Built-in Gains tax is a BIG bad wolf. Every business owner should strive to avoid the built-in gains (BIG) tax like you would avoid the BIG bad wolf. It’s not always possible to avoid it, but by planning ahead you can definitely minimize it. So what is the BIG tax anyway? It is a tax that applies to companies that were previously a C Corporation and have made an S Corporation election.
Since BIG only applies to S Corps that were previously C Corps, that knocks out quite a few companies right off the top. The second qualifier is the BIG only applies to the 5 years after the S election. So any companies that made the election more than 5 years ago are off the hook; they have outlasted the BIG. Any companies that have made those S elections in the past 5 years probably have an issue, whether they realize it or not.
The BIG tax is calculated when the S Corp sells an asset that had a built-in gain at the time of the S election. Basically when a company makes an S election, you need to determine the FMV of all the assets. For the next 5 years you need to keep track of those assets and when any of them are sold the BIG tax will apply. For cash basis taxpayers, the accounts receivable would all be subject to BIG. That is the single biggest and most common item subject to BIG, but it can apply to other types of assets too.
Ideally you would just not sell any of the assets that have a BIG. Realistically that’s not always feasible, so there are a few ways to minimize the tax. An NOL carryforward from the C Corp years can offset the BIG. Also any built-in loss assets that are sold will offset the built-in gains. Spending enough time and detail when you are doing the FMV appraisal is important to minimize the BIG from the outset.
The BIG tax applies to the sale of an asset and the S Corp pays the tax at the highest corporate rate. The tax paid is passed through to the shareholder as a loss, but the tax can’t be used as a deduction for calculating the BIG in the first place. Paying the tax plus passing through the income to the shareholder makes the BIG something you should definitely avoid.