether an item of income or loss is capital in nature is determined at the corporate level. Shareholders of an S corporation increase the basis of their stock by the amount of income and reduce the basis of their stock (not below zero) by the amount of loss passed through to them.

An S corporation may be subject to the built-in gains tax at the entity level, as discussed below. An S corporation may also be subject to entity-level tax on its excess net passive income, if (1) the S corporation inherited any earnings and profits from a C corporation, and (2) more than 25 percent of its gross receipts consist of passive investment income.

S corporation shareholders who sell S corporation stock can elect (generally, with the purchaser's consent) to treat the sale of stock as a sale of assets for federal income tax purposes. In that case, for federal income tax purposes, the S corporation would be treated as if it (1) sold all of its assets to a new corporation, and (2) made a liquidating distribution of the consideration to its shareholders.

The Built-In Gains Tax

The built-in gains tax is an entity-level tax on an S corporation that (1) was formerly a C corporation or received assets from a C corporation in a carryover basis transaction (for example, a tax-free reorganization or corporate separation), and (2) disposes of the assets that had built-in gain in the hands of the C corporation in a taxable sale or exchange during the recognition period. The recognition period is a five-year period that begins when a C corporation converts to an S corporation, or when an S corporation receives assets from a C corporation in a carryover-basis transaction.

The built-in gains tax is imposed at the highest corporate rate, currently 35 percent. It generally applies to built-in gains in the hands of the C corporation that are recognized during the recognition period. The amount subject to the built-in gains tax is generally reduced by any loss recognized on a disposition of an asset held by the C corporation, to the extent the C corporation had a built-in loss in the asset. Net operating losses inherited from a C corporation can generally also be used to reduce the amount subject to the built-in gains tax. In addition, other items of deduction and loss can generally shelter the recognized built-in gains that would be subject to the built-in gains tax. However, in that case the recognized built-in gain would carry over into the subsequent year and could be subject to the built-in gains tax in that year, if it is within the recognition period. (Recognized built-in losses, corporate net operating losses, and other items of deduction and loss generally could be used to shelter such carryover recognized built-in gain.)

The Recognition Period

Prior to the PATH Act, taxpayers have faced significant uncertainty for several years with respect to the duration of the recognition period. From the time when the built-in gains tax was first enacted in 1986 until 2009, the recognition period was 10 years; however, in response to the 2008 financial crisis, beginning in 2009 through 2014 Congress temporarily shortened the recognition period several times.

On Feb. 17, 2009, the recognition period was reduced to seven years for tax years beginning in 2009 and 2010 by the American Recovery and Reinvestment Act of 2009. For tax years beginning in 2011, the Creating Small Business Jobs Act of 2010, enacted on Sept. 27, 2010, reduced the recognition period to five years. For tax years beginning in 2012 and 2013, the American Taxpayer Relief Act of 2012 extended the reduced five-year recognition period. However, that legislation was enacted on Jan. 2, 2013, and thus the planning environment for S corporations with built-in gains was fraught with uncertainty for the 2012 tax year. The Tax Increase Prevention Act of 2014, enacted on Dec. 19, 2014, extended the five-year reduced recognition period to tax years beginning in 2014. However, once again, because the law was enacted at the end of 2014, S corporations with built-in gains endured an uncertain planning environment for nearly all of 2014.

The PATH Act made permanent the five-year recognition period for tax years beginning in 2015. Thus, changing the five-year duration of the recognition period in the future would require congressional action.

Planning Opportunities

There are several planning opportunities that can minimize or eliminate the built-in gains tax.

An S corporation could wait until after the recognition period to dispose of the assets that would trigger the built-in gains tax. The PATH Act provides a more predictable planning environment than the one that existed in recent years because the duration of the recognition period has been shortened and made permanent.

An S corporation could dispose of built-in loss assets in the same year as when it disposes of built-in gain assets in order to minimize the built-in gain subject to the built-in gains tax.

Toward the end of the recognition period, an S corporation could accelerate items of deduction and loss (other than built-in loss) in order to shelter the recognized built-in gains from the built-in gains tax. The PATH Act has made this strategy substantially more viable, because (1) the sheltered built-in gain carries over into subsequent years, and (2) the shortened recognition period makes it easier to implement. However, not all items of deduction and loss may be appropriate. For example, paying substantial bonuses to reduce the S corporation's income is not always appropriate, especially if it is done in more than one year.

If the shareholders wish to dispose of the S corporation, they could sell the stock without electing the deemed asset sale treatment. The purchasers may object, however, because they would not get the benefit of tax-basis step-up in the corporation's assets. For example, in the case of consideration allocable to goodwill, which is generally amortizable over 15 years, the purchasers would miss out on the benefit of amortization deductions equal to one-fifteenth of the consideration per year for 15 years.

Shareholders could get an appraisal to establish the amounts of built-in gain and loss on the date when a C corporation converts to an S corporation, or when an S corporation receives assets from a C corporation in a carryover-basis transaction. That could help in connection with any subsequent dispute with the taxing authorities over the amount of built-in gains that are subject to the built-in gains tax.

If an S corporation disposes of a built-in gain asset in a nonrecognition transaction, the disposition would not trigger the built-in gains tax. Thus, where applicable, an S corporation could dispose of unwanted built-in gain assets in a tax-free exchange.

Originally published by Law 360

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Jacob M. Oksman
In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.