Lone Tree, Colorado
Footnotes · for the preparer’s desk
An S corporation that was always an S corporation owes no income tax of its own. Ever.
One that used to be a C corporation can owe two: a tax on the gain that was already built in when it elected, and a tax on investment income if it kept its old earnings and profits.
Both are computed on Schedule D or page 1 of the 1120-S, and both are avoidable with a calendar and an appraisal.
Four corporate-level taxes can apply to an S corporation, and every one of them requires a C-corporation history: the built-in gains tax of §1374, the excess net passive income tax of §1375, recapture of investment credit claimed in C years (§1371(d)), and LIFO recapture on the conversion itself (§1363(d), paid by the C corporation in four installments). A corporation that elected S status from its first day and never absorbed C-corporation assets in a tax-free reorganization can skip this page. Everything below is for the converted C corporation — which in our practice is usually a business that incorporated in the 1990s, elected S later, and still has the old retained earnings on its balance sheet.
An S corporation is never subject to the regular corporate income tax, the accumulated earnings tax (§531) or the personal holding company tax (§541).
Ask three questions on the first return after an election, and again whenever a client brings in a corporation someone else has been preparing.
Where it goes wrong
The common case is a former C corporation that wound down its operating business and now holds a building it rents to the successor. Rent is passive investment income; the old E&P is still on the books; the 25% test fails every year. Three years later the S election is gone and nobody noticed.
The purpose: a C corporation cannot escape the corporate-level tax on its appreciated assets by electing S and then selling them.
Recognition period. Five calendar years beginning on the first day of the first S year (§1374(d)(7), permanent since the PATH Act of 2015; it was ten years, then seven). For assets acquired from a C corporation with carryover basis, five years from the acquisition date. After the period closes the exposure ends completely.
Net unrealized built-in gain (NUBIG). The fair market value of all the corporation’s assets on the conversion date less their aggregate adjusted basis, with built-in losses netted against built-in gains (§1374(c)(2)). This figure caps the total gain that can ever be taxed under §1374. It includes cash-basis receivables (zero basis, built-in gain as collected) and is reduced by cash-basis payables and accrued but unpaid liabilities — including reasonable bonuses declared before the conversion and paid after (Reg. §1.1374-4(b), (c)). Inventory is valued at what a buyer of the whole business would pay: below retail, above replacement cost (Reg. §1.1374-7).
Recognized built-in gain in a year is the gain on any asset held on the conversion date, to the extent of its built-in gain on that date (post-conversion appreciation is not taxed). Built-in losses recognized in the same year reduce it. Installment sales during the period keep their built-in status as collected (Reg. §1.1374-4(h)).
The tax each year is 21% of the lowest of three numbers: (a) net recognized built-in gain for the year, (b) taxable income computed as if a C corporation without the NOL deduction or the dividends-received deduction, and (c) the NUBIG not yet taxed (§1374(a), (d)(2)). Gain not taxed because of the taxable-income cap carries forward within the recognition period and is taxed in a later year if income allows; it dies when the period ends (§1374(d)(2)(B)). C-year NOL and capital-loss carryovers, and general business credit carryforwards, may offset the §1374 gain or tax (§1374(b)(2), (3)) — the only use an S corporation ever gets from them.
Pass-through. The tax paid is treated as a loss sustained by the corporation, allocated to shareholders in the same character as the gain that produced it (§1366(f)(2)). On a $100,000 built-in gain the corporation pays $21,000 and the shareholders report $79,000.
↑ Back to topThe course’s example, carried through three years.
| Asset on conversion date | Basis | FMV | Built-in gain (loss) |
|---|---|---|---|
| Cash-basis receivables | $0 | $100,000 | $100,000 |
| Equipment | $70,000 | $40,000 | ($30,000) |
| Land | $50,000 | $90,000 | $40,000 |
| NUBIG | $110,000 |
Change the facts: if year 1’s C-basis taxable income had been $60,000, year 1’s tax is 21% × $60,000 = $12,600 and the untaxed $40,000 of recognized gain carries forward into year 2, where it is taxed if year 2’s taxable income allows.
↑ Back to topApplies in any year the corporation has C-corporation E&P at year end and passive investment income exceeding 25% of gross receipts.
