An S corporation that was formerly a C corporation and still has accumulated E&P faces another potential tax: the § 1375 tax on “excess net passive income.” If the S corporation’s passive investment income exceeds 25% of its gross receipts for three consecutive years, it loses its S election. § 1362(d)(3). But even before that, if it has any E&P, it may owe the § 1375 tax.
“Passive investment income” includes royalties, rents, dividends, interest, and annuities. § 1362(d)(3)(C)(i). Capital gains are excluded. “Gross receipts” for this purpose are adjusted: gains from capital assets are netted, and only gains (not gross proceeds) from stock or securities are included. § 1362(d)(3)(B).
The tax is computed as:
ENPI = NPI × [(PII – 0.25×GR) / PII]
Where:
- ENPI = excess net passive income (the tax base)
- NPI = net passive income (passive income minus direct expenses)
- PII = passive investment income
- GR = gross receipts (as specially defined)
The tax rate is the highest corporate rate (21%). The tax reduces the shareholders’ share of passive income that passes through. § 1366(f)(3).
Example from Reg. § 1.1375‑1(f): M Corp has GR of 100,000, and NPI of
90,000 × [(
50,000) /
45,000. Tax =
9,450.
If the S corporation distributes its accumulated E&P, it can avoid the § 1375 tax. So if you have an S corporation with old E&P, consider paying out the E&P as dividends (taxable to shareholders) to avoid the passive income tax.
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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