Converting a C-Corp to S-Corp: Built-In Gains Tax, Timing, and the 5-Year Recognition Period

C-Corp to S-Corp conversion essentials:

1. The election is straightforward. File Form 2553 (Election by a Small Business Corporation) with all shareholder consents. The deadline is March 15 for a calendar-year conversion effective January 1.

2. S-Corp eligibility requirements: 100 or fewer shareholders, all US citizens or residents, only one class of stock, no corporate or partnership shareholders.

3. The built-in gains tax (IRC 1374). Any asset that was appreciated at the time of conversion and is sold within 5 years of the conversion date triggers a corporate-level tax at the highest corporate rate (21%) on the built-in gain. This prevents a business from converting to S-Corp and immediately selling appreciated assets at pass-through rates.

4. AAA and E&P tracking. A former C-Corp that converts retains its accumulated earnings and profits (E&P). Distributions first come from the accumulated adjustments account (AAA, post-S-Corp earnings) tax-free (return of basis), then from E&P (taxed as dividends). The E&P layer must be tracked until it’s fully distributed or eliminated.

5. LIFO recapture (IRC 1363(d)). If the C-Corp used LIFO inventory, the excess of FIFO value over LIFO value is included in the final C-Corp return as income. Tax is paid over 4 years.

6. Passive income limitation. An S-Corp with C-Corp E&P that receives more than 25% of gross receipts as passive investment income for 3 consecutive years risks losing the S-Corp election. Rental income, interest, dividends, and royalties count. Distributing the E&P eliminates this risk.