How Is Passive Income Taxable to an S Corporation Shareholder?

By John Cromwell

A chief benefit of being an S Corporation is that it allows the corporation’s shareholders to be taxed directly on all income earned by the business. Owners benefit from direct taxation because a C Corporation's profits are taxed twice: once when earned by the corporation and again when distributed to the owners as a dividend. When an S Corp shareholder pays taxes on the business’s income, the funds are broken down based on how the S Corp earned the money. As a result, a shareholder may pay different tax rates on different portions of her S Corporation’s income. One aspect of S Corporate income that may be taxed differently is the business’s passive income.

A chief benefit of being an S Corporation is that it allows the corporation’s shareholders to be taxed directly on all income earned by the business. Owners benefit from direct taxation because a C Corporation's profits are taxed twice: once when earned by the corporation and again when distributed to the owners as a dividend. When an S Corp shareholder pays taxes on the business’s income, the funds are broken down based on how the S Corp earned the money. As a result, a shareholder may pay different tax rates on different portions of her S Corporation’s income. One aspect of S Corporate income that may be taxed differently is the business’s passive income.

Passive Income Generally

Passive income is revenue from activities in which the S Corporation did not materially participate. For an S Corporation to not have “materially participated,” it cannot have worked in the business on a regular, continuous and substantial basis. An example of passive income would be if the S Corporation was a limited partner in a business that it did not materially participate in. Any income the S Corporation received from the business would be considered passive. Rents and royalties are generally considered passive income.

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Passive Income Exceptions

Any dividends an S Corporation receives from a C Corporation subsidiary are never considered passive income, so long as the S Corporation owns 80 percent of the subsidiary’s outstanding stock and the dividends are derived from subsidiary’s active trade or business. Also, if an S Corporation’s active business is based on rents and royalties, those revenues are never passive.

Schedule K-1

Every year, an S Corporation provides its shareholders with Schedule K-1, which informs the shareholders what amounts they need to include on their personal income tax returns. The passive income attributed to the shareholder is included in box 1 of part III, labeled as “ordinary business income.” The passive income is also included with the S Corporation’s nonpassive income. If you are an S Corporation shareholder, request a breakdown of “ordinary income” so you know how much of the income you must report as passive and how much you must report as ordinary.

Schedule 1040

Once the shareholder receives his K-1 and passive income breakdown, he must complete a series of forms. If the S Corporation has any losses from passive activities, the shareholder must report his share of those losses on Form 8582, Passive Loss Limitations. This form will inform the shareholder how much of the passive losses can be used to offset income. The shareholder would then transfer that amount onto line 28, section (f) of Schedule E, Supplemental Income and Loss, of the shareholder’s 1040. The shareholder’s share of the S Corporation’s passive income is listed on line 28, section (g). Then the permissible passive losses are added to the passive income. The result is ultimately included on line 17 of the shareholder’s 1040. That amount is ultimately taxed at the shareholder’s ordinary tax rate.

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S Corporation Passive Income Restrictions

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Basics of an S Corporation

To gain the protection of limited liability, many businesses incorporate. However, this subjects the profits to two layers of taxation: the corporate tax on company earnings and the personal income tax on distributions. To take advantage of the more favorable pass-through tax treatment, corporations that meet certain requirements can elect to become an S corporation.

S Corporation Restrictions

An S corporation offers companies the ability to funnel their earnings and losses directly to the owners, thereby avoid double taxation. In addition, the use of the corporate structure grants the shareholders limited liability. However, the S corp election is very fragile. Making a mistake on just one of the restrictions can cause the company to lose its special status and therefore be taxed as a regular corporation.

Subchapter S Corporation Advantages

A subchapter S corporation is an IRS approved and regulated business organization. To qualify, a business must comply with several restrictions. These restrictions include the business only being allowed to have 100 or fewer shareholders, none of which can be partnerships or corporations. S-Corp shareholders are also prohibited from owning preferred shares in the business. S-Corps are prohibited from participating in certain industries, such as insurance. These restrictions may make it more difficult to obtain investment, but for many businesses, the advantages of being an S corporation outweigh any disadvantages from the S-Corp regulations.

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