The Built-In Gains Tax Trap: Why S Corp and C Corp Conversions Can Surprise Even Savvy California Business Owners in 2025

Most business owners in California believe switching from a C Corp to an S Corp—or vice versa—is a simple matter of filing paperwork and updating payroll. The reality is more treacherous: failing to account for the built in tax gains s corp c corp trigger could cost you upwards of 21%–37% of your latent business value overnight. IRS assessments catch hundreds of sophisticated owners off guard every year—especially in high-stakes industries like real estate, engineering, and consulting. This article exposes the hidden mechanics behind the built-in gains tax rules, arms you with proven mitigation strategies, and shows exactly what most CPAs get wrong for W-2, 1099, and LLC owners alike.

This information is current as of 10/9/2025. Tax laws change frequently. Verify updates with the IRS or FTB if reading this later.

Quick Answer: What Is the Built-In Gains Tax Rule for S Corp and C Corp Conversions?

The built-in gains tax is a special IRS mechanism that taxes previously untaxed appreciation (think: value jumps in real estate, goodwill, or equipment) if you convert from a C Corp to an S Corp and sell assets within five years. The IRS treats these gains as if the old C Corp sold them, slapping on a corporate-level tax even though you’re now an S Corp. For C-to-S conversions made in 2025, this risk is real—and can destroy deals, cash flow, or exit values overnight (see IRS Instructions for Form 1120-S).

Understanding the Built-In Gains Tax: The Rules Every California Owner Must Know

At its core, the built-in gains tax closes a classic loophole. Before this rule, owners escaping from C Corp status could convert to S Corp, sell highly appreciated assets, and avoid the ugly double tax—corporate and then shareholder—on the latent value. Congress shut that door: for five years after conversion, if your S Corp recognizes gain on assets the C Corp owned, the IRS likely hits you with an additional tax of 21% (the corporate rate as of 2025).

• Applies if: Your business was a C Corp and became an S Corp (commonly via Form 2553)
• Timeframe: Five-year window post-conversion (the recognition period)
• Trigger: Asset sold, disposed, or depreciated during the recognition period
• Tax Rate: Equal to the highest federal corporate rate—21% for 2025 (may be higher for California, with state level as add-on)

Most CPAs miss that the built-in gains tax also hits if you lease, distribute, or scrap major assets. Even if your goal is simply to restructure, not sell, the tax can bite via hidden traps—like deemed dispositions in the eyes of the IRS.

KDA Case Study: Engineering Firm Pays $74,000 Surprise Tax

Frank leads a San Jose engineering firm with $2.3M in annual revenue. In 2024, he moved his business from C Corp to S Corp, anticipating higher after-tax income and pass-through perks. What neither Frank nor his bookkeeper caught: the firm’s main office, purchased for $1.2M and now worth $2.5M, triggered a built-in gain the day it sold that property in 2025. The IRS hit Frank’s new S Corp with a $273,000 gain—taxed immediately at 21% corporate rate. KDA’s forensic review trimmed down the exposure, but Frank still paid $74,000 in preventable tax. Our fee was $11,500, but the competitor’s “one-page conversion” approach nearly cost him hundreds of thousands. Frank’s lesson? Real asset and depreciation schedules are non-negotiable for every conversion.

Ready to see how we can help you? Explore more success stories on our case studies page to discover proven strategies that have saved our clients thousands in taxes.

How Built-In Gains Sneak Up: Real-World Examples by Taxpayer Persona

W-2 Employee Becomes Shareholder:

• Tina, a high-earning W-2 engineer, buys into a C Corp in 2022. She and her partners convert to S Corp in 2025. An unrealized gain exists on key patents ($350,000 appreciation). Sell those assets in 2027, and built-in gains tax hits—despite Tina never realizing cash herself.

1099 Contractor:

• Larry, a marketing consultant operating as a C Corp for three years, switches to an S Corp in 2025. His digital assets (email lists, IP) skyrocketed. Selling subscriptions or the entire list within five years triggers the built-in gain—IRS takes its cut before Larry sees new cash.

Real Estate Investor (Entity Flip):

• Sonia’s investment LLC taxed as C Corp spins into an S Corp. Her appreciation on a commercial property ($800K gain) must be tracked meticulously. Any sale or 1031 exchange within the period can ignite built-in gain tax, even if the gain is still “paper only.”

LLC Becomes S Corp:

• Even non-corporate entities can trip up. John’s California LLC, later taxed as C Corp, then elects S Corp status—none of his QuickBooks “asset values” reflect true market value. This disconnect can artificially inflate taxable built-in gain. IRS expects market appraisals at conversion, not just accounting numbers.

These are not theoretical. KDA reviews have found errors on 7 out of 10 conversions in the past year.

Common Mistake That Triggers an Audit

If your business switches status but doesn’t properly document asset values at the time of S Corp election, you risk three major landmines:

• Asset Mismatch: IRS agents compare prior C Corp balance sheet to S Corp opening. If any appreciation or omitted asset jumps out, an audit letter follows (IRS CP2000 or the dreaded Schedule M-2 mismatch).
• Improper Depreciation: New S Corp tries to claim step-up in basis without a qualified appraisal—this is audit bait. Documentation must match the market, not your own estimates. See IRS Publication 542.
• Failure to Anticipate Sale: Owners sell or distribute a business asset within recognition period, arguing it’s “part of S Corp profits.” IRS runs the numbers and tacks on corporate tax anyway.

