Are you considering converting your C corporation into an S corporation? It’s a common strategy for small business owners who want to avoid double taxation. However, before you make the switch, there’s a critical tax concept you need to understand: the Built-In Gains (BIG) tax.
In short, the BIG tax is a tax on gains from assets that your C corporation held before making the S corporation election. These gains can surprise you, so it’s important to plan ahead to minimize the potential impact.
Let’s break it down so you can navigate the conversion smoothly.
What Is the BIG Tax?
When a C corporation converts to an S corporation, the IRS treats certain assets, those held by the C corporation at the time of conversion as “built-in gains”. These assets may be subject to the BIG tax when the S corporation recognizes gains from selling them.
The kicker? You’ll likely have to change your accounting method to accrual when you convert to an S corp, even if your C corporation was on the cash basis method. This change can trigger unexpected tax consequences, particularly if you have receivables on the books at the time of conversion.
Example:
Let’s say your C corporation operates on the cash method and has receivables (money owed to the business) at the time of conversion. Once you convert to an S corporation and start collecting those receivables, you may face the BIG tax, this is where things can get tricky.
The BIG Tax Breakdown: What You Need to Know
The BIG tax is a two-part tax burden:
The Corporate-Level Tax:
- The first part of the tax is a 21 percent tax on the gains recognized by the S corporation from assets that were held when it was a C corporation.
The Individual-Level Tax:
- The remaining profits (after the corporate-level tax) pass through to you as the business owner, where they are subject to individual income tax rates, which can be as high as 40.8 percent.
So, you could be facing up to 61.8 percent in taxes on those built-in gains (21 percent corporate tax + up to 40.8 percent individual tax). Ouch!
It’s clear that the BIG tax can significantly impact your tax bill if not properly planned for.
How to Avoid or Minimize the BIG Tax: 5 Strategic Approaches
Don’t panic! There are several strategies you can employ to navigate or even avoid the BIG tax.
Here are five approaches that may help:
Avoid Selling During the BIG Tax Penalty Period
The IRS imposes a five-year BIG tax penalty period on assets that were held by the C corporation at the time of conversion. During this period, any gains recognized on these assets are subject to the BIG tax.
Tip: One of the best ways to avoid paying the BIG tax is to hold onto the assets for at least five years before selling them. This gives you time to allow any built-in gains to “expire” without triggering the tax.
Identify Personal Goodwill and Protect It
Personal goodwill isn’t considered a corporate asset, and it’s not subject to the BIG tax. If you can prove that certain goodwill belongs to you personally (as the business owner) rather than the corporation, it may be excluded from the BIG tax.
Tip: Have a professional appraiser assess your goodwill to determine its personal nature. Then, make sure to document this thoroughly for the IRS.
Reduce Building Appreciation with an Accurate Appraisal
If your C corporation holds real estate or other depreciable property, you may be able to reduce the built-in gain on those properties by having an accurate appraisal done at the time of conversion. This can help you minimize the gains and, in turn, reduce the BIG tax liability.
Tip: Work with a qualified appraiser to get an accurate valuation of the property and reduce its appreciated value. Proper documentation is key here.
Pay Yourself a Bonus
You can reduce built-in gains by paying yourself a bonus within the first few months after converting to an S corporation. A bonus is a deductible business expense, which could help lower the overall taxable income for the corporation.
Tip: Be sure to structure the bonus properly, following all payroll tax rules. Consult your accountant or tax professional to ensure everything is accounted for correctly.
Create a Liability for Unpaid Compensation
If your C corporation has unpaid compensation (like accrued wages or bonuses) from previous years, you can establish this as a liability. Then, have the S corporation pay it within two and a half months after the conversion. This creates a built-in loss that can offset other built-in gains, reducing your exposure to the BIG tax.
Tip: This is a strategy that requires careful documentation. Make sure the unpaid compensation is clearly recorded and structured properly to avoid any IRS red flags.
Converting your C corporation to an S corporation can provide significant tax benefits, but it’s important to carefully plan for the potential impact of the BIG tax. By understanding how the BIG tax works and using the strategies outlined above, you can minimize your tax exposure and make the transition to an S corporation as smooth as possible.
Let’s Talk About Your Conversion Plans
If you’re considering converting your C corporation to an S corporation and want to discuss strategies to minimize the BIG tax, I’m here to help. Call us at 480 355-1398, and let’s make sure you’re prepared for a smooth transition with minimal tax impact.