How to Convert a C Corp to an S Corp: Built-In Gains, E&P, and LIFO

Converting a C corporation to an S corporation ends the corporate-level income tax on future earnings, but the tax implications of the conversion itself are more complicated than the switch to pass-through treatment suggests. For five years after the election takes effect, appreciated assets sold out of the company trigger a corporate-level built-in gains tax. Old C corporation earnings and profits follow the company into S status and can both tax your distributions and terminate your election. LIFO inventory gets recaptured. Most C corporation losses lose their value. And shareholders who were counting on the Section 1202 small business stock exclusion give it up permanently the day the S election takes effect.

Here is what each of those costs looks like in practice, and where the planning levers are.

Built-In Gains Tax on Appreciated Assets

The built-in gains (BIG) tax is the single biggest conversion-specific tax cost, and it exists for a reason: Congress didn’t want C corporations to stockpile appreciated assets, convert to S status, and then sell those assets paying only shareholder-level tax. So any gain attributable to appreciation that occurred while the company was a C corporation gets taxed at the corporate level when the asset is sold after conversion, on top of the pass-through tax at the shareholder level.¹

The tax runs during a five-year recognition period that begins on the first day the S election is effective. Sales of built-in gain assets during that window are hit at the highest corporate rate, currently 21%. Sales after the five years close escape the BIG tax entirely.

Your total exposure is capped at the corporation’s net unrealized built-in gain on the conversion date — the amount by which the aggregate fair market value of the assets exceeded their aggregate adjusted basis on the day the S election became effective. Once cumulative recognized built-in gains hit that ceiling, no more BIG tax applies even if you’re still inside the five-year window.¹

Two offsets help. Net operating loss carryforwards from C corporation years can be used against net recognized built-in gain, and business credit carryforwards from C corporation years can be applied directly against the BIG tax. These old attributes have no use against regular S corporation income, so the BIG tax is one of the few places they still have value.¹

Which Assets Create the Most Exposure

The usual culprits are appreciated real estate, internally developed goodwill that doesn’t show up on the balance sheet, and, for cash-basis C corporations, accounts receivable with zero basis but real market value. Inventory can also trigger BIG tax when its market value exceeds carrying cost. If your corporation holds any of these and you expect to sell within five years, model the BIG tax before you elect.

Get a Valuation on the Conversion Date

Your NUBIG ceiling depends on asset-by-asset fair market values on the day the election takes effect, intangibles included. If the IRS challenges a BIG tax calculation years later and you have no contemporaneous appraisal, your position is weak. A professional valuation done at the time of conversion, kept permanently with your tax records, is far stronger than a retroactive estimate.

Accumulated Earnings and Profits Follow You

C corporations build up earnings and profits (E&P) over time — a running measure of the corporation’s economic capacity to pay dividends. That E&P balance doesn’t disappear at conversion. It carries into S status and creates two durable problems.²

Distributions Follow a Layered Order

Distributions from an S corporation that carries accumulated E&P are sourced in a fixed order. They come first from the accumulated adjustments account (AAA), which tracks post-conversion S corporation earnings that already hit shareholders’ personal returns; AAA distributions are generally tax-free to the extent of stock basis. Once AAA is exhausted, further distributions are treated as dividends to the extent of remaining C corporation E&P and taxed at dividend rates. Only after E&P is depleted do distributions reduce stock basis, with amounts above basis taxed as capital gains.²

The Passive Income Trap

An S corporation that still carries C corporation E&P and earns passive investment income — royalties, rents, dividends, interest, annuities — exceeding 25% of gross receipts owes a corporate-level tax on the excess net passive income at the highest corporate rate.³ Cross that 25% line for three consecutive tax years while E&P is still on the books and the S election terminates automatically on the first day of the fourth year.⁴ After an involuntary termination, you generally can’t re-elect S status for five tax years without IRS consent.

Clearing E&P Off the Books

The clean fix is to distribute all accumulated E&P to shareholders as a taxable dividend, before or shortly after conversion. That zeros the balance and takes both the distribution-ordering issue and the passive income threat off the table for good. If the business doesn’t have the cash, it can make a deemed dividend election by attaching a statement to a timely filed return. The deemed dividend is treated as a distribution of E&P followed by a capital contribution back to the corporation: shareholders owe the dividend tax, but no cash leaves the company. Every affected shareholder has to consent.⁵

LIFO Recapture for Inventory on LIFO

If your C corporation uses last-in, first-out inventory accounting, the final C corporation tax year includes a mandatory income adjustment. You add to income the difference between the inventory’s FIFO value and its LIFO value — the LIFO recapture amount. Because LIFO usually produces a lower inventory value, this recapture typically increases taxable income.⁶

The resulting tax can be spread. The additional tax from LIFO recapture is paid in four equal annual installments: the first with the final C corporation return, the next three with the first three S corporation returns. No interest accrues while the installments are paid on schedule.⁶

Old C Corporation Losses Mostly Die at the Door

Net operating loss carryforwards from C corporation years cannot offset the S corporation’s regular pass-through income. The Code is categorical: no carryforward or carryback arising from a C corporation year may be carried to an S corporation year.⁷

The only meaningful use left is against the BIG tax. C corporation NOL and capital loss carryforwards can reduce net recognized built-in gain during the five-year recognition period.¹ If your C corporation has sizable loss carryforwards, that constrains your timing. The losses are useful only against BIG tax inside the five-year window, and they continue to expire on their normal schedule either way.