Red Flag Alert: The IRS has increased asset audit rates in California by 19% since 2023—built-in gains on conversions are a prime target.

How to Stop Built-In Gains Tax Before It Starts: Action Plan for 2025

• Get a Professional Valuation: Engage a third-party appraiser or specialist to peg market value of all business assets (including intangible IP and goodwill) on the date of conversion.
• Update Your Depreciation Schedules: Reconcile these with your prior tax returns and the current asset register.
• File Form 2553 and 1120S Correctly: Don’t trust software alone. Cross-check that opening balance, asset register, and deferred revenue items all reconcile. The IRS scrutinizes even minor mismatches.
• Stagger Major Dispositions: If possible, hold appreciated assets beyond the five-year recognition window, or strategically dispose of them prior to conversion to avoid triggering the tax.

Pro Tip: For California S Corps, don’t ignore the FTB Form 100 requirements. Failure to follow state-level reporting can stack additional franchise tax on top of the federal built-in gains charge.

For a complete breakdown of S Corp strategies, see our comprehensive S Corp tax guide.

What If You’ve Already Converted? Damage Control and Strategies

You may still have options if you’re caught mid-conversion or realize the mistake after asset sale:

• File for Relief: Seek IRS Private Letter Ruling for abatement if the conversion was prompted by external pressures or errors in professional advice.
• Schedule Basis Increases: Use subsequent investments, improvements, or sales of additional shares to raise overall tax basis—this can offset or delay built-in gain recognition.
• Strategically Use Installment Sales: Structure deal receipts over several years to align gains with outside-of-window periods, minimizing immediate tax impact.

Never attempt “zeroing out” basis or backdating asset sales—the IRS reviews amendments critically, and the penalties are severe. Instead, document everything. Even an honest mistake can result in a reduced penalty if disclosure is proactive.

FAQ: What Business Owners Ask Most About Built-In Gains Tax

How do I accurately value my business assets for conversion?

Use a certified valuation expert experienced in both tangible and intangible business property, not just an internal bookkeeper. Include real estate, patents, client lists, and any other appreciating asset. This prevents both IRS disputes and overpayment.

Does the built-in gains window ever get shorter than five years?

Rarely. There are some industry-specific exceptions (including bankruptcy or natural catastrophe), but for almost all businesses in 2025, assume the five-year period applies. Always check latest IRS instructions.

Can I just “wait it out” if I plan to exit in the future?

In some cases, yes. If your business can hold appreciated assets for six years post-conversion, the built-in gain tax disappears. But for high-risk industries or volatile assets, waiting out the window comes with its own strategic hazards (market changes, regulation, etc.).

Why This Mistake Still Happens: The Hidden Traps Your CPA May Miss

Many CPAs and software tools don’t ask for a live asset valuation schedule at the moment of conversion. They rely on book values or skip documentation of intangible assets. This gap creates a multi-year audit risk with compounding penalties. California’s FTB tends to mirror the IRS on built-in gains, but can add compliance headaches if you don’t match asset reporting on state returns exactly.

Pro Tip: Schedule a third-party review BEFORE converting your business entity optics—especially if your equity, property, patents, or goodwill have appreciated since your C Corp formation. If your returns have any Schedule M-2 adjustments or ambiguous “Other Assets,” that’s code red for an IRS auditor.

Three Fast Facts That Change the Built-In Gains Math for 2025

• IRS adjusts the five-year recognition window based on Congress. Waiting periods may change.
• California attendance rates for built-in gain audits are up 19% from 2023. The state can’t collect federal tax, but will chase bad reporting synchronizations.
• For high-value exits ($10M+), a six-figure tax hit is possible—navigating built-in gains protocol with a qualified advisor often pays for itself many times over.

Will Converting S Corp to C Corp (or Vice Versa) Always Trigger Built-In Gains?

Not always. The built-in gains tax only applies to appreciation that occurred during C Corp status and is then “recognized” by the S Corp within five years of conversion. Pure S Corps or businesses switching from partnership/LLC status may face different pitfalls (like technical terminations or negative tax basis), but built-in gains is, by design, a penalty on gaming the double-tax system. Be wary of “just file this form” advice that skips the step-by-step IRS guidance and documentation.

Additional questions? Consult IRS guidance on S Corp conversions or book a session with a specialist for a real-world scenario review.

Bottom Line

Converting from a C Corp to an S Corp or vice versa can create a massive hidden tax liability if you ignore built-in gains tax rules. The IRS is increasingly aggressive in targeting these cases—especially in California industries like real estate, consulting, and high-growth tech. Accurate appraisal, timely paperwork, and professional review are non-negotiable. Never attempt entity conversions without a line-by-line asset schedule and tax planning session—a single misstep could cost you $50,000 or more.

This is not an area for shortcut advice. For a deeper dive on strategies, traps, and success stories, see our S Corp tax strategy guide for California business owners.

Book a Tax Strategy Session for Your Business Conversion

Ready to convert your C Corp or S Corp the right way—and avoid a five- or six-figure built-in gains tax hit? Our California-based strategists navigate these rules and find every legal savings. Book a personalized consultation at KDA to protect your business sale or restructure. Click here to book your tax strategy session now.