Converting C-Corp to S-Corp: Tax Implications and Built-In Gains

By Yarik Yarosh, CPA ·September 5, 2026 ·6 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

Converting from C-Corp to S-Corp is one of the most common entity changes for growing small businesses, but it carries unique tax consequences that require careful planning. The S-Corp election itself is straightforward (file Form 2553 by March 15 of the year the election takes effect). The tax complications come from two sources: the built-in gains (BIG) tax under IRC 1374, which imposes a corporate-level tax on appreciation that existed at the time of conversion if assets are sold within 5 years, and the accumulated earnings and profits (E&P) from C-Corp years that affect distribution ordering under IRC 1368.

✓Key takeaway

C-Corp to S-Corp conversion: key tax issues

Built-in gains (BIG) tax (IRC 1374):

Applies to any C-Corp that converts to S-Corp status
Imposes a corporate-level tax (21%) on “net recognized built-in gain” if assets with built-in gain are sold within 5 years of conversion
“Built-in gain” = fair market value of assets at conversion date MINUS adjusted basis at conversion date
The BIG tax only applies to gain that existed AT the time of conversion, not appreciation after conversion
After 5 years: no BIG tax on asset sales (the “recognition period” has expired)
The BIG tax is in ADDITION to shareholder-level tax on the S-Corp income

How to calculate BIG tax:

Determine FMV of all assets on the conversion date
Determine adjusted basis of all assets on the conversion date
Net unrealized built-in gain (NUBIG) = total FMV - total adjusted basis
Each year during the 5-year recognition period, net recognized built-in gain is the lesser of:
- Gains recognized on assets that had built-in gain at conversion
- Remaining NUBIG (reduced by prior years’ recognized gains)
- S-Corp taxable income for the year
BIG tax = net recognized built-in gain x 21%

Accumulated E&P (earnings and profits):

C-Corp E&P does not disappear when converting to S-Corp
The E&P stays with the entity and affects how distributions are taxed
Distribution ordering for a former C-Corp with E&P:
1. First: Accumulated Adjustments Account (AAA), tax-free return of S-Corp earnings
2. Second: C-Corp E&P, taxed as dividends
3. Third: Return of stock basis, tax-free
4. Fourth: Capital gain
AAA starts at $0 on the conversion date (only S-Corp earnings increase it)
The E&P trap: if the S-Corp distributes more than its AAA, the excess comes from E&P and is taxed as a dividend

Passive investment income (PII) tax:

If the S-Corp has C-Corp E&P AND passive investment income exceeds 25% of gross receipts, an additional corporate-level tax applies (IRC 1375)
If this occurs for 3 consecutive years, the S-Corp election is TERMINATED
Passive investment income includes: rents, royalties, dividends, interest, annuities, gains from stocks/securities
This is rarely an issue for operating businesses but is critical for holding companies

Planning considerations:

Get a formal appraisal of all assets on the conversion date (to establish the NUBIG)
Consider distributing C-Corp E&P as a dividend BEFORE conversion (taxed at qualified dividend rates, 0/15/20%)
Avoid selling appreciated assets during the 5-year recognition period
Build up AAA through S-Corp operations to create a tax-free distribution layer

How does the BIG tax work in practice?

Hypothetical example

Round numbers. A C-Corp converts to S-Corp status on January 1, 2025. The C-Corp has been operating for 10 years.

Assets on conversion date:

Asset	FMV	Adjusted Basis	Built-In Gain
Equipment	$50,000	$10,000	$40,000
Real property	$500,000	$300,000	$200,000
Goodwill	$200,000	$0	$200,000
Inventory	$30,000	$25,000	$5,000
Cash and A/R	$100,000	$100,000	$0
Total	$880,000	$435,000	$445,000

NUBIG = $445,000

C-Corp E&P (accumulated): $150,000 AAA on conversion: $0

Year 2 (2027): equipment sold for $45,000

Adjusted basis at sale: $10,000 (assume no further depreciation was claimed as C-Corp)
Gain on sale: $35,000
Built-in gain at conversion: $40,000
Recognized built-in gain: $35,000 (lesser of actual gain and built-in gain)
BIG tax: $35,000 x 21% = $7,350 (corporate-level tax)
Shareholder-level tax: the $35,000 is also reported on the K-1 and taxed at the shareholder level (but reduced by the BIG tax paid)
Effective total tax: approximately $7,350 + ($35,000 - $7,350) x 23.8% = $7,350 + $6,573 = $13,923
If sold after Year 5 (2030): BIG tax = $0. Only shareholder-level tax applies.

Year 3: S-Corp earns $200,000 in ordinary income, distributes $100,000

AAA increases by $200,000 (S-Corp earnings)
AAA balance: $200,000
Distribution of $100,000:
1. First $100,000 from AAA: tax-free (return of S-Corp earnings)
2. AAA reduced to $100,000
3. C-Corp E&P untouched ($150,000 remains)
No dividend taxation because the distribution came from AAA, not E&P

Year 4: S-Corp distributes $250,000 (owner extracting cash)

AAA balance: $100,000 + current year income (assume $150,000) = $250,000
Distribution of $250,000:
1. First $250,000 from AAA: tax-free
2. AAA reduced to $0
3. C-Corp E&P still $150,000
Still no dividend because AAA covered the full distribution

Year 5: S-Corp distributes $200,000 but only earned $50,000

AAA: $0 + $50,000 (current income) = $50,000
Distribution of $200,000:
1. First $50,000 from AAA: tax-free
2. Next $150,000 from E&P: taxed as dividends (qualified dividend rate: 0/15/20%)
3. E&P reduced to $0
4. No remaining distribution (exactly used up)
$150,000 is taxed as a dividend. This is the E&P trap.

How to avoid the E&P trap:

Distribute E&P as a dividend BEFORE conversion (while still a C-Corp, taxed at qualified dividend rates)
Build enough AAA through S-Corp operations to cover distributions
Make the IRC 1368(e)(3) AAA bypass election: elect to treat distributions as coming from E&P first (to intentionally eliminate the E&P and clear the path for future tax-free AAA distributions)

Illustrative numbers only, not a real client and not advice for your facts.

Can I spread the gain from a business sale over multiple years?

If the buyer pays in installments, you can report the gain proportionally under IRC 453 as you receive each payment. The installment method applies automatically to any sale where at least one payment is received after the tax year of the sale. Each payment consists of three components: return of basis (tax-free), gain (taxed at capital gains rates), and interest income (taxed as ordinary income). Dealer dispositions, sales of inventory, and sales of depreciable property to a related party don’t qualify for installment treatment. If you elect out of the installment method (by reporting the full gain in the year of sale), you cannot reverse that election without IRS consent.

Related guides:

Want this checked against your own situation?

Start with a Diagnostic: a CPA licensed in the US and Canada reads your file and tells you in writing what's wrong and how to fix it, three to four business days after you finish the questions. The report is $250. If you hire us for any work after that, you get the $250 back as a discount on that work. Or send us your return or your letter and get a fixed price, free.

Start a Diagnostic →See prices

Get a fixed price, free

Get the next cross-border guide by email

One or two plain-English guides a week on US-Canada tax. No spam, unsubscribe anytime.

Cite this page

Yarik Yarosh, CPA. "Converting C-Corp to S-Corp: Tax Implications and Built-In Gains." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-tax-implications-converting-ccorp-to-scorp

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.