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What is the built-in gains tax under section 1374?

A corporate-level tax on an S corporation's net recognized built-in gain in any year beginning in the 5-year recognition period, at the highest section 11(b) rate — 21 percent. It applies to a corporation that was a C corporation before electing S status, or that acquired assets on a transferred basis from one.

How long is the recognition period?

Five years, beginning on the first day of the first taxable year for which the corporation was an S corporation. For an election effective January 1, 2026, that is January 1, 2026 through December 31, 2030 — and a sale on January 2, 2031 escapes section 1374 entirely.

What is net unrealized built-in gain?

The amount by which the fair market value of the corporation's assets at the start of its first S year exceeds their aggregate adjusted basis. In the worked example, $2,400,000 over $1,500,000 of basis gives a $900,000 NUBIG.

Where does the built-in gains tax go on the return?

Schedule D (Form 1120-S), Part III, lines 16–23. Line 23 is the tax, flowing to Form 1120-S, page 1, line 23b. The section 1375 excess net passive income tax goes on line 23a.

Can a C-year net operating loss reduce the built-in gains tax?

Yes. Section 1374(b)(2) allows a net operating loss carryforward — and a capital loss carryforward — from a C corporation year as a deduction against net recognized built-in gain. In the worked example, a $50,000 C-year NOL cuts the base from $300,000 to $250,000.

Does section 1374 apply to a corporation that was always an S corporation?

No. Section 1374(c)(1) provides that the tax does not apply if a section 1362(a) election has been in effect for each of the corporation's taxable years. The exposure starts only with a C corporation past or a transferred-basis acquisition.

Taxes • 11 min read

Section 1374 Built-In Gains Tax: The 5-Year Clock, the NUBIG Cap, and Schedule D Part III

A C corporation that elects S status does not erase the appreciation it built up as a C corporation. For five years, gains on assets it held at conversion are taxed at the corporation level at 21 percent — here is the recognition period, the net unrealized built-in gain cap, and the Schedule D math, worked from the statute.

By Enow A. Jovial • Published 2026-11-11

Section 1374 Built-In Gains Tax: The 5-Year Clock, the NUBIG Cap, and Schedule D Part III

Meridian Fabrication Inc. was a C corporation for twelve years. On January 1, 2026, it elects S status; in March it sells a warehouse held since its C years for $950,000. The $450,000 gain produces $52,500 of corporate-level tax, even though Meridian is now an S corporation. That is section 1374.

Section 1374 taxes an S corporation at 21 percent on net recognized built-in gain in the 5-year recognition period, with a lifetime ceiling — net recognized built-in gain can never exceed NUBIG — computed on Schedule D (Form 1120-S), Part III, flowing to line 23b.

This guide works from the 2025 forms and instructions. Meridian Fabrication is an illustrative construction to make the form lines reproducible, not a real corporation's return; every statutory number is quoted from the Code or the IRS instructions below.

Who pays it — section 1374(a) and (c)

Section 1374(a) imposes the tax when an S corporation "has a net recognized built-in gain" in "any taxable year beginning in the recognition period." Two kinds of corporations are exposed: one that was a C corporation before electing S status, and, under section 1374(d)(8), one that acquires an asset on a transferred basis from a C corporation, with a fresh recognition period.

One class never pays it. Section 1374(c)(1) provides that subsection (a) "shall not apply to any corporation if an election under section 1362(a) has been in effect with respect to such corporation for each of its taxable years." A company formed as an S corporation from day one has no section 1374 exposure.

Section 1374(a) through (c) text on Cornell LII: general rule, 21 percent rate, always-S exemption, NUBIG cap

The recognition period — section 1374(d)(7)

The recognition period is "the 5-year period beginning with the 1st day of the 1st taxable year for which the corporation was an S corporation." For Meridian, effective January 1, 2026, the period runs January 1, 2026 through December 31, 2030. A disposition on January 2, 2031 escapes section 1374 entirely.

The consequence is a timing trade-off: holding an appreciated C-year asset one more year can be worth 21 percent of its built-in gain. Installment sales do not stretch the clock: under section 1374(d)(7)(B), payments are governed by the rules for the year of sale.

Net unrealized built-in gain — section 1374(d)(1)

The ceiling on everything is net unrealized built-in gain. Section 1374(d)(1) defines it as the amount by which "the fair market value of the assets of the S corporation as of the beginning of its 1st taxable year for which an election under section 1362(a) is in effect, exceeds the aggregate adjusted bases of such assets at such time." Meridian's assets were worth $2,400,000 at conversion against $1,500,000 of basis:

\text{NUBIG} = \$2{,}400{,}000 - \$1{,}500{,}000 = \$900{,}000

That $900,000 is the lifetime cap: section 1374(c)(2) limits the net recognized built-in gain in any year to NUBIG less prior years' net recognized built-in gain.

