Built-In Gains Tax on S Corporation

The Department of Revenue has received several questions regarding the applicability of the federal S corporation built-in gains tax for Iowa tax purposes. This guidance is not a detailed analysis of the calculation of this federal tax, but is instead intended to generally describe Iowa’s conformity with the federal built-in gains tax on S corporations, with a particular focus on Iowa’s conformity since the change to the recognition period enacted in federal Public Law 114-113, Division Q, section 127, Commonly referred to as the Protecting Americans from Tax Hikes (PATH) Act. The Department of Revenue will update administrative rules if necessary to reflect the information in this guidance.

What is the federal built-in gains tax?

Section 1374 of the Internal Revenue Code (IRC) imposes an entity-level tax on the net built-in gain from the disposition of property of certain S corporations that were once C corporations or S corporations that acquired property with a basis determined in whole or in part by reference to the basis of such asset (or any other property) in the hands of a C corporation, and on certain other income items. The federal tax generally applies if the built-in gain is recognized by the S corporation any time during a defined period beginning in the first tax year that the corporation became an S corporation or acquired certain property. This period is referred to as the “recognition period” and is governed by IRC section 1374(d)(7). The PATH Act modified section 1374(d)(7) by permanently decreasing the recognition period from 10 years to 5 years, for tax years beginning on or after January 1, 2015. Therefore, for federal tax purposes for tax years 2015 and later, an S corporation that has a net recognized built-in gain during the 5-year period after it makes its S corporation election or acquires certain property is subject to a federal built-in gains tax under IRC section 1374.

An exception to this typical recognition period applies to installment sales. If the S corporation sells property using the installment method under IRC section 453, the treatment of all payments is governed by the recognition period applicable to the taxable year in which the sale was made. In other words, the federal built-in gain tax on sales of property made prior to tax year 2015 may be governed by a different recognition period for federal tax purposes than the one described above.

  • The starting point for computing the Iowa tax on built-in gains is the amount of net built-in gains (including built-in gain carryforward amounts) calculated for federal tax purposes after considering the federal income limitation, but before considering any federal net operating loss (NOL) carryforward adjustment. The allocation and apportionment rules in Iowa Administrative Code Chapter 701—54 apply if the S corporation is carrying on business within and without Iowa.

    Any remaining Iowa NOL carryforward arising from a tax year for which the corporation was a C corporation is allowed as a deduction against the net recognized built-in gains to the extent the Iowa NOL carryforward period has not expired. For purposes of determining the amount of Iowa NOL which may be carried forward to subsequent tax years, the net recognized built-in gain shall be treated as taxable income.

    The amount of Iowa taxable built-in gains is subject to tax at the same Iowa tax rates as C corporation income. Any remaining tax credit carryforward under Iowa Code section 422.33 arising from a tax year for which the corporation was a C corporation is allowed against the Iowa built-in gains tax to the extent the credit’s carryforward period has not expired. These credits and estimated tax payments are the only Iowa tax credits allowed against the Iowa built-in gains tax.&

    The Iowa built-in gains tax described above is calculated and reported on the IA 1120S, Part III, line 11, and is paid by the S corporation.

    Iowa allows a deduction for 50% of federal income tax paid or accrued by a corporation, including federal built-in gains tax paid or accrued by an S corporation. This federal built-in gains tax is deducted on the IA 1120S, Part III, line 5, and flows through to the shareholders as a net modification on the IA 1120S Schedule K-1, line 15. Note that an S corporation may also be eligible for an adjustment under IRC section 1366(f)(2) in computing federal taxable income (relating to federal tax imposed on built-in gains). To the extent that adjustment is allowed for federal tax purposes, it will already be included for Iowa purposes in the amount of federal net income reported on the IA 1120S, Part III, line 1, so no additional Iowa adjustment related to IRC section 1366(f)(2) is required or allowed.

    Iowa law requires corporations to add back any Iowa income tax (including Iowa built-in gains tax) deducted in computing federal taxable income. Any Iowa built-in gains tax paid or accrued by the S corporation and deducted for federal tax purposes is added back on the IA 1120S, Part III, line 3, and flows through to the shareholders as a net modification on the IA 1120S Schedule K-1, line 15.

  • Iowa was conformed to the federal reduction in the recognition period for tax years beginning on or after January 1, 2015, but before January 1, 2016 (“tax year 2015”). Thus, Iowa used a 5-year recognition period for determining the Iowa built-in gains tax for tax year 2015.

    The provisions of IRC section 1374(d)(7) relating to installment sales also apply for Iowa tax purposes. If an S corporation sold an asset in tax year 2015 on an installment basis, and that sale was outside its 5-year recognition period and thus not subject to the federal or Iowa built-in gains tax, any income reported from that installment sale in a later tax year will not be subject to the Iowa built-in gains tax even though the income was reported during a tax year (e.g. 2016) in which Iowa used a 10-year recognition period because of federal nonconformity (see Example 2 below).

