S Corporations: Losing S-Corp Status Due to Passive Income

Owners of corporations elect S corporation taxation status for the pass through and other benefits the election provides. There are various things that can arise that would cause an S corporation to lose its election.  In this and following posts, I’ll walk through some of the most common.  The one I want to discuss now is the S corporation passive income restriction. 

While being taxed as an S corporation allows shareholders to report the business income and losses on their own returns, being taxed as regular income at their  own rates, they are also responsible for some built-in gains and passive income.

Passive income is income generated through “passive activities” which the Internal Revenue Code Section 469(c) defines as “any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate.”  Another section of the IRC Section 469(h), states that material participation is being involved in an activity on a regular, continuous and substantial basis.  One of the most common types of passive income are portfolio income and rental income (although there are exceptions, such as the renting of property by a real estate professional) [also note that IRS Private Letter Ruling 200527013 shows how an S corporation’s rental income can escape classification as passive investment income with proper planning].

The rule is that in any year where an S corporation has earnings and profits (E&P), the S corporation can have no more than 25 percent of its gross receipts for any year generated by passive income [see IRC section 1362(d)(3)(A)(i)].  Anything over that amount is taxed at a higher rate [see IRC Section 11(b)’s highest rate] as per IRC Section 1375.

Then here’s the kicker, if an S corporation is taxed for excess net passive income for three years in a row, then under IRC Section 1362(d)(3), the S corporation status will be lost on the first day of the fourth tax year.

There’s a saving provision, however, and under IRC Section 1362(f), the IRS may allow S corporation status to continue if the taxpayer can show and the IRS is convinced (by issuing a private letter ruling) that the termination of S corporation status was “inadvertent” (a topic for a later post).

The loss of S corporation status would default the corporation to being taxed as a C corporation, and that can result in adverse tax consequences. Not only would corporate earnings be subject to two levels of tax, gains from the sale of corporate assets would be taxed at corporate tax rates. Additionally, if you are really unlucky, the personal holding company tax and the excess earning tax penalty might apply.