S Corp Lifecycle

S Corp Lifecycle Events 2025

Navigating the "Minefield": From the Built-in Gains Tax at conversion to the complex mechanics of Deemed Asset Sales at exit.

Executive Summary

The S Corporation is not a static entity; it is a dynamic tax status vulnerable to "Lifecycle Events." Converting from a C Corp triggers dormant liabilities like the Built-in Gains (BIG) Tax. Operational changes involving trusts require choosing between QSST and ESBT status to avoid disqualification.

Finally, exiting an S Corp involves high-stakes structuring. Sellers can use Section 338(h)(10) to arbitrage the buyer's need for asset depreciation against their own need for single-layer taxation.

The Entry Toll

BIG Tax (Sec 1374): A 21% corporate tax on pre-conversion appreciation if sold within 5 years.

The Trust Trap

QSST vs. ESBT: Choosing the wrong trust structure for a family transfer can terminate the S election instantly.

The Exit Fix

Deemed Asset Sales: Elections like 338(h)(10) allow stock sales to be taxed as asset sales, bridging the buyer-seller gap.

Entry: Conversion Traps

5-Year Recognition Period

If you convert from C to S, the IRS watches you for 5 years. Selling "built-in gain" assets during this window triggers corporate tax (21%) AND shareholder tax.

Key Conversion Liabilities

  • Built-in Gains (BIG) Tax: Capped at the "Net Unrealized Built-in Gain" (NUBIG) at the moment of conversion. Valuation is critical.
  • LIFO Recapture: Immediate tax. If you used LIFO inventory, you must recapture the reserve into income in your final C Corp year. Payable over 4 years.
  • Section 357(c) (LLC Conversion): If LLC liabilities > asset basis, converting to S Corp triggers immediate gain. "Negative Capital" trap.

Operations: Trusts & Shareholders

S Corps are limited to 100 shareholders. Trusts are allowed, but only specific types.

QSST (Qualified Subchapter S Trust)

  • Rule: ONE beneficiary only.
  • Distribution: Must distribute ALL income annually.
  • Tax: Income taxed at Beneficiary's individual rate.
  • Use Case: Simple transfers to children.

ESBT (Electing Small Business Trust)

  • Rule: Multiple beneficiaries allowed.
  • Distribution: Trustee can accumulate ("sprinkle") income.
  • Tax: Punitive. Taxed at highest Trust Rate (37%).
  • Use Case: Complex estate planning; asset protection.

Exit Strategies

The conflict: Buyer wants Assets (Step-up). Seller wants Stock (Capital Gain).

Section 338(h)(10) Election

Legally a stock sale, taxed as an asset sale.

  • Buyer: Gets step-up in basis (depreciation).
  • Seller: Pays tax on asset gain (often higher rate), but avoids double tax.
  • Gross-Up: Buyer usually pays Seller extra to cover the tax difference.
Personal Goodwill

Founder sells "relationships" directly to buyer, bypassing the corp.

  • Benefit: Avoids BIG Tax and corporate level tax.
  • Requirement: No existing non-compete with the corp (Martin Ice Cream doctrine).

Interactive: BIG Tax Estimator

Estimate the tax impact of selling pre-conversion assets within the 5-year recognition window.

Asset Details

Liability Analysis

Built-in Gain (NUBIG)
Cap on Corporate Tax
$0
Corporate Tax (21%)
Paid by S Corp
$0
Pass-Through Gain
Total Gain - Corp Tax
$0