The built-in gains tax runs five years from conversion

Section 1374 taxes a former C corporation at 21 percent on built-in gain recognized during a five-year recognition period that starts the first day of the first S tax year. The company pays first. You divide what is left. Counting the five years correctly is most of the defense. Stated as of September 2026.

What is the built-in gains tax, and why does it matter when I sell my company?

The built-in gains tax is a corporate-level tax imposed on an S corporation that used to be a C corporation, applied to appreciation that existed on the conversion date and is later recognized inside the recognition period. It is charged to the company, not to you. Your proceeds shrink by the tax before anything reaches your pocket.

The logic is simple. A C corporation’s appreciation is meant to be taxed twice, and an S election alone cannot erase the first layer. Congress kept that layer alive for a fixed window, and inside it an asset sale pulls the old corporate tax back into the deal.

One exclusion belongs in the same breath. Section 1374(c)(1) puts a corporation outside this tax entirely if the S election has been in effect for every one of its taxable years. No C corporation year and no carryover-basis assets from one means no exposure here.

Application is where owners get hurt. You converted in 2023. A buyer arrives in 2026 and wants assets, because that gives the buyer amortizable basis. You agree, because stock versus assets sounds like a lawyer’s distinction. The company then pays 21 percent on its net recognized built-in gain, and the rest passes through and is taxed again on your return.

Law: 26 U.S.C. 1374(a), (b)(1), (c)(1); 26 U.S.C. 11(b).

When does the five-year clock start, and when is it safely over?

The recognition period is the five-year period beginning with the first day of the first taxable year for which the corporation was an S corporation. It does not run from the date you filed Form 2553, and not from incorporation. It runs from the day the election took effect, and it ends five years later.

For a calendar-year company whose S election was effective January 1, 2022, the period runs through December 31, 2026. A sale closing in 2026 is inside it. A sale closing in January 2027 is not. A few days of drift on a closing date can move an entire corporate tax layer.

If your first S year did not begin on January 1, the period closes mid-year, and gain recognized after that date is outside Section 1374 even though the tax year straddles the line. Never assume a fiscal year end and a recognition period end are the same date.

I date the election from the filed Form 2553 and the first Form 1120-S before I look at a single line of the buyer’s structure.

Law: 26 U.S.C. 1374(a), (d)(7)(A).

Does the old ten-year rule still apply to a conversion from years ago?

No. Five years is the permanent rule under Section 1374(d)(7)(A) as amended by the PATH Act, and it applies to every taxable year beginning after December 31, 2014. The period is fixed by the tax year in which gain is recognized, not by the year in which your S election took effect.

Work it through. A company that converted in 2009 once faced a ten-year window under the pre-PATH statute. For a closing in a current tax year that history is spent, because the period tested is five years from the first S year. The ten-year text can only govern a taxable year beginning before 2015, which means an old return, not your closing.

The rate has moved too. The tax is computed at the highest rate specified in Section 11(b), a flat 21 percent for taxable years beginning after December 31, 2017. Analyses assuming 34 or 35 percent describe a dead rate; memos assuming ten years describe a dead period.

Law: 26 U.S.C. 1374(b)(1), (d)(7)(A); PATH Act, Pub. L. 114-113, sec. 127; 26 U.S.C. 11(b), as amended by Pub. L. 115-97, sec. 13001.

How much does the built-in gains tax actually cost at closing?

Built-in gains tax at 21 percent of net recognized built-in gain is paid by the company out of deal proceeds, and only part of it comes back to you. Section 1366(f)(2) treats the Section 1374 tax as a loss sustained by the S corporation that year. It is an offset, not a refund.

That loss reduces what passes through, and its character is allocated proportionately among the recognized built-in gains that produced the tax. The true cost is 21 percent at the company, minus the value of that deduction at your marginal rate, plus whatever your state charges.

Law: 26 U.S.C. 1374(a), (b)(1); 26 U.S.C. 1366(f)(2); Treas. Reg. 301.7701-2(c)(2)(i).

What transactions trigger Section 1374 in a sale?

Recognition events, not conversions, trigger Section 1374. The election itself costs nothing. The tax arrives when the company disposes of appreciated assets, or recognizes income an accrual-method C corporation would already have reported, during the recognition period. In a sale process, these are the live triggers:

• A straight asset sale. The company sells its assets and the buyer takes basis. Each asset’s gain is tested against its own conversion-date spread.
• A Section 338(h)(10) deemed asset sale. Available only where the buyer is a corporation making a qualified stock purchase, and elected jointly by that corporation and all of the target’s shareholders, selling and non-selling.
• A Section 336(e) deemed asset sale. A qualified stock disposition meeting the 80 percent vote and value test within a twelve-month disposition period, elected by all of the S corporation shareholders and the target under a written binding agreement. Uncommon in smaller deals, but it is the route open to a non-corporate buyer.
• A sale of the operating entity after an F reorganization. Where the company sits under a new holding company and becomes a disregarded single-member LLC, a sale of all of that LLC’s interests is a sale of its assets for tax purposes. The wrapper changes; the Section 1374 consequence does not.
• Collection of cash-basis receivables. Income properly taken into account during the recognition period is recognized built-in gain if an accrual-method taxpayer would have included it before the period began. The regulation’s example is a cash-method corporation converting with $50,000 of receivables for services already rendered.
• Installment sales. Sell inside the window and report on the installment method, and the rules applicable to the year of sale govern all later payments. Stretching the paper does not outlast the clock.
• Assets taken from a C corporation in a carryover-basis transaction. Those carry a separate recognition period, measured from acquisition.