The cap is measured asset by asset. Under section 1374(d)(3), a recognized built-in gain is a gain on a disposition during the recognition period, except to the extent the corporation establishes that the asset was not held at the start of the first S year, or that the gain exceeds the asset's conversion-date fair market value over its basis. Meridian's warehouse was worth $800,000 at conversion against a $500,000 basis and sold for $950,000: the $450,000 gain contains only $300,000 of built-in gain, because the $150,000 above conversion value is post-conversion appreciation. Section 1374(d)(5) adds built-in items that are not dispositions: income or deductions from pre-S periods but taken into account during the recognition period count as recognized built-in gains and losses.

The computation — Schedule D, Part III

Section 1374(b)(1) sets the rate: the tax is computed "by applying the highest rate of tax specified in section 11(b)" — flat 21 percent — to net recognized built-in gain. The mechanics are Schedule D (Form 1120-S), Part III, lines 16–23.

Schedule D (Form 1120-S) 2025, page 2, Part III Built-in Gains Tax, lines 16 through 23

Line	What it carries	Authority
16	Excess of RBG over RBL	§ 1374(d)(2)(A)(i)
17	Form 1120-method taxable income	§ 1374(d)(2)(A)(ii)
18	NRBG — smallest of lines 16, 17, Schedule B line 8	§ 1374(d)(2), (c)(2)
19	§ 1374(b)(2) deduction — C-year NOL/capital loss carryforwards	§ 1374(b)(2)
20	Line 18 minus line 19	Schedule D
21	21 percent of line 20	§ 1374(b)(1); § 11(b)
22	§ 1374(b)(3) credit — C-year business credits	§ 1374(b)(3)(B)
23	Tax — line 21 minus line 22, to line 23b	Schedule D

Worked example — Meridian's year 1 (2026): the warehouse produces a $300,000 recognized built-in gain, the equipment a $20,000 gain, the land a $20,000 recognized built-in loss. Line 16 is the excess of gains over losses:

\text{Line 16} = \$300{,}000 + \$20{,}000 - \$20{,}000 = \$300{,}000

Taxable income on the Form 1120 method is $360,000, and Schedule B line 8 — NUBIG less prior years' gain — is $900,000, there being no prior years. Line 18 is the smallest of the three:

\text{Line 18 (NRBG)} = \min(\$300{,}000,\ \$360{,}000,\ \$900{,}000) = \$300{,}000

Meridian carries a $50,000 net operating loss from a C corporation year. Section 1374(b)(2) allows it against net recognized built-in gain, so line 19 is $50,000 and line 20 is $250,000:

\text{Tax} = 21\% \times \$250{,}000 = \$52{,}500

Line 22 is $0, so line 23 — the built-in gains tax — is $52,500, on Form 1120-S, page 1, line 23b. The tax estimator runs the 21 percent rate on your own numbers before you commit to a sale price.

In year 2 (2027), Meridian sells its remaining appreciated C-year assets: line 16 is $700,000, taxable income $800,000, Schedule B line 8 now $600,000 — the $900,000 NUBIG minus year 1's $300,000. Line 18 is $600,000; the tax is $126,000. The $100,000 above the cap is never taxed — the section 1374(c)(2) cap has no carryover, unlike section 1374(d)(2)(B), which applies only when taxable income binds.

The NUBIG cap is a lifetime ceiling, not a yearly allowance — and it is measured once, at conversion. A corporation that never appraises its assets at the start of its first S year cannot prove its NUBIG. Get the valuation done before the election.

Run the Schedule D math before the sale closes, so shareholders can plan distributions around the deemed loss.

What the tax does to the shareholders

The built-in gains tax is not a dead cost on top of shareholder tax — it is treated as a loss sustained by the corporation in the same tax year. The Instructions for Schedule D allocate the deemed loss proportionately: the short-term portion as a short-term capital loss (Schedule D, line 6), the long-term portion as a long-term capital loss (line 14), and the ordinary portion as a deduction for taxes (Form 1120-S, line 12).

