S Corporation Passive Income Restrictions

By John Cromwell

An S corporation is a corporation consisting of 100 or fewer shareholders that has a special tax designation granted by the IRS. While this designation offers the shareholders certain tax benefits, it requires the company to adhere to several restrictions and conditions. One of these restrictions involves how much passive income the business earns. It is important for an S corporation to closely monitor how much passive income it earns to ensure that it avoids any IRS penalties or tax repercussions.

Benefits of S-Corp Status

The chief benefit of an S corporation is that it retains the liability protection of a corporation but is taxed like a partnership. An S Corporation is a distinct legal entity, so its shareholders are generally protected from being personally liable for any of the business’s liabilities, debts or legal responsibilities. The S corporation’s annual income is divided amongst the shareholders based on each shareholder's ownership stake in the company. Each shareholder then adds his share of the business’s income to his personal return and pays tax on it. Traditional corporations are “doubled-taxed” because the company pays tax on the income when it's earned -- and the shareholders pay another tax on any dividends they receive from the corporation. S Corporations avoid this double taxation scenario.

Accumulated Earnings and Profits

The restrictions regarding passive income only take effect if the business has accumulated earnings and profits. S corporations cannot earn accumulated earnings and profits. However if the business was a C corporation for a period prior to becoming to an S corporation, it may have accumulated earnings and profits “left over” from that period. Accumulated earnings and profits are any funds a C corporation earned and did not distribute to its shareholders.

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Passive Income Defined

Passive income is generated through an activity in which the recipient did not materially participate. Examples of passive income include rent payments, royalties and dividends. For S corporation purposes, what qualifies as passive income varies slightly from the common definition. If an S corporation receives dividends from a C corporation subsidiary that are generated by the C corporation’s active trade or business, those dividends are not considered passive as long as the S corporation owns 80 percent or more of the outstanding C Corporation’s stock. Also, all rents and royalties that are derived from an S corporation’s active business are not classified as passive income.

S Corporation Restriction

An S corporation is not permitted to generate more than 25 percent of its gross receipts from passive income in any given year if it has accumulated earnings and profits. If the business does generate more than 25 percent of its receipts from passive income, the excess is taxed at the highest corporate income rate. For example, if an S corporation earns $100,000 in a year, $35,000 of which is from passive income, the total passive income percentage for the year would be 35 percent. The S corporation would have to pay tax on $10,000, or the difference between the total passive income it generated and how much passive income it was permitted to earn without penalty.

Continued Violations

If the S corporation has accumulated earnings and profits and earns more than 25 percent of its total gross receipts from passive income for three consecutive tax years, the IRS will automatically terminate the S corporation’s tax status. As a result, the former S corporation would be taxed as a C corporation.

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How Is Passive Income Taxable to an S Corporation Shareholder?


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Tax Consequences of Converting a C-Corp to an S-Corp

Corporations are business entities formed under state law that exist separately from their owners. An S corporation is simply a C corporation that has elected to be taxed as a pass through entity. Converting from a C-corp to an S-corp has significant tax implications, which include potentially lowering the overall tax burden on the shareholders, but also changing who reports the income each year and limiting when the income can be reported on the shareholder's tax returns. However, an S-corp must meet several criteria, including having less than 100 owners, only having U.S. resident or U.S. citizen individuals and certain entities as shareholders, and not having more than one class of stock.

S Corporation Structure

An S corporation is a tax designation that a business must apply for with the Internal Revenue Service. Used for small businesses, the benefit of the S corporate designation is that it allows the business to be taxed as a partnership. To apply for S corporate status, the business must submit a completed Form 2553 within 2 months and 15 days after the beginning of the first tax year that it wants to be treated as an S corporation.

Tax Laws for a Subsidiary Corporation

In order for the tax laws of subsidiaries to be applicable, the business must first meet the definition of a subsidiary under the tax code but this requires meeting very specific criteria. If the corporation qualifies as a subsidiary, its parent company may elect to consolidate its returns with the subsidiary as well as other subsidiaries. If a qualified subsidiary “spins off” from the parent, the stock of the subsidiary may be distributed to shareholders of the parent corporation without any tax implications.

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