What Is the Excess Net Passive Income Tax?

The excess net passive income tax is a corporate-level tax for S corporations. It is designed to discourage C corporations from electing S corporation status simply to avoid taxes on passive investment income. The tax targets entities with accumulated earnings from their time as a C corporation that now earn significant income from passive sources. This ensures a company cannot use the S corporation status as a holding company for investments without tax consequences.

Determining Applicability of the Tax

Two conditions must be met for an S corporation to be subject to the excess net passive income tax. The first is the presence of accumulated earnings and profits (E&P) from when the corporation operated as a C corporation. E&P is a measure of a company’s economic ability to pay dividends, and only S corporations that were previously C corporations, or acquired a C corporation with E&P, can have this attribute. A business that has operated as an S corporation for its entire existence will not have C corporation E&P and is not at risk for this tax.

The second condition is that the S corporation’s passive investment income must exceed 25% of its total gross receipts for the tax year. Passive investment income includes:

• Royalties
• Rents
• Dividends
• Interest
• Annuities
• Gains from the sale or exchange of stocks and securities

It is important to distinguish this from rents received in the active conduct of a business, as the latter is not considered passive. Gross receipts are the corporation’s total revenues before deducting returns, allowances, or the cost of goods sold.

To illustrate the 25% test, consider an S corporation with $500,000 in gross receipts for the year. Of that total, $150,000 comes from dividends and interest. Since 25% of the gross receipts is $125,000, the corporation’s passive income of $150,000 is greater than the threshold, satisfying the second condition for the tax.

Calculating the Excess Net Passive Income Tax

To calculate the tax, first determine the “net passive income.” This is the total passive investment income minus any allowable expenses directly connected with generating that income, such as investment advisory fees or portfolio management costs.

The next step is to find the “excess net passive income” (ENPI), which is the base for the tax. ENPI is calculated by multiplying the net passive income by a specific ratio. This ratio is the amount of passive income exceeding 25% of gross receipts, divided by the total passive investment income. The resulting ENPI cannot be greater than the corporation’s taxable income for the year, calculated as if it were a C corporation.

The tax is imposed at the highest federal corporate income tax rate of 21%, which is applied to the ENPI. The corporation reports and pays this tax with its annual return, Form 1120-S, U.S. Income Tax Return for an S Corporation.

For example, assume an S corporation has $800,000 in gross receipts, including $300,000 of passive investment income and $40,000 in related expenses. The net passive income is $260,000 ($300,000 – $40,000). The passive income threshold is $200,000 (25% of $800,000), meaning the excess is $100,000.

The ENPI is then calculated as $260,000 multiplied by ($100,000 / $300,000), which equals approximately $86,667. The final tax is 21% of this amount, or $18,200.

Strategies for Managing Passive Income Exposure

S corporations can take steps to manage their exposure to this tax. The most direct strategy is to eliminate the C corporation E&P by distributing the entire balance to shareholders as a dividend. While this distribution is taxable to shareholders, it permanently removes the corporation from the scope of this tax.

Another strategy is to manage the company’s income mix to keep passive income below 25% of gross receipts. This can involve timing asset sales over multiple years to spread out gains. A company could also focus on increasing its active business revenue, which raises the gross receipts total and makes it harder for passive income to breach the threshold.

Accurate record-keeping is also important. The corporation must track its passive investment income separately from its active business income. It must also document all expenses directly connected to producing passive income, as these deductions reduce the net passive income used in the tax calculation.

Consequences of Consecutive Excess Passive Income

An S corporation that has C corporation E&P and passive income over 25% of gross receipts for three consecutive tax years will have its S corporation election automatically terminated. The termination is effective on the first day of the tax year following the third consecutive year.

This change forces the company back to C corporation status, where it will be subject to the C corporation tax regime, including potential double taxation. The entity generally cannot re-elect S corporation status for a five-year waiting period without receiving special consent from the IRS.

The IRS offers a path for relief in some situations. If a corporation can show that the termination was inadvertent, it may be able to retain its S status. To qualify, the corporation must take corrective action, such as distributing the C corporation E&P, within a reasonable time after discovering the issue. This relief is not automatic and requires a formal request to the IRS.