S Corporation Built-In Gains Tax: How the Section 1374 Tax Is Computed

The S corporation built-in gains tax is a corporate-level tax under Section 1374 that applies when a former C corporation sells or otherwise disposes of assets it held on the day its S election took effect, within the first five years of S status. The tax equals 21% of the year's net recognized built-in gain, capped by the company's taxable income and by the total built-in gain that existed at conversion.

Below, each step of the S corporation built-in gains tax follows the order of Part III of Schedule D (Form 1120-S), with a two-year worked example. Figures are current as of October 2026.

Which Companies Owe the S Corporation Built-In Gains Tax

Section 1374 targets one move. A C corporation holding appreciated assets files Form 2553 to elect S status, then sells those assets so the gain flows straight to shareholders without the corporate layer of tax. The built-in gains tax keeps the corporate layer in place for gain that had already accrued while the company was a C corporation.

The IRS instructions for Schedule D (Form 1120-S) list two groups of S corporations that can owe the tax:

• an S corporation that was a C corporation before it elected S status;
• an S corporation that acquired an asset with a basis carried over from a C corporation, such as in a tax-free merger (a "transferred-basis acquisition" under section 1374(d)(8)).

A company that has been an S corporation for every tax year since formation is outside the rule. The statute says the tax "shall not apply to any corporation if an election under section 1362(a) has been in effect with respect to such corporation for each of its taxable years." That exemption does not cover the second group, because section 1374(d)(8) switches it off for carryover-basis assets. An LLC that chose corporate classification on Form 8832 and filed as a C corporation for any year before electing S status is in the first group.

If you are still weighing whether to convert, the C corp guide for 2026 explains how a C corporation is taxed and when staying one makes sense; this tax is one line item in that decision.

The 5-Year Recognition Period

Section 1374(d)(7) defines it as "the 5-year period beginning with the 1st day of the 1st taxable year for which the corporation was an S corporation." For assets that came in through a transferred-basis acquisition, the five years start on the date the S corporation acquired the asset, and the IRS instructions say a company with both kinds of assets must figure the tax separately for each group.

For a calendar-year company whose S election took effect on January 1, 2023, the recognition period runs through December 31, 2027. A sale on or after January 1, 2028 is outside the window, even if the asset had a large gain on conversion day.

Three timing rules catch people out:

1. Installment sales. If a sale inside the window is reported on the installment method, payments collected after the window closes are still governed by the rules for the year of sale, under section 1374(d)(7)(B).
2. Built-in income items. Income that is "attributable to periods before the 1st taxable year for which the corporation was an S corporation" but is taken into account during the window counts as recognized built-in gain under section 1374(d)(5)(A). Receivables of a cash-method business that were earned before conversion and collected afterward are a common example.
3. Swapped assets. Under section 1374(d)(6), property whose basis is determined by reference to a conversion-date asset is treated as held on conversion day. Replacement property received in a like-kind exchange keeps the old asset's built-in gain, so the exchange defers the issue within the window without erasing it.

Net Unrealized Built-In Gain: The Lifetime Cap

Net unrealized built-in gain, or NUBIG, is a one-time snapshot taken on the first day of S status. Section 1374(d)(1) defines it as the amount by which "the fair market value of the assets of the S corporation as of the beginning of its 1st taxable year for which an election under section 1362(a) is in effect" exceeds "the aggregate adjusted bases of such assets at such time."

NUBIG matters in two ways.

First, it caps the total gain that can ever be taxed. Under section 1374(c)(2), the net recognized built-in gain taken into account in any year cannot exceed NUBIG minus the net recognized built-in gain from prior years in the recognition period. Once the cumulative amount reaches NUBIG, later sales inside the window carry no built-in gains tax.

Second, it limits the gain on each asset. The tax applies only to the appreciation that existed on conversion day. If an asset worth $1.1 million on day one with a $600,000 basis later sells for $1.25 million, only $500,000 is built-in gain. The other $150,000 accrued during S years and passes through to shareholders with a single level of tax. Section 1374(d)(3) treats any gain as built-in "except to the extent that the S corporation establishes" otherwise, so a conversion-date appraisal is the main evidence.

The Form 1120-S instructions tell the corporation to report on Schedule B, item 8, "the corporation's net unrealized built-in gain reduced by the net recognized built-in gain from prior years." That running balance is the remaining cap.

How to Compute the S Corporation Built-In Gains Tax on Schedule D

The computation sits in Part III of Schedule D (Form 1120-S), lines 16 through 23. Here is what each line does.

The instructions require an attachment for line 16 that shows "its total net recognized built-in gain and list separately any capital gain or loss and ordinary gain or loss," and an attachment for line 17 showing the Form 1120 computation or other worksheet used to figure taxable income.

The taxable income limit and carryover

Section 1374(d)(2)(A) defines net recognized built-in gain as the lesser of the built-in amount and the corporation's taxable income for the year. If the business has an operating loss that offsets part of the gain, the tax shrinks with it.

The relief is a deferral. Under section 1374(d)(2)(B), when line 16 exceeds taxable income, "such excess shall be treated as a recognized built-in gain in the succeeding taxable year." The IRS instructions note this carryover applies to corporations that made the S election after March 30, 1988. Because the tax itself only applies "for any taxable year beginning in the recognition period," an amount carried into a year after the window closes is no longer taxed.

The 21% rate

Section 1374(b)(1) applies "the highest rate of tax specified in section 11(b)," and section 11(b) sets the corporate tax at "21 percent of taxable income." Schedule D, line 21 reads "Enter 21% (0.21) of line 20."

