Lewes CPA
officeProgar & Company, P.A.
Certified Public Accounting services for businesses and individuals
S corporation passive income tax (MS Word)
S corporation passive income tax (.pdf)
S corporation passive income tax
Dear Reader:
You've told me that you are currently considering whether to convert
your C corporation to an S corporation. You should be aware that if
your corporation has any “earnings and profits,” then, even if it
elects S corporation status, it may be subject to a
corporate-level tax on its passive investment income.
This tax would apply in any year the S corporation's passive
investment income exceeds 25% of its gross receipts. If that
happens, the net passive income (after applicable deductions) that
exceeds 25% of gross receipts is taxed at the highest corporate tax
rate (currently 35%). Thus, a corporation that has (for the sake of
simplicity) $100,000 of passive investment income and no other
income or deductions would pay a tax of $26,250, i.e., 35% of
$75,000 (the excess of $100,000 gross receipts over 25% of
$100,000).
The tax does reduce the amount of income passed through by the S
corporation to the shareholders. Thus, in the above example, the S
corporation would pass through income of only $73,750 ($100,000
minus the $26,250 of tax), rather than $100,000. However, there
would still be double taxation, since a tax was imposed at the
corporate level. In addition, if the tax applies for three
consecutive years, the corporation's S corporation election will
terminate.
“Earnings and profits” defined.
Since even the smallest amount of accumulated earnings and profits
from C corporation years will subject an S corporation to a
potential passive investment income tax, it's important to know (a)
whether the corporation has any accumulated earnings and profits,
and (b), if so, exactly how much the corporation has (because the
corporation can eliminate its tax risk completely by distributing
all the earnings and profits, see below). You can think of
accumulated earnings and profits, generally, as any net income, from
any year of the corporation's existence, that hasn't been
distributed by the corporation. We can help you determine just what
your earnings and profits are for tax purposes (and therefore how
much the corporation would have to distribute in order to eliminate
its accumulated earnings and profits from C corporation years).
Passive investment income and gross receipts defined.
These are also defined by the tax Code and don't necessarily mean
what they do for normal business purposes. Passive investment income
generally includes items, such as dividends, interest, rents, and
royalties. (For tax years beginning before May 26, 2007, passive
investment income also includes stock gains.) However, there are
exceptions for royalties and rents derived from an active trade or
business. Passive investment income does not include dividends
received from an 80%-or-more owned C corporation subsidiary when
those dividends are generated by the C corporation's active conduct
of a trade or business. Gross receipts generally includes all
amounts realized by the corporation, without reduction for cost of
goods sold, returns, allowances, or other deductions.
Avoiding the tax. You can
avoid the tax by either (1) eliminating the accumulated earnings and
profits from C corporation years, or (2) limiting the corporation's
passive investment income to 25% of its gross receipts.
Specifically, you can avoid any risk of the tax by having the
corporation make an actual or deemed distribution of its accumulated
earnings and profits from C corporation years before the end of the
first S corporation tax year. However, the distribution would be
taxed to the recipients as ordinary income. You should consider
making a distribution if the amount of the accumulated earnings and
profits from C corporation years is small. However, if a
distribution would mean too much tax to the shareholders, you can
still elect S corporation status and avoid the passive investment
income tax as long as the passive income the corporation generates
doesn't exceed 25% of its gross receipts. If you decide to elect S
status, but not to distribute the corporation's accumulated earnings
and profits from C corporation years, you would have to carefully
watch the corporation's future income to be sure that it doesn't
exceed the 25%-of-gross-receipts threshold. We can work with you to
develop strategies to reduce the passive investment income and/or
increase the corporation's nonpassive income.