The Five-Year BIG Tax Tail After Converting a C-Corp to an S-Corp (§1374)

Sell an appreciated asset in year three after your S election and you can get taxed twice on the same gain: once at the corporate level and again on your 1040. That is the trap §1374 sets for owners who flip from C to S and assume the entity-level tax died with the election. It didn't. It went dormant for five years.

The built-in-gains (BIG) tax is the price the Code charges for having accumulated appreciation inside a C-corp and then converting to a pass-through instead of liquidating and paying the double tax outright. For the first five years of S life, the government keeps a claim on the gain that was already baked in on conversion day.

What is the built-in-gains tax under §1374?

The BIG tax is a corporate-level tax, imposed under §1374 at the highest corporate rate (currently 21% under §11(b)) on gains that were economically built in when a C-corp converted to an S-corp and are then recognized during the "recognition period."

Without §1374, the conversion-plus-later-sale sequence would let a corporation dodge the C-corp double tax entirely: convert to S, sell the appreciated asset a week later, and pass the gain straight through to shareholders at individual rates. §1374 closes that door by clawing back the corporate-level tax on gain that accrued while the entity was still a C-corp.

Two conditions have to line up for the tax to apply:

1. The corporation was a C-corp before its S election (a corporation that has been an S-corp since inception has no BIG exposure), and
2. It recognizes a "net recognized built-in gain" during the recognition period.

How long is the §1374 recognition period?

Five years. Under §1374(d)(7), the recognition period is the five-year period beginning on the first day the S election is effective.

This has moved around. The period was originally ten years, was temporarily shortened by a series of stimulus-era provisions, and was made permanently five years by the PATH Act of 2015, amending §1374(d)(7). For any conversion since 2015, plan on a clean five-year window.

The practical consequence: gain recognized on the first day of year six is completely outside §1374. I've watched clients defer a building sale by a matter of weeks to clear the recognition period and save six figures of entity-level tax. The date the election became effective, not the date you filed Form 2553, starts the clock.

What counts as a built-in gain?

Only the appreciation that existed on the conversion date, and only to the extent it is recognized inside the five-year window. Post-conversion appreciation is not BIG.

The mechanic is a snapshot. On the first day of the S period, you conceptually mark every asset to fair market value. The spread between fair market value and adjusted basis on that day is the "net unrealized built-in gain" (NUBIG) under §1374(d)(1). That NUBIG is the lifetime ceiling on what §1374 can ever tax.

• An asset worth $1,000,000 with a $400,000 basis on conversion day carries $600,000 of built-in gain.
• Sell it in year two for $1,100,000, and only $600,000 is subject to the BIG tax. The extra $100,000 accrued as an S-corp and passes through cleanly.
• Sell it in year six for anything, and none of it is BIG. The window closed.

Built-in gain items reach further than a straightforward asset sale. Under §1374(d)(5), income items that would have been reported by a cash-basis C-corp (collected receivables, for example) are treated as recognized built-in gain. Completing a long-term contract, collecting on work performed before conversion, and similar timing items get pulled in. Correspondingly, recognized built-in losses offset the gains in computing the net figure.

How is the BIG tax actually calculated?

Start with net recognized built-in gain for the year, apply the 21% rate, and then run it through three separate limitations. The tax is the lowest result of those limits, and it is computed on Part III of Schedule D (Form 1120-S).

The three limitations under §1374(d) work as ceilings:

Limitation	What it caps	Source
Net recognized built-in gain	Recognized built-in gains minus built-in losses for the year	§1374(d)(2)
Taxable income limitation	Corporation's taxable income as if it were a C-corp	§1374(d)(2)(A)
Net unrealized built-in gain	Lifetime cap: total NUBIG at conversion, reduced each year	§1374(c)(2)

The taxable income limitation matters more than owners expect. If the S-corp has an operating loss in the year of an appreciated-asset sale, the taxable income limit can push the current-year BIG tax to zero. But under §1374(d)(2)(B), the deferred amount carries forward and is treated as recognized built-in gain in later years, so a loss year defers the tax, it does not delete it, as long as you're still inside the window.

And the sting: the BIG tax paid at the corporate level is itself deductible by the S-corp under §1366(f)(2), reducing the gain that passes through to shareholders. It softens the double hit, but it does not eliminate it.

Does the S-corp really get taxed twice?

Yes, on built-in gain recognized in the window. The corporation pays 21% at the entity level under §1374, and the remaining gain still passes through to shareholders on their personal returns.

Work a $600,000 built-in gain in year two:

• Entity-level BIG tax: $600,000 x 21% = $126,000.
• That $126,000 is deducted per §1366(f)(2), so $474,000 passes through to shareholders.
• Shareholders pay individual tax on the $474,000 (rate depends on character, long-term capital gain versus ordinary).

The blended result lands well above a straight pass-through and is the whole reason to plan around the timing rather than sell on autopilot.

How do you plan around the built-in-gains tax?

Time recognition, document valuation, and use the limitations deliberately. The BIG tax is one of the most avoidable entity-level taxes in the Code because the trigger is a sale you usually control.

What I tell clients weighing a conversion:

• Get a conversion-date valuation. NUBIG under §1374(d)(1) is a factual snapshot. Without a defensible appraisal on the effective date, you cannot prove how much of a later gain accrued after conversion, and the IRS will treat ambiguity in its favor. Zero-basis goodwill built entirely as a C-corp is fully exposed.
• Hold appreciated assets through the five years where the business allows. Clearing §1374(d)(7) makes the entity-level tax vanish.
• Watch cash-basis receivables and long-term contracts: §1374(d)(5) sweeps these in even without an "asset sale."
• Stack loss years. The taxable income limitation of §1374(d)(2)(A) can defer the tax into a stronger year, but confirm the deferred gain still recognizes before the window closes.
• Model conversion versus staying C. For a business planning to sell appreciated real estate or goodwill within five years, an S election can accelerate rather than reduce total tax.

Whether §1374 bites turns entirely on your assets, your appraisal, and your timing, and on the rules of the state where the corporation operates, several of which impose their own BIG-style tax. Model the numbers with your advisor before you file Form 2553, not after.

Sources

• IRC §1374: Tax imposed on certain built-in gains (including §1374(c)(2), (d)(1), (d)(2), (d)(5), and (d)(7))
• IRC §11(b): 21% corporate tax rate
• IRC §1366(f)(2): deduction for tax imposed under §1374
• Protecting Americans from Tax Hikes (PATH) Act of 2015: permanent five-year recognition period under §1374(d)(7)
• IRS Form 1120-S and Schedule D (Form 1120-S), Part III: computation of the built-in gains tax
• IRS Form 2553: Election by a Small Business Corporation