Passive investment income is gross receipts from royalties, rents, dividends, interest (including tax-exempt interest) and annuities (§1362(d)(3)(C)). Not passive: interest on notes from sales of inventory; interest earned by a lending or finance business; rents where the corporation provides significant services (hotel-type) or where the property was built or developed by the corporation (Reg. §1.1362-2(c)(5)); and gains on stock and securities count in gross receipts only to the extent of the net gain, so churning a portfolio at cost cannot dilute the ratio.
Net passive income is passive investment income less the deductions directly connected with producing it — no NOL, no dividends-received deduction, no organizational amortization.
Excess net passive income = net passive income × (passive investment income − 25% of gross receipts) ÷ passive investment income.
The tax = 21% × the lesser of excess net passive income or taxable income computed as a C corporation without the NOL and special deductions (§1375(b)(1)(B)). A year with zero C-basis taxable income owes nothing. The tax reduces the passive items passed through to shareholders (§1366(f)(3)).
Waiver. The IRS may waive the tax where the corporation believed in good faith that it had no E&P and distributes the E&P within a reasonable time after discovering it (§1375(d)).
↑ Back to topGross receipts $100,000, of which rents $40,000; expenses directly connected with the rents $5,000; C-basis taxable income $10,000.
Larger numbers from the study questions: receipts $1,000,000, passive $500,000, direct expenses $200,000 → excess net passive income $300,000 × ($500,000 − $250,000)/$500,000 = $150,000; with C-basis taxable income of $100,000 the tax is 21% × $100,000 = $21,000.
↑ Back to topThe tax is the warning. The termination is the damage.
If the corporation has C-corporation E&P at the end of each of three consecutive tax years and passive investment income over 25% of gross receipts in each, the S election terminates on the first day of the fourth year (§1362(d)(3)(A)). Then the five-year wait before a new election (§1362(g)) begins, and the corporation is back to double taxation.
The cure is to get rid of the E&P before the third year closes: elect under §1368(e)(3), with the consent of all shareholders receiving distributions, to treat distributions as coming first from E&P (a taxable dividend to the shareholders) rather than from AAA; or elect a deemed dividend of the entire E&P without writing a check (Reg. §1.1368-1(f)(3)). The dividend is taxed at qualified-dividend rates, which is usually a small price. The distributions page has the mechanics; this page is the reason to use them.
Alternatively, restructure the income: provide real services with the rentals, sell the building to the shareholders, or move the investments out. A termination that happens because nobody looked at the three-year count is an inadvertent termination for which relief under §1362(f) is usually available — at the cost of a ruling or Rev. Proc. 2022-19 compliance and the embarrassment.
↑ Back to topInvestment credit recapture (§1371(d)(3)): credits claimed on property placed in service in C years are recaptured at the corporate level if the property is disposed of early during the S years; the shareholders are not liable. Rare since the general investment credit was repealed in 1986, but energy credits claimed in a C year follow the same rule.
LIFO recapture (§1363(d)): a C corporation using LIFO inventory must include the LIFO reserve (LIFO value versus FIFO value) in income on its last C-corporation return and pay the tax in four equal annual installments, without interest, starting with that return (Reg. §1.1363-2). The S corporation’s inventory basis is stepped up by the amount recaptured. Ask about the inventory method before every C-to-S election.
↑ Back to topYes, for §1375 and the three-year termination. The five-year §1374 window has closed, so built-in gains are no longer taxed, but as long as C-year E&P sits on the balance sheet, a year with rents, interest and dividends over 25% of gross receipts is a tax year and a strike toward termination. The simplest permanent fix is the deemed-dividend election to purge the E&P.
Check the dates. The recognition period is five calendar years beginning with the first S year; a sale in year six is outside it and no §1374 tax is due. Amend if the return is open.
Reconstruct one now from the best evidence — a contemporaneous broker opinion, assessor records, the books — and document it. Without a conversion-date value the IRS position is that the entire later gain is built in, and the burden is the corporation’s.
Then §1375 and the three-year rule cannot apply, however passive the income. Note it in the file so the next preparer does not panic.
One line each, from the course study questions and the final exam; the bracketed tag is the question and the answer I derived.
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Written for the Tax Shop desk from my continuing-education course notes; figures are for the 2026 tax year unless stated. Items marked (verify) are to be confirmed against primary sources before they are relied on. Private reference, not client advice.