When a C corporation becomes an S corporation, appreciation that accrued pre-conversion can still be taxed at the corporate level if realized during the five-year recognition period.
For ESOP-owned S corps, the BIG tax is entity-level — it does not flow through to shareholders — and it can meaningfully affect transaction timing, repurchase planning, and exit strategy.
In this article, we break down what triggers BIG, how it’s calculated, and how your CPA and tax team are key to the decision-making process and timeline for a C- to S-corporation conversion.
What is the Built-In Gains Tax?
Under IRC §1374, an S corporation that previously operated as a C corporation may owe corporate-level tax on net recognized built-in gain (NRBIG) realized during the five-year recognition period.
The tax applies at the highest corporate rate (Section 11(b), currently 21%). NRBIG is limited to the company’s net unrealized built-in gain (NUBIG) at conversion, reduced by amounts previously recognized.
What Commonly Triggers Built-In Gains Tax?
Here’s a breakdown of common triggers:
- Sale, exchange, or disposition of appreciated assets held at conversion (for example, selling real estate, equipment, or inventory)
- Installment payments for sales occurring before or during the recognition period (later payments may still be subject to BIG)
- Accounting method changes / §481 adjustments: if the method change relates to pre-conversion periods, the adjustment may be treated as built-in gain
- Cancellation of debt (COD) income or bad debt deductions tied to obligations held at conversion
- Pass-through items from partnerships where the S corp held an interest
| Practical takeaway: Don’t assume “S = tax-free.” If a trigger occurs inside 5 years, the company — not the shareholders — may owe BIG tax. Work with your tax advisor to identify potential triggers before S conversion. |
How is BIG Tax Calculated?
Net unrealized built-in gain, or NUBIG, is determined at the conversion date using fair market value (FMV) valuations.
- Identify net unrealized built-in gain as of conversion: fair market value minus adjusted basis, net of built-in losses. Recognized built-in loss may offset built-in gain in the same period
- Each year, compute net recognized built-in gain (NRBIG) — the lesser of (a) gain recognized that year, or (b) remaining NUBIG (after subtracting previous recognized)
- Multiply NUBIG (or NRBIg) by the corporate rate (typically 21%)
- Offset by C-year net operating losses or loss carryforwards, to the extent permitted under §1374(b)(2)
- Any remaining gain passes through to shareholders under normal S rules
Here’s a simplified example:
At conversion: asset FMV = $1,000, basis = $600 → NUBIG = $400
Year 2: company sells asset for $1,100
Recognized gain = $500, but only $400 remains in NUBIG, so NRBIg = $400
Corporate-level BIG tax = $400 × 21% = $84
Any excess gain beyond that (if sale > $1,000) would pass through to shareholders.
Note: BIG tax calculations involve complex timing and valuation considerations that should be addressed by your tax professional. Most situations require specialized expertise to properly evaluate exposure at conversion.
ESOP-Specific Considerations
BIG tax is a specialized area that requires careful coordination between your CPA and ESOP advisors. While your ESOP consultant will typically flag BIG as a consideration for C-to-S conversions, the detailed calculations and exposure modeling should be handled by your tax team.
BIG tax can still bite under S-corp structure. Even though S-ESOP income is generally tax-exempt to the ESOP shareholders, BIG is a corporate-level tax and still applies during the recognition period. Keep a running inventory of potentially “built-in” items and monitor triggers (e.g., asset sales, method changes).
1042 goals may necessitate C-status before selling. Selling shareholders pursuing Section 1042 deferral need C-corp status at the time of sale. Some companies intentionally remain (or convert back to) C to complete a 1042-eligible ESOP sale—then consider an S-election later, factoring the BIG window and overall tax efficiency. Sequence matters; this requires detailed analysis with your tax team.
Stock vs. asset sales. ESOP transactions are stock sales, which can help mitigate certain asset-level BIG exposures, but your broader plan (future asset dispositions, step-up needs, state conformity) still needs modeling.
State taxes and conformity. Ask your tax professional about state corporate taxes and conformity rules that may affect your specific situation.
Plan Your Exit Strategy With Confidence
Built-in gains rules can create serious tax friction during an ownership transition. Working with your tax advisors to model BIG tax exposure alongside your ESOP structure and transaction timing helps you keep more of what you’ve built.
The key is raising these considerations early with your CPA and ESOP advisors, so your tax strategy and transaction timeline align from the start. With proactive planning, you can design an exit strategy that minimizes exposure and maximizes after-tax value for both owners and employees.
Learn how incorporating an ESOP into your exit strategy can help you capture the full value of your company, while protecting your business legacy. Download your copy below.