Two reliefs sit inside the computation. Section 1374(b)(2) lets C-year net operating loss and capital loss carryforwards absorb net recognized built-in gain — Meridian's $50,000 NOL saved $10,500 at 21 percent. Section 1374(b)(3)(B) lets C-year section 39 business credit carryforwards offset the tax. What is not allowed is any other credit: section 1374(b)(3)(A) bars every part IV credit except section 34.

Section 1375 — the passive-income tax on the same corporations

Section 1374 is not the only corporate-level tax that follows a C corporation into S status. Section 1375 imposes a second one when the corporation still holds C-year accumulated earnings and profits and passive investment income exceeds 25 percent of gross receipts.

Section 1375(a) and (b) text on Cornell LII: general rule, excess net passive income ratio, net passive income

Section 1375(a) applies when the S corporation has "(1) accumulated earnings and profits at the close of such taxable year, and (2) gross receipts more than 25 percent of which are passive investment income." The tax is excess net passive income times the highest section 11(b) rate — 21 percent. Passive investment income is defined in section 1362(d)(3) as "gross receipts derived from royalties, rents, dividends, interest, and annuities."

Meridian's 2026 passive income: receipts $1,000,000, passive investment income $400,000, connected deductions $50,000, net passive income $350,000:

\text{ENPI} = \$350{,}000 \times \frac{\$400{,}000 - \$250{,}000}{\$400{,}000} = \$350{,}000 \times 37.5\% = \$131{,}250

The tax is 21 percent of that, $27,562.50, on Form 1120-S, page 1, line 23a. Combined with the $52,500 built-in gains tax, Meridian's 2026 entity-level tax is $80,062.50 — and under section 1366(f)(3) the section 1375 tax reduces each item of passive investment income passed through to shareholders.

The coordination rule is the point most preparers miss. Section 1375(b)(4) provides that passive investment income "shall be determined by not taking into account any recognized built-in gain or loss of the S corporation for any taxable year in the recognition period." Meridian's $300,000 warehouse gain is therefore excluded — the two taxes never double-count the same dollar.

Section 1375 carries the sharper long-term threat. Under section 1362(d)(3), an S election terminates after 3 consecutive years with accumulated earnings and profits at each year-end and gross receipts over 25 percent passive in each year. Three years of heavy passive income does not just cost 21 percent a year — it ends S status. Section 1375(d) offers one escape hatch: a waiver for a good-faith belief of no AE&P plus prompt distribution.

When and where to file

File Schedule D with Form 1120-S: the built-in gains tax from Part III, line 23 goes on Form 1120-S, page 1, line 23b; the excess net passive income tax goes on line 23a. Form 1120-S is due by the 15th day of the 3rd month after year-end — March 15 for a calendar-year corporation, falling on March 16, 2026 because March 15 is a Sunday. The return must also answer Schedule B, item 8 with NUBIG less prior years' NRBG — the number that caps line 18.

The filing is made under the corporation's EIN; the Form 1120 computation feeding line 17 is attached to Schedule D, usually built by a CPA. S-Corp and C-Corp treatment diverge: the same income is measured once as a C corporation for the cap, and again as an S corporation for the pass-through. An LLC taxed as an S corporation follows the same rules, and shareholders report pass-through shares under their SSN or ITIN. FICA and SECA never apply: this is an entity-level income tax, not payroll tax. Our S corporation election playbook covers the election; the entity classification playbook covers the classification.

Founder & CEO Insight — Enow A. Jovial

"The S election is the best tax decision most operating companies ever make — and the built-in gains tax is the bill for the appreciation they brought with them. Get the valuation done before the election and sell the appreciated assets on a calendar you control."

— Enow A. Jovial, Founder & Chief Executive Officer

Execution checklist

Step 1: Confirm exposure — a C corporation past or a transferred-basis acquisition; always-S corporations skip it.
Step 2: Value every asset at the start of the first S year and compute NUBIG.
Step 3: Record each C-year asset's conversion-date FMV and basis, so the per-asset cap is provable.
Step 4: Calendar the five-year recognition period and flag any planned sale inside it.
Step 5: Track built-in items under section 1374(d)(5) — pre-conversion receivables and expenses.
Step 6: Complete Schedule D, Part III, lines 16–23, applying C-year NOL and capital loss carryforwards.
Step 7: Enter the line 23 tax on Form 1120-S, line 23b, and answer Schedule B, item 8 with NUBIG less prior NRBG.
Step 8: Test section 1375 separately — AE&P at year-end and passive income over 25 percent of receipts — and run the break-even calculator on holding or selling.
Step 9: Pay estimated tax if the three entity-level taxes together reach $500, and distribute old C earnings before three passive years end the election.