Law: 26 U.S.C. 1374(d)(3), (d)(7)(B), (d)(8); Treas. Reg. 1.1374-4(b); Treas. Reg. 1.338(h)(10)-1(c); Treas. Reg. 1.336-1(b)(6); Treas. Reg. 1.336-2(h)(3); Treas. Reg. 301.7701-2(c)(2)(i).

The election is free. The recognition event is what costs you. A buyer choosing the structure is a buyer choosing who pays.

Is there a cap on the built-in gains tax, or is all my gain exposed?

Exposure under Section 1374 is capped three ways: by net unrealized built-in gain measured at conversion and reduced by net recognized built-in gain in prior years of the period, by taxable income computed as if the company were a C corporation, and by the amount of built-in gain actually recognized.

The mechanics are visible on the return. Schedule D of Form 1120-S, Part III, takes the smallest of the recognized built-in gain figure, the taxable income figure, and the net unrealized built-in gain limitation from Schedule B, applies 21 percent, then subtracts allowable business credit and any remaining minimum tax credit carryforwards from the C years. C-year net operating losses are a deduction against net recognized built-in gain.

One warning about the taxable income limitation: inside the window it defers, it does not forgive. Gain shut out by the limitation is treated as recognized built-in gain in the succeeding taxable year. The qualification matters as much as the rule. If that succeeding year falls outside the recognition period, the carryover is not taxed under Section 1374 at all.

Law: 26 U.S.C. 1374(b)(2), (b)(3), (c)(2), (d)(1), (d)(2); Treas. Reg. 1.1374-3; IRS Form 1120-S, Schedule D, Part III (2025).

Why does a conversion-date valuation decide whether my goodwill is taxed?

Goodwill and value created after the S election are not built-in gain, because built-in gain is capped at the appreciation that existed on the first day of the first S year. But the burden sits on the corporation. Section 1374(d)(3) presumes recognized gain is built-in gain until the company proves otherwise.

The statute names the only two ways out: prove the asset was not held at the start of the first S year, or prove the gain exceeds the conversion-date excess of fair market value over adjusted basis. Application: a company that converted in 2023 with no appraisal sells assets in 2026 for a number driven by three years of new customers and a rebuilt management team. Consequence: nothing allocates that increase to post-conversion periods, and the presumption does what presumptions do.

A valuation prepared now, three years after conversion, is reconstructive and weaker. A valuation prepared at conversion and kept with the first Form 1120-S workpapers is the document that carries the argument.

Before I look at the purchase price allocation, I ask for the conversion-date appraisal, and I refuse to assume that goodwill on the buyer’s schedule is post-conversion goodwill.

Law: 26 U.S.C. 1374(d)(3).

The buyer wants an asset deal and I am three years past conversion. What are my options?

Three practical options exist for a seller inside the recognition period facing a buyer who wants assets: wait until the period closes, restructure so no asset-level gain is recognized inside the corporation, or price the corporate-level tax into the deal. Ignoring it is not a fourth option; it only means you absorb it.

• Wait. If the window closes in a few months and the buyer can live with the timing, waiting is the cleanest answer. Confirm the exact end date and which tax year the closing lands in.
• Restructure. A stock sale with no Section 338(h)(10) or Section 336(e) election keeps the gain outside the corporation. Expect resistance, because the buyer loses the step-up, and expect a demand for broader reps and more indemnity instead.
• Price it. Compute the tax and negotiate for it in the price. Be realistic about the ceiling: a full gross-up is routine talk in large transactions and much harder to extract from an individual or small-company buyer, who may cover part of it or walk. Ask for the whole number and know your walk-away before you open.

Also check your state. Conformity to the federal recognition period is not uniform, and some states set their own conformity dates and impose entity-level charges on S corporations. Confirm your state position as of September 2026 before you model proceeds.

Tax structure is not a closing detail. It is a term of the price, and it belongs in the letter of intent, not in the last week of diligence.

What should I do in the next thirty days?

Five concrete steps establish your built-in gains position before a buyer sets the structure for you. Do them in order, and do them before you sign a letter of intent, because the structure fight is cheap at the term sheet and expensive to reopen later.

• Pull the filed Form 2553 and the IRS acceptance letter, and write down the effective date of the election.
• Count five years from the first day of the first S tax year. Write that end date on the front of the deal file, and note whether it falls mid-year.
• Pull the first Form 1120-S filed after conversion and look for the net unrealized built-in gain computation and any conversion-date appraisal.
• Ask your accountant for the current-year taxable income limitation estimate and whether built-in gain was carried forward from a prior year.
• Tell your tax adviser and your deal counsel, in writing, that you are inside the recognition period, so no asset sale, pre-closing reorganization, Section 336(e) election or Section 338(h)(10) election is agreed before someone prices it.

Then, in the letter of intent, say what the structure is. “Stock sale, no Section 338(h)(10) or Section 336(e) election, no pre-closing reorganization” is one line, and it is worth more than any indemnity you will negotiate later.

Law: 26 U.S.C. 1374; 26 U.S.C. 1366(f)(2); Treas. Reg. 1.1374-3, 1.1374-4. Analysis stated as of September 2026.