Many business owners are aware that, if a business is operated through a C corporation, the corporation pays tax on the profits and, when the profits are distributed to the shareholders in the form of dividends, the shareholders pay tax on the dividends. In contrast, if a business is operated through an S corporation, in general only the shareholders pay tax on the profits.

In light of the two levels of tax associated with C corporations, and the single level of tax associated with S corporations, business owners often choose to form S corporations or convert their C corporations into S corporations. To discourage business owners from converting a C corporation into an S corporation shortly before selling the assets of the business, in 1986 Congress enacted the built-in gains tax (see Internal Revenue Code § 1374). In general, the built-in gains tax is a special tax imposed on an S corporation that was previously a C corporation. The tax applies with respect to appreciated assets that the corporation owns on the date it converts to an S corporation and sells within a prescribed number of years after the conversion. The built-in gains tax also applies to profit attributable to any assets received by an S corporation from a C corporation in certain nontaxable transactions. The built-in gains tax is imposed at the highest corporate rate, currently 35%.

When the built-in gains tax was enacted, it generally applied to an S corporation during the 10-year period that followed its conversion from C corporation status. During the economic recession that began in 2007-2008, the 10-year period was temporarily reduced to seven years, and then temporarily reduced to five years. The temporary reductions were intended to decrease the tax cost associated with asset sales by S corporations and thereby spur economic activity.

As part of the Protecting Americans From Tax Hikes Act of 2015, passed and signed into law in December 2015, the general 10-year built-in gains period was reduced to five years, permanently. Accordingly, the built-in gains tax will affect fewer S corporations, and its deterrent effect will be present for fewer years.

If you operate a business through an S corporation that was formerly a C corporation or that acquired assets from a C corporation in certain nontaxable transactions, or if you operate a business through a C corporation and wish to convert it to an S corporation, the built-in gains tax remains one factor to consider, but its significance is declining.