Taking the ‘Sting’ Out of S Corporations' Earnings and Profits
Taxpayers can elect several methods to avoid a sizable tax bite.
Under current tax law, an S corporation cannot produce earnings and profits (E&P); only C corporations can. However, if the S corporation was previously a C corporation, it may have accumulated E&P from years when it was a C corporation. Similarly, if an S corporation was a party to a tax-free reorganization with another corporation that had accumulated E&P, the S corporation may have inherited the other corporation’s accumulated E&P. S corporations that have accumulated C corporation E&P can have both problems and opportunities. This article examines both and explores solutions.
An S corporation with E&P may have either or both of two problems: the IRC § 1375 passive investment income tax (sometimes called the “sting tax”) and the possible loss of its S corporation status.
If the gross passive investment income (interest, dividends, certain types of rent, etc.) exceeds 25 percent of gross receipts, the corporation may be subject to the sting tax on its net passive investment income (gross passive investment income minus expenses of earning that income). This is not a problem if the S corporation has no accumulated E&P. However, if it does have both E&P and excess passive investment income, some of the excess net passive investment income may be subject to tax at the highest corporate income tax rate (currently 35 percent—thus the “sting”). The tax will not apply to a year in which there is no taxable income. Furthermore, the IRS can waive this tax if the corporation mistakenly determined that it had no E&P and it distributes the E&P within a reasonable time after its discovery (section 1375(d)). The request to waive the passive investment income tax is made to the IRS in the district where the Form 1120S, U.S. Income Tax Return for an S Corporation, was filed. The S corporation bears the burden of proof for showing the mistake was inadvertent. The request must contain a written statement including a description of when and how the mistaken determination was made, along with a description of any steps taken to distribute the E&P after they were discovered (see Treas. Reg. § 1.1376-1(d)). If the distributions have not yet been made, the request must include a schedule of proposed distributions and an explanation of why the timetable is reasonable. The distributions must have been made by the time the waiver becomes effective.
Even if there is no taxable income and the sting tax does not apply, if the S corporation has both E&P and excess passive investment income for three consecutive tax years, then under section 1362(d)(3), the S corporation status will be lost on the first day of the fourth tax year. However, under section 1362(f), the IRS may allow S corporation status to continue if it is convinced that the termination of S corporation status was inadvertent. To obtain this relief, the corporation must submit a private letter ruling request to the IRS National Office in Washington. Letter Rulings 200930027, 201031030 and 201025033 are examples of situations where this occurred.
It may be possible to eliminate the excess passive investment income by increasing the relative amount of active income. The S corporation might accomplish this by selling or distributing the assets that produce the passive investment income. Or the corporation might acquire a new active business, either directly or by investing in a partnership from which an allocable portion of the partnership’s active gross receipts will flow through to the corporation. Section 702(b) preserves the character of items constituting each partner’s distributive share of partnership items.
Example 1: Increasing gross receipts. An S corporation has $100,000 of gross receipts of which $30,000 is interest and dividends. The corporation invests in a partnership from which its share of active gross receipts equals $60,000. Thus, the gross receipts are increased to $160,000 and the $30,000 of dividends and interest are less than 25 percent of the $160,000 in gross receipts.
Another solution would be for the S corporation to pay out all its accumulated E&P as dividends to its shareholders. As indicated above, an S corporation with no E&P can have unlimited amounts of passive investment income without either of these problems.
This article has been excerpted from the Journal of Accountancy. View the full article here.