Question: Horizon Creative Studios, Inc. is a small graphic design business that began operations in 2000 as a C corporation. In 2021, the company generated a net operating loss (NOL) that it has been carrying forward each subsequent year. The company meets all the eligibility requirements to make the S election and timely files a Form 2553, Election by a Small Business Corporation, to be treated as an S corporation with an effective date of Jan. 1, 2023. As of December 31, 2022, its last day as a C corporation, the remaining NOL carryforward for Horizon was $10,000. During 2023, the business sold an asset for which they had to recognize built-in gain. Can the NOL carryforward be used to offset ordinary income or reduce the built-in gains of the S corporation in 2023?
Answer: The NOL cannot be used to offset ordinary income; however, it can be used to reduce built-in gains tax [IRC §1374(b)].
When Horizon Creative Studios, Inc. made the election to be treated as an S corporation, any NOL carryforwards were essentially paused. The NOL cannot be carried into a tax year that the C corporation elected S status. However, if Horizon reverts back to a C corporation, then the NOL could continue to be used for the remainder of the time allowed in the carryover period. An NOL generated by a C corporation can be used to reduce the built-in gains tax if the S corporation sells an asset and is subject to that tax.
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