  • Iowa was not conformed to the federal reduction in the recognition period, from 10 years to 5 years, for any tax year that began on or after January 1, 2016, but prior to January 1, 2019 (“tax years 2016—2018”). For tax years 2016–2018, Iowa used a 10-year recognition period for determining the Iowa built-in gains tax. As a result, an S corporation that recognized a built-in gain after the 5-year federal recognition period, but within the 10-year Iowa recognition period was subject to a built-in gains tax in Iowa during tax years 2016–2018, even if the corporation was not subject to a federal built-in gains tax for the same period. This 10-year Iowa recognition period was measured from the first taxable year that the corporation was an S corporation or from the date the S Corporation acquired certain C corporation property.

    Example 1: W is a former C corporation that is a calendar-year taxpayer and that converted to an S corporation in tax year 2012. At the time of the conversion, assume W had an unrealized built-in gain in an asset. If W disposed of the asset in tax year 2018, the resulting built-in gain would have been subject to Iowa’s built-in gains tax because the disposition occurred within Iowa’s 10-year recognition period, even though W would not have been subject to the federal built-in gains tax because such disposition would have been outside of the federal 5-year recognition period.

    This Iowa built-in gains tax would have been calculated as described above and reported on the 2018 IA 1120S, Part III, line 11, and paid by W. W would not be allowed a deduction for 50% of the federal built-in gains tax paid or accrued because no such federal tax was actually paid or accrued. Similarly, no adjustment described in IRC section 1366(f)(2) (relating to federal tax imposed on built-in gains) would be allowed for federal or Iowa tax purposes because no federal built-in gains tax was actually imposed on W. If W subsequently deducted the Iowa built-in gains tax in calculating W’s federal taxable income, W would have been required to add back that Iowa tax on the IA 1120S, Part III, line 3.

    Example 2: X is a former C corporation that is a calendar-year taxpayer and that converted to an S corporation in tax year 2009. At the time of the conversion, assume X had an unrealized built-in gain in an asset. If X sold the asset in tax year 2015 on an installment basis, but reported income from that installment sale in tax year 2017, no built-in gains tax would be due for Iowa tax purposes on any income reported in tax year 2017. Even though the income from the installment sale was reported during a tax year for which Iowa used a 10-year recognition period, the payments are governed by provisions in effect for Iowa in tax years 2015 (the year of the sale) pursuant to IRC section 1374(d)(7), and no Iowa built-in gains tax applied in the year of the sale.

  • Iowa is conformed with the federal reduction in the recognition period for tax years beginning on or after January 1, 2019. Thus, Iowa uses a 5-year recognition period for determining the Iowa built-in gains tax for tax years beginning on or after January 1, 2019, except for certain installment sales as described below. This 5-year Iowa recognition period is measured from the first taxable year that the corporation was an S corporation or the date the S corporation acquired certain C corporation property. It applies to all qualifying S corporations, not just those that first elect S corporation status or acquire certain C corporation property in a tax year beginning on or after January 1, 2019.

    However, income recognized in tax years 2019 or later may still be subject to the Iowa built-in gains tax, even if not subject to the federal built-in gains tax, if the income relates to an installment sale made during tax years 2016–2018, when Iowa used a 10-year recognition period. This is because, pursuant to IRC section 1374(d)(7), all payments from such installment sale are governed by provisions in effect for Iowa in tax years 2016–2018 when an Iowa built-in gains tax applied to the sale.

    Example 3: Y is a former C corporation that is a fiscal-year taxpayer and that converted to an S corporation in its tax year beginning July 1, 2012. At the time of the conversion, assume Y had an unrealized built-in gain in an asset. If Y disposed of the asset during its tax year beginning on July 1, 2019, the resulting built-in gain would not be subject to the federal built-in gains tax or the Iowa built-in gains tax because the disposition occurred after the 5-year recognition period, which Iowa has now adopted for tax years beginning on or after January 1, 2019.

    It is not necessary that Y first elect S corporation status for a tax year beginning on or after January 1, 2019, in order to qualify for this treatment. In other words, a C corporation that elected to convert to an S corporation prior to 2019 still gets the benefit of the 5-year recognition period for tax years beginning on or after January 1, 2019.

    Example 4: Z is a former C corporation that is a calendar-year taxpayer and that converted to an S corporation in tax year 2010. At the time of the conversion, assume Z had an unrealized built-in gain in an asset. If Z sold the asset in tax year 2016 on an installment basis, but reported income from that installment sale in tax year 2019, a built-in gains tax may be due for Iowa tax purposes, even if not for federal purposes. Even though the income from the installment sale was reported during a tax year for which Iowa used a 5-year recognition period, the payments are governed by provisions in effect for Iowa in tax year 2016 (the year of the sale) pursuant to IRC section 1374(d)(7), and an Iowa built-in gains tax applied in tax year 2016 because Iowa used a 10-year recognition period.

    • The federal built-in gains tax imposed on S corporations also applies for Iowa income tax purposes.
    • Because of nonconformity to federal law, Iowa may use a different recognition period to calculate the tax depending on the tax year.  
    • Iowa used a 5-year recognition period to compute the tax for tax year 2015.
    • Iowa used a 10-year recognition period to compute the tax for tax years 2016-2018.
    • Iowa will use a 5-year recognition period to compute the tax for tax years beginning on or after January 1, 2019.