S Corporation Passive Income Tax Rules
If your S corp was once a C corp, its passive income may be taxed. Learn how past earnings can create current tax liabilities and how to navigate the rules.
S corporations provide the benefit of avoiding the double taxation inherent in C corporation structures, allowing profits to pass directly to shareholders without a corporate-level tax. However, specific rules can impose a tax on S corporations with certain types of income. These regulations can also lead to the termination of a company’s S corporation status, making the passive income rules important for maintaining compliance.
The Two Preconditions for Passive Income Issues
The passive income rules for S corporations do not apply universally, as they are targeted at companies that meet two distinct conditions. If either of these is absent, the passive income tax is not a concern. This means many S corporations, particularly those that have always operated as such, will never have to address these regulations.
The first condition is the existence of accumulated earnings and profits (E&P) from prior years when the company operated as a C corporation. E&P is an accounting measure that tracks a C corporation’s ability to pay dividends to its shareholders. An S corporation that was never a C corporation, or one that distributed all of its E&P before making the S election, does not meet this requirement and is exempt from the passive income tax.
The second condition is that the S corporation’s passive investment income must be more than 25% of its gross receipts for the tax year. “Gross receipts” refers to the total amount of money the corporation receives from all sources, without any reduction for costs of goods sold or other operating expenses. It is a measure of total inflow, not profitability.
“Passive investment income” generally includes revenue from sources that do not require significant active participation. Common examples are gross rents, royalties, dividends, interest, and annuities, as well as gains from the sale or exchange of stocks and securities. For income to be considered active rather than passive, particularly in areas like rentals, the corporation typically needs to provide significant services.
Calculating the Net Passive Income Tax
If an S corporation meets both preconditions, it becomes subject to a tax under Internal Revenue Code Section 1375. This tax is levied at the highest corporate tax rate, currently a flat 21%. The tax is not applied to all passive income but to a calculated amount known as “excess net passive income” (ENPI).
The calculation begins by determining the ENPI. To find the ENPI, you first calculate the percentage of passive income that is in excess of the 25% gross receipts threshold. This percentage is then multiplied by the “net passive income” to arrive at the final ENPI amount that will be taxed.
“Net passive income” is the corporation’s passive investment income minus any allowable deductions directly connected with producing that income. For instance, if an S corporation has interest income, the investment management fees directly associated with generating that interest would be deductible. These deductions cannot include certain items like the net operating loss deduction under section 172.
To illustrate, consider an S corporation with $200,000 in gross receipts and $100,000 in passive investment income. This company has $10,000 in expenses directly related to generating the passive income and also has C corporation E&P. Its passive income (50% of gross receipts) exceeds the 25% threshold, and its net passive income is $90,000 ($100,000 – $10,000).
The excess portion of its passive income is $50,000 ($100,000 passive income – (25% of $200,000 gross receipts)). The ENPI is calculated as $90,000 (net passive income) ($50,000 / $100,000), which equals $45,000. The tax would be 21% of $45,000, or $9,450. The ENPI subject to tax cannot exceed the corporation’s total taxable income for the year.
Termination of S Corporation Status
Beyond the passive income tax, a more severe consequence exists for S corporations that repeatedly violate the passive income thresholds. This outcome is a complete revocation of the company’s S corporation status, which has significant and long-lasting tax implications.
The rule for termination is based on a three-year lookback period. An S corporation will have its S election terminated if it has accumulated C corporation E&P and its passive investment income exceeded 25% of gross receipts for three consecutive tax years. If this three-year test is met, the S election automatically terminates on the first day of the following tax year.
The result of termination is that the company reverts to being a C corporation for tax purposes. This change subjects the corporation’s profits to the corporate income tax, and distributions to shareholders from earnings and profits are taxed again at the individual level as dividends.
The Internal Revenue Service may provide relief if the termination was unintentional. If a corporation can demonstrate that it was unaware of the circumstances and takes prompt action to correct the underlying issues, such as distributing the E&P, it may obtain a waiver from the IRS. The burden of proof lies with the corporation to establish that the termination was inadvertent.
Managing Passive Income and Accumulated E&P
S corporations with a history as C corporations can avoid the passive income tax by eliminating one of the two triggering preconditions. This proactive management can secure a company’s S corporation status and prevent unnecessary tax liabilities.
The most direct solution is to eliminate the corporation’s accumulated E&P. Distributing these earnings to shareholders removes the problem entirely, as the passive income rules only apply to S corporations with C corporation E&P. These distributions are generally taxable to shareholders as dividends.
Normally, distributions from an S corporation come from its accumulated adjustments account (AAA) first, which is tax-free to the extent of a shareholder’s basis. To clear E&P more quickly, a corporation can make a special election to treat distributions as coming from its E&P first. This election accelerates the removal of the problematic E&P.
Another approach involves structuring corporate activities to minimize income classified as passive. For rental income, this could mean providing significant services to tenants, which can convert the income from passive to active. For example, a company that rents real estate and also provides extensive maintenance and security may be considered to be running an active trade or business, thereby reclassifying its rental receipts.