What Is the S Corporation Passive Income Test?

An S corporation provides business owners with liability protections and pass-through taxation, where income and losses are reported on the owners’ personal tax returns. This structure avoids the double taxation often associated with C corporations. However, the passive income test can introduce tax complications for S corporations with a history of operating as a C corporation. The test is designed to prevent the use of an S corporation structure primarily as a holding company for passive investments.

Determining Applicability of the Test

The passive income test does not apply to all S corporations; its relevance is contingent on two specific conditions. First, the S corporation must have accumulated earnings and profits (E&P) at the close of the tax year. E&P are profits retained by the company from previous years when it was a C corporation and had not been distributed as dividends. If a business has always operated as an S corporation, it will not have C corporation E&P, and this test is not a concern.

The second condition is that the corporation’s passive investment income must exceed 25% of its total gross receipts for that year. Both having C corporation E&P and exceeding the 25% passive income threshold must be present for the rules to be triggered. An S corporation with significant passive income is not subject to the tax if it has no C corporation E&P.

The purpose of this rule, outlined in Internal Revenue Code Section 1375, is to discourage C corporations from making an S election simply to avoid corporate-level taxes on investment income. Without this provision, a C corporation could sell its operating assets, elect S corporation status, and then hold the proceeds in passive investments. The test ensures that the benefits of the S corporation structure are for active businesses.

Defining Key Terms for the Test

The IRS defines the test’s components in Internal Revenue Code Section 1362. “Passive investment income” includes gross receipts derived from sources such as:

• Royalties from intellectual property
• Rents from real estate holdings
• Dividends from stock investments
• Interest from loans or bonds
• Annuities

There are exceptions to what is considered passive investment income. For instance, interest earned on notes from the sale of inventory to customers in the ordinary course of business is not passive. Rental income may also be excluded if the corporation provides significant services to the occupant, such as in the operation of a hotel where services like cleaning are substantial.

The term “gross receipts” is not interchangeable with gross profit or taxable income. Gross receipts represent the total amount a corporation receives or accrues under its accounting method, without reduction for the cost of goods sold or returns. This includes all receipts from the company’s primary business, passive investment income, and proceeds from the sale of capital assets, though for stock and securities, this is limited to capital gains.

The Passive Income Tax Calculation

When an S corporation with C corporation E&P has passive investment income exceeding 25% of its gross receipts, it becomes subject to a corporate-level tax. This tax is calculated on its “excess net passive income” and is levied at the highest federal corporate income tax rate, currently 21%. This means an S corporation can face direct taxation at the entity level.

First, calculate “net passive income” by taking the total passive investment income and subtracting allowable deductions directly connected with producing that income. These expenses might include property taxes on a rental property or investment advisory fees. The result is the net profit from passive activities.

Next, the “excess net passive income” (ENPI) is calculated. The formula is: Net Passive Income x [(Passive Investment Income – 25% of Gross Receipts) / Passive Investment Income]. The tax is then calculated by multiplying the ENPI by the 21% corporate tax rate. The amount subject to tax cannot exceed the corporation’s total taxable income for the year.

For example, consider an S corporation with $200,000 in gross receipts and C corporation E&P. It has $80,000 in passive investment income and $10,000 in related expenses. The 25% threshold is $50,000. Since $80,000 exceeds this, the tax applies. Its net passive income is $70,000 ($80,000 – $10,000). The ENPI is $26,250, and the tax owed is $5,512.50 (21% of $26,250).

Termination of S Corporation Status

Beyond the annual tax, a more severe consequence exists for repeatedly failing the passive income test. An S corporation’s tax status can be terminated if it has E&P from its C corporation years and its passive income exceeds 25% of gross receipts for three consecutive tax years. This is sometimes called the “three-strikes” rule.

If an S corporation triggers this three-year rule, its S election is automatically terminated. The termination becomes effective on the first day of the tax year following the third year of non-compliance. The business then reverts to being a C corporation for tax purposes, subjecting it to corporate income tax and its shareholders to tax on dividends.

The IRS provides a potential remedy for this situation. A corporation may seek an “inadvertent termination waiver” if it can demonstrate to the IRS that the termination was unintentional and not part of a tax avoidance plan. The shareholders and corporation must also take steps within a reasonable period to correct the issue, which involves distributing the C corporation E&P.

Strategic Management of Passive Income and E&P

Proactive management can help S corporations avoid the annual passive income tax and termination. The most direct strategy is to eliminate the accumulated C corporation E&P by distributing it to shareholders as a dividend. Once the E&P balance is zero, the passive income rules no longer apply in future years, regardless of the level of passive income.

Normally, S corporation distributions come first from its tax-free accumulated adjustments account (AAA). However, a corporation can make a special election to treat distributions as coming from its accumulated E&P first. This allows the corporation to target and eliminate the problematic E&P. Shareholders will pay personal income tax on these dividends, but it resolves the passive income issue permanently.

Another approach involves managing the ratio of passive income to gross receipts. If a corporation nears the 25% threshold, it can increase active business gross receipts by accelerating sales or taking on new projects to boost the ratio’s denominator. This dilutes the percentage of passive income. Alternatively, the corporation could restructure income streams to qualify as active, such as by providing significant services with its rental activities.