Permanent Loss of the Section 1202 Exclusion

This is the implication business owners most often miss. Section 1202 lets shareholders selling qualified small business stock (QSBS) exclude a large portion of their gain from federal tax — up to the greater of $10 million or ten times adjusted basis, with a $15 million cap for stock issued after July 4, 2025. For stock held more than five years, the exclusion can reach 100% of the gain.⁸

Only C corporation stock qualifies. The statute requires the issuing corporation to be a C corporation when the stock is issued and during substantially all of the shareholder’s holding period.⁸ Electing S status breaks that condition. For a shareholder sitting on several million dollars of potential QSBS gain, the annual payroll and double-tax savings from S status may not come close to replacing a permanently forfeited Section 1202 exclusion. Run both scenarios in dollars before you file.

Fringe Benefits for Shareholders Who Own More Than 2%

C corporation shareholder-employees can receive many fringe benefits tax-free: employer-paid health insurance, group-term life insurance, commuter benefits, and others. After converting, shareholders who own more than 2% of the stock lose most of those exclusions because the IRS treats them like partners in a partnership for fringe benefit purposes.⁹

Health insurance is the biggest change. The S corporation can still pay premiums for a more-than-2% shareholder-employee, but those premiums must be reported as wages on the shareholder’s W-2. They go in Box 1 (income tax wages) but not in Boxes 3 and 5, so no FICA applies. The shareholder then takes an above-the-line deduction for the premiums on the personal return, which largely offsets the income inclusion, provided the coverage was established by the S corporation and the shareholder wasn’t eligible for a subsidized plan through a spouse’s employer.¹⁰

Other benefits that become taxable to 2%-plus shareholders include group-term life insurance (full cost, not just coverage above $50,000), employer HSA contributions, qualified transportation benefits, meals and lodging furnished for the employer’s convenience, and adoption assistance. De minimis perks and working condition benefits generally remain excludable.⁹

Reasonable Compensation and the Payroll Tax Risk

One of the main reasons owners convert is to split income between salary (subject to payroll taxes) and distributions (not). The IRS knows the incentive and requires that S corporation officers who perform services receive reasonable compensation before taking distributions.¹¹

There is no safe harbor and no formula. Reasonable depends on what similar businesses pay for similar work in your area and industry. The audit profile the IRS targets is the active shareholder-officer taking large distributions while reporting an unusually low salary or none at all. Courts have held that the label on the payment doesn’t control: cash distributions to a shareholder who actively works in the business are wages regardless of what the corporation calls them.¹¹

If the IRS reclassifies distributions as wages, the company owes back employment taxes (the employer’s 7.65% share of FICA plus the employee share that should have been withheld), accuracy-related penalties, and interest from the original due date. A defensible compensation policy, documented from the first S corporation year, is cheap insurance.

State Tax Implications

The federal election governs only federal income tax. Most states recognize it automatically, but the details vary. Some states require a separate state-level S election in addition to Form 2553. Skip it where it’s required and you end up an S corporation federally and a C corporation for state purposes — a mismatch that produces double reporting and surprise state tax bills.

Even states that honor the federal election sometimes impose their own entity-level taxes on S corporations, from flat minimum franchise taxes to taxes measured by net income or gross receipts. Federal pass-through treatment does not automatically mean zero state corporate-level tax. Confirm what your state requires before you convert.

What the Election Itself Looks Like

Converting is procedurally simple: a qualifying corporation files IRS Form 2553, signed and consented to by every shareholder on the day the election is made.¹²⁴ Timing is strict: to take effect for the current tax year, Form 2553 must be filed during the preceding tax year or no later than two months and 15 days into the current tax year — March 15 for a calendar-year corporation.¹³

The eligibility rules sit alongside the tax consequences and are easy to trip on later: the corporation must stay domestic, keep to 100 or fewer shareholders (spouses and family counted as one), hold only eligible shareholders (U.S. citizens or residents, estates, certain trusts — no partnerships, other corporations, or nonresident aliens), maintain a single economic class of stock, and avoid the ineligible categories (reserve-method banks, Subchapter L insurance companies, DISCs).¹⁴ A single violation after the election — a stock transfer to an ineligible owner, or a debt instrument the IRS treats as a second class of stock — terminates S status immediately and locks you out of re-electing for five years without IRS consent.

The decision to convert, in other words, isn’t really about the form. It’s about whether the recurring pass-through savings outweigh the BIG tax exposure, the E&P aftermath, LIFO recapture, lost loss carryforwards, forfeited QSBS treatment, and the fringe benefit and compensation changes that come with the new status. Run those numbers before March 15.

1
Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains
2
Office of the Law Revision Counsel. 26 USC 1368 – Distributions
3
Office of the Law Revision Counsel. 26 USC 1375 – Tax Imposed When Passive Investment Income of Corporation Having Accumulated Earnings and Profits Exceeds 25 Percent of Gross Receipts
4
Office of the Law Revision Counsel. 26 USC 1362 – Election, Revocation, Termination
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Internal Revenue Service. Distributions With Accumulated Earnings and Profits
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Office of the Law Revision Counsel. 26 USC 1363 – Effect of Election on Corporation
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Office of the Law Revision Counsel. 26 USC 1371 – Coordination With Subchapter C
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Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock
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Internal Revenue Service. Employers Tax Guide to Fringe Benefits
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Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
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Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers
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Internal Revenue Service. About Form 2553, Election by a Small Business Corporation
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Internal Revenue Service. Instructions for Form 2553
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Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined