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

Converting a C corporation to an S corporation ends corporate-level income tax on future earnings and shifts profits and losses to shareholders’ personal returns, but the tax implications of converting a C corp to an S corp are not limited to that forward-looking benefit. The conversion triggers a built-in gains tax on appreciated assets for five years, forces a LIFO recapture pickup in the final C year, drags accumulated earnings and profits into the S corporation with distribution and passive-income consequences, strips C corporation loss carryforwards of most of their value, permanently forfeits any Section 1202 qualified small business stock exclusion, and changes how shareholder compensation and fringe benefits are taxed. Each of these deserves its own look before you file Form 2553.

Built-In Gains Tax on Appreciated Assets

The largest tax trap in a C-to-S conversion is the built-in gains (BIG) tax. Congress didn’t want corporations to accumulate appreciated assets as C corps, convert, and then sell those assets while only paying shareholder-level tax. So any gain attributable to appreciation that occurred while the corporation was a C corp gets taxed at the corporate level when the asset is sold, on top of the shareholder-level tax on the pass-through income.¹

The BIG tax applies during a five-year recognition period that starts on the first day the S election takes effect. Sell a built-in gain asset during those five years and the gain is taxed at the highest corporate rate, currently 21%. After the five-year window closes, assets can be sold without triggering this corporate-level tax.

Total BIG exposure is capped at the corporation’s net unrealized built-in gain (NUBIG) as of the conversion date, meaning the amount by which the fair market value of all assets exceeded their total adjusted basis on the day the S election became effective. Once cumulative recognized built-in gains reach that ceiling, no further BIG tax applies, even inside the five-year window.¹

Two things reduce the BIG bill. Net operating loss carryforwards from C corporation years can be deducted against net recognized built-in gain, even though those carryforwards can’t offset regular S corporation income. Business credit carryforwards from C years can be applied directly against the BIG tax.¹

The assets that most often drive BIG exposure are appreciated real estate, internally developed goodwill, and, for cash-basis corporations, accounts receivable with a zero book basis but real market value. Inventory can also produce BIG tax if its market value exceeds carrying cost.

Calculating the NUBIG ceiling requires knowing the fair market value of every asset on the conversion date, including intangibles like goodwill that may not appear on the balance sheet. A contemporaneous, asset-by-asset appraisal done before the election takes effect is worth much more than a retroactive estimate if the IRS later challenges a BIG calculation. Keep it permanently with your tax records.

LIFO Recapture in the Final C Corporation Year

If your C corporation uses the last-in, first-out (LIFO) inventory method, you face a mandatory income adjustment in the final C corporation tax year. You must include in income the difference between the inventory’s value under FIFO and its value under LIFO, called the LIFO recapture amount. Because LIFO typically produces a lower inventory value, this recapture usually increases taxable income.²

You don’t have to pay the entire tax at once. The additional tax from LIFO recapture is spread over four equal annual installments. The first installment is due with the final C corporation return, and the remaining three are due with the next three S corporation returns.² No interest accrues on the unpaid installments if you pay them on schedule.

Accumulated Earnings and Profits Carry Over

C corporations accumulate earnings and profits (E&P) over time, a running measure of the corporation’s economic capacity to pay dividends. When you convert to S status, that accumulated E&P carries over and creates two ongoing tax problems.³

Distributions Follow a Layered Ordering Rule

Distributions from an S corporation with accumulated E&P are treated as coming first from the accumulated adjustments account (AAA), which tracks post-conversion S corporation earnings that have already been taxed on the shareholders’ returns. Distributions from AAA are generally tax-free to the extent of the shareholder’s stock basis. Once AAA is exhausted, any additional distribution is a dividend to the extent of remaining accumulated E&P, taxed at dividend rates. Amounts beyond that reduce stock basis, and anything above basis is a capital gain.³

The Passive Investment Income Tax and Termination Risk

An S corporation with accumulated E&P that earns passive investment income (royalties, rents, dividends, interest, annuities) above 25% of gross receipts faces a corporate-level tax on the excess net passive income at the highest corporate rate.⁴ Worse, if the corporation crosses the 25% threshold for three consecutive years while still carrying E&P, the S election terminates automatically on the first day of the fourth year. After an involuntary termination, the corporation generally cannot re-elect S status for five tax years without IRS consent.⁵

Clearing E&P at Conversion

The cleanest solution is to distribute all accumulated E&P to shareholders as a taxable dividend, either before or shortly after the conversion. That zeroes out the E&P balance and removes both the distribution-ordering complication and the passive income threat permanently. If the corporation lacks cash to make an actual distribution, 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 matching capital contribution back to the corporation. Shareholders owe tax on the dividend, but no cash actually leaves the business.⁶ Every affected shareholder must consent.

C Corporation Losses Lose Most of Their Value

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

The one exception is the BIG tax. C corporation NOL carryforwards can reduce net recognized built-in gain, which directly lowers the BIG tax. Capital loss carryforwards work the same way, useless against regular S corporation income but applicable against built-in gains.¹ If your C corporation has significant accumulated losses, factor this into your conversion timing. Those losses are only useful against BIG tax during the five-year recognition period, and they expire on their normal carryforward schedule regardless.

You Give Up the Section 1202 Exclusion

This is the conversion cost business owners most often overlook. Section 1202 allows shareholders who sell qualified small business stock to exclude a substantial portion of their gain from federal income tax, up to the greater of $10 million or ten times their adjusted basis in the stock, with a $15 million cap for stock issued after July 4, 2025.⁸ The exclusion can reach 100% of the gain on stock held more than five years.

The catch: only C corporation stock qualifies. The statute requires the issuing corporation to be a C corporation both when the stock is issued and during substantially all of the shareholder’s holding period.⁸ Converting to S status breaks that requirement. For a shareholder sitting on several million dollars of potential QSBS gain, the annual pass-through savings from S status can be dwarfed by the tax they will pay on a sale they could otherwise have excluded. Model both scenarios before you file.

Reasonable Compensation for Shareholder-Employees

One reason owners convert to S status is to split income between salary, which carries payroll tax, and distributions, which don’t. The IRS knows the incentive and requires S corporation officers who perform services to receive reasonable compensation before taking distributions.⁹

There is no safe harbor and no formula. Reasonable depends on what similar businesses pay for similar work in your area and industry. What the IRS watches for is an officer taking large distributions while reporting an unusually low salary, or no salary at all. Courts have consistently held that the intent to minimize wages doesn’t override the substance of the payments, and that cash distributions to a shareholder who actively works in the business are wages regardless of what the corporation calls them.⁹

If the IRS reclassifies distributions as wages, the corporation owes back employment taxes (the employer’s 7.65% share of FICA plus the employee share that should have been withheld), plus accuracy-related penalties and interest running from the original due date. This is one of the most common S corporation audit issues and one of the easiest to defuse with a documented compensation policy from day one.

Fringe Benefits Change for 2% Shareholders

C corporation shareholders can receive many tax-free fringe benefits, including employer-paid health insurance, group-term life insurance, and commuter benefits. After converting to S status, shareholders who own more than 2% of the stock lose most of these exclusions. The IRS treats them more like partners in a partnership for fringe benefit purposes.¹⁰

The biggest change involves health insurance. The S corporation can still pay premiums for a 2%-plus shareholder-employee, but it must report those premiums as wages on the shareholder’s W-2. The premiums go into Box 1 (wages subject to income tax) but not into Boxes 3 and 5 (Social Security and Medicare wages), so no FICA applies. The shareholder then claims an above-the-line deduction for the premiums on the personal return, which largely offsets the income inclusion, but only if the coverage was established by the S corporation and the shareholder wasn’t eligible for a subsidized plan through a spouse’s employer.¹¹

Other benefits that become taxable to 2%-plus shareholders include group-term life insurance (the 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.¹⁰

State Tax Treatment Doesn’t Follow Automatically

The federal S election only governs federal income tax. Most states recognize it automatically, but the details vary. Some states require a separate state-level S corporation election in addition to the federal Form 2553. Skip the state filing where one is required and you can end up as an S corporation federally but a C corporation for state purposes, which produces double reporting and unexpected state tax bills.

Even in states that honor the federal election, several impose their own entity-level taxes on S corporations. These range from flat minimum franchise taxes to taxes based on net income or gross receipts. The federal pass-through benefit doesn’t automatically translate into zero corporate-level state tax. Check your state’s revenue department before converting to see what entity-level taxes apply and whether a separate election is needed.

Timing the Conversion to Manage These Costs

Most of the tax implications above are sensitive to timing. Distributing accumulated E&P before or immediately after the conversion removes both the distribution-ordering problem and the passive-income termination risk. A pre-conversion appraisal locks in NUBIG evidence. Holding appreciated assets past the five-year BIG window avoids the corporate-level tax on their sale. Using expiring C corporation NOLs against built-in gains rather than letting them lapse preserves whatever value they still have. And a shareholder sitting on qualifying Section 1202 stock should compare the exclusion they would forfeit against the pass-through savings they would gain, because that trade-off usually decides whether the conversion is worth doing at all.

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 1363 – Effect of Election on Corporation
3
Office of the Law Revision Counsel. 26 USC 1368 – Distributions
4
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
5
Office of the Law Revision Counsel. 26 USC 1362 – Election, Revocation, Termination
6
Internal Revenue Service. Distributions With Accumulated Earnings and Profits
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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
9
Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers
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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