S Corporation Excess Net Passive Income Tax
S Corporations that have previously been a C Corporation and have accumulated earnings and profits at the end of the tax year will be assessed a passive income tax if passive investment income for the year exceeds 25% of gross receipts for the year. The tax is assessed at the maximum corporate tax rate of 35%. Recognized built-in gains and losses are not taken into account in determining the amount of passive investment income.
== Illustration == X, a C corporation with earnings and profits, holds stock with a value of $1,000 and a basis of $500. X elects S status for Year 2. During Year 2, X sells the stock for $1,200. X's passive investment income is $200 ($700 gain on the stock minus the $500 that is a recognized built-in gain).
Code Section 1362(d) (3(C)(i) defines passive investment income to be income derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities. An exception is made for interest on notes from sales of inventory (Code Section 1362(d) (3(C)(ii)), and for income derived directly from the active and regular conduct of a lending or finance business(Code Section 1362(d) (3(C)(iii)).
If passive investment income exceeds 25% of gross receipts for three consecutive years, then the S Corporation election is terminated immediately following the third tax year.
To avoid the passive income tax, the S Corporation can either (1) distribute E&P from C corporation years as an actual or deemed dividend, or (2) generate enough operating income so that passive investment income does not exceed 25% of gross receipts for the year. Also, the passive income tax calculated using the lesser of "excessive net passive income" or taxable income. By reducing taxable income, the S Corporation is able to minimize the passive income tax. Keep in mind, however, that the S Corporation election will still terminate if passive investment income exceeds 25% of gross receipts for three consecutive years.
Any passive income tax paid is a reduction to income that passes to the S Corporation shareholders.