Generally, an S corporation pays no federal income taxes. Any income or loss is usually passed through to shareholders in proportion to the ownership interests on a per-share, per-day basis, and the shareholders report their portion of the entity's income or loss on their individual tax returns. However, additional taxes may be assessed against S corporations with excess passive income.
If an S corporation has accumulated earnings and profits from years as a C corporation and passive investment income that totals more than 25 percent of gross receipts, it is subject to an income tax at the highest corporate rate. This tax is imposed on the lesser of the S corporation's excess net passive income or its taxable income. In addition, the S corporation is not entitled to offset this tax by any credits other than those allowed for certain uses of gasoline and special fuels.
For the purposes of the passive investment income tax, passive investment income is the gross receipts from royalties, rents, dividends, interest, annuities, and any gain from the sale or exchange of securities. Rents earned in the active trade of business of renting property are not considered passive investment income. However, an S corporation is only in the active business of renting property if it provides significant services or incurs substantial costs in the rental business.
The Internal Revenue Service has defined "net passive income" as passive investment income reduced by any allowable deductions directly connected with the production of that income. The IRS provides a formula for calculating "excess net passive income." Excess net passive income cannot exceed the S corporation's taxable income for the year as computed without regard to any net operating loss deduction or certain other special deductions.
An S corporation can eliminate its accumulated earnings and profits subject to the passive investment income tax by distributing those earnings and profits as a dividend to shareholders. However, the shareholders must include those dividends in income on their individual tax returns.
Congress has given the IRS the authority to waive the tax on passive investment income if the S corporation shows that it had determined in good faith that it had no earnings and profits from its years as a C corporation but that during a reasonable time it was determined that it did in fact have earnings and profits. In order to qualify for relief, the S corporation must establish that these earnings and profits were distributed to the shareholders.
Copyright 2010 LexisNexis, a division of Reed Elsevier Inc.