Carryforwards from C corporation years

Under section 1374(b)(2), "any net operating loss carryforward arising in a taxable year for which the corporation was a C corporation shall be allowed" as a deduction against net recognized built-in gain, and similar rules apply to capital loss carryforwards. The Schedule D instructions limit a capital loss carryforward to the net capital gain included in recognized built-in gain for the year, and Regulations section 1.1374-5 allows these carryforwards only to the extent the rules for C corporations would allow them. The amount absorbed is treated as taxable income for the purpose of figuring what remains to carry. For a refresher on how corporate carryforwards are tracked, see the guide to NOL carryforward rules for businesses.

Credits work differently. Section 1374(b)(3) allows section 39 business credit carryforwards from C years against the tax, and line 22 of Schedule D also covers minimum tax credit carryforwards from C years, both subject to the limits in Regulations section 1.1374-6(b). The instructions add a caution that "the AMT refundable credit provisions do not apply to S corporations."

Worked Example: Two Years Inside the Window

Assume Harbor Supply Inc., a calendar-year C corporation, elected S status effective January 1, 2023. On that date its assets had a fair market value of $2,400,000 and an aggregate adjusted basis of $1,500,000, so NUBIG is $900,000. It also carries a $60,000 NOL from its C years. The 80% of taxable income limit in section 172(a) for NOLs arising after 2017 does not change the result here: even if it applies to this deduction, 80% of 2025 taxable income is $240,000, which is more than the $60,000 NOL. The recognition period runs from January 1, 2023 through December 31, 2027.

2025. Harbor sells investment land for $1,250,000. The land had a $600,000 basis and a $1,100,000 value on January 1, 2023. Total gain is $650,000, of which $500,000 is built-in gain and $150,000 accrued after conversion. Harbor also sells securities held at conversion for a $40,000 recognized built-in loss. The business itself runs a $310,000 operating loss, so taxable income computed as a C corporation is $650,000 minus $40,000 minus $310,000, or $300,000.

In 2025, taxable income of $300,000 is the smallest figure, so line 18 is $300,000 and the $160,000 excess carries to 2026. After the $60,000 NOL, the tax is 21% of $240,000.

2026. Harbor sells another parcel held at conversion with $100,000 of built-in gain, and its taxable income computed as a C corporation is $500,000. Line 16 is the $160,000 carryover plus $100,000. The remaining cap is $900,000 minus $300,000, or $600,000, so line 18 is $260,000. The cap left for 2027 is $340,000.

Across both years Harbor pays $105,000 of built-in gains tax.

How the Tax Flows Through to Shareholders

The built-in gains tax does not replace the shareholder-level tax. The gain still passes through on Schedule K-1, and the tax paid reduces it. The Schedule D instructions state that "the built-in gains tax is treated as a loss sustained by the corporation during the same tax year," with its character matching the gains that produced it. Tax attributable to long-term capital gain goes on Schedule D, line 14, and tax attributable to ordinary income is deducted on Form 1120-S, line 12.

In the example, all of the 2025 built-in gain is long-term capital gain, so the $50,400 is a long-term capital loss. Shareholders report net long-term capital gain of $650,000 minus $40,000 minus $50,400, or $559,600, before any other items. Each shareholder's stock basis rises by their share of that net gain, which is tracked on Form 7203 for S corporation stock and debt basis.

Planning Points During the Recognition Period

• Get a conversion-date appraisal. The corporation must prove which part of a gain is post-conversion appreciation and which assets had built-in losses. Without a valuation, the IRS can treat the whole gain as built-in up to the remaining cap.
• Time sales against the calendar. Holding an appreciated asset until the first day after the window closes removes the tax entirely. Pairing a built-in gain sale with a year of operating losses can push part of it into a carryover, which helps most when the carryover lands after the window.
• Harvest built-in losses in the same year. Selling assets that were worth less than basis on conversion day reduces line 16 dollar for dollar.
• Keep C-year carryforwards on file. NOL, capital loss and credit carryforwards that are otherwise unusable in S years can offset this tax.
• Watch owner pay and distributions. Setting reasonable compensation for S corp owners and timing distributions both change the cash left after a taxed sale.

For a new venture, the sole proprietorship vs. S corp guide is the better starting point, since a company formed as an S corporation never owes this tax. Former C corporations may also carry accumulated earnings and profits from their C years, which raises separate questions covered in the guide to the accumulated earnings tax on C corporations.

Frequently Asked Questions

How long does the S corporation built-in gains tax apply after conversion? Five years, starting on the first day of the first S corporation tax year. For assets received in a carryover-basis acquisition from a C corporation, the five years start on the acquisition date.

What tax rate applies to built-in gains? The highest rate under section 11(b), which is 21% as of October 2026.

Can the S corporation built-in gains tax exceed the company's taxable income? No. Net recognized built-in gain is limited to taxable income figured as if the company were a C corporation. Any excess carries to the next year and can be taxed then if that year is still inside the recognition period.

Where is the built-in gains tax reported? It is figured in Part III of Schedule D (Form 1120-S) and carried to Form 1120-S, page 1, line 23b. Schedule B, item 8 shows the remaining net unrealized built-in gain.

Does a company that was always an S corporation owe the tax? Generally no. The exception is an always-S corporation that acquires assets from a C corporation with a carryover basis, for example in a tax-free merger. Those assets carry their own five-year recognition period.

Next Step

Madras Accountancy supports US CPA firms and their clients with S corporation tax preparation and planning, including tracking net unrealized built-in gain, preparing Form 1120-S and its schedules, and modeling the timing of asset sales after a C-to-S conversion. To discuss a conversion or an upcoming sale, contact our team.