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% 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%—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% 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.
Example 2: Distribution of AAA and E&P. An S corporation has accumulated E&P of $10,000 and an accumulated adjustments account (AAA) of $25,000. If the S corporation distributes $35,000 or more to its shareholders, it will have paid out all of its accumulated E&P. The $10,000 E&P is taxable as a dividend to shareholders, requiring the corporation to issue Forms 1099-DIV, Dividends and Distributions. The $25,000 AAA is tax-free to the shareholders if they have at least that amount of basis for their S corporation stock.
Sometimes, an S corporation may not have sufficient cash to pay a dividend equal to its total AAA and E&P. In that case, there are several alternatives. The corporation could issue notes to shareholders as a dividend. Alternatively, it could make the election under Treas. Reg. § 1.1368-1(f)(2) to distribute E&P prior to the AAA. Shareholder consents to the election should be obtained. The S corporation makes the election on its tax return for the year in which the distribution is made. A description of how the election is made appears later in this article.
Example 3: Distribution of E&P and part of AAA. The facts are the same as in Example 2, except that the election to distribute E&P first has been made. This time, a distribution of $12,000 is made. All the $10,000 E&P has thus been distributed and would be taxable as a dividend to the shareholders, requiring the issuance of Forms 1099-DIV. The additional $2,000 is from the AAA and is tax-free to the shareholders, provided they have sufficient basis in the stock of the S corporation. The distribution of all E&P eliminates any passive investment income problems.
If the corporation does not have sufficient cash to pay out the E&P, even with the election to distribute E&P first, there is another possible solution to the problem. Treas. Reg. § 1.1368-1(f)(3) provides that a deemed dividend election may be made with shareholder consents. If this election is made, nothing needs to be distributed. It is treated as though E&P had actually been distributed to the shareholders and they had contributed the deemed distribution amounts back to the corporation, all on the last day of the tax year for which the election is made. The corporation can elect to treat all or any part of the E&P as having been distributed. To eliminate the passive investment income problems, the corporation should elect as to all of its accumulated E&P.
The deemed dividend election is made on the tax return for the year to which it applies. A statement must be attached to the tax return, as described later in this article.
Example 4: Deemed dividend election. The facts are the same as in Example 2, except that no distribution is made, but the deemed dividend election is made for all of the E&P. In that case, the $10,000 of E&P is treated as having been distributed on the last day of the tax year, and the shareholders are treated as having immediately recontributed that amount to the corporation. Thus, the corporation will no longer have any E&P. The $10,000 E&P is taxed as a dividend to the shareholders, and the corporation will need to file Forms 1099-DIV.
HOW TO MAKE THESE ELECTIONS
An S corporation makes an election to distribute E&P before AAA or to make a deemed dividend for a tax year by attaching a statement to a timely filed original or amended Form 1120S for that tax year. In the statement, the corporation must identify which election it is making under Treas. Reg. § 1.1368-1(f) and must state that each shareholder consents to the election. The statement is verified by signing the return to which it is attached. A statement of the election to make a deemed dividend under Treas. Reg. § 1.1368-1(f)(3) must also include the amount of the deemed dividend that is treated as being distributed to each shareholder. These elections are irrevocable and are effective only for the tax year for which they are made.
As indicated above, making a deemed dividend distribution of the E&P under Treas. Reg. § 1.1368-1(f)(3) is also treated as a contribution of capital to the corporation, thus increasing the stock basis of the shareholders. This can be used to a taxpayer’s advantage in a situation in which the taxpayer has insufficient basis to deduct losses of the S corporation.
Example 5: Moving E&P into basis. The facts are the same as in the previous example. In addition, the sole shareholder had a zero basis for his stock as of Jan. 1, 2010. The corporation had an ordinary operating loss of $15,000 for its 2010 tax year. If the deemed dividend election is made for all the E&P on the 2010 Form 1120S, which is due to be filed in 2011, the shareholder would have a basis of $10,000 and so would be able to currently deduct $10,000 of the $15,000 loss. The remaining $5,000 loss would be carried over for that shareholder to his 2011 Form 1040. Thus on his 2010 Form 1040, the shareholder would be able to deduct the $10,000 as an ordinary loss and would be taxed on the $10,000 as a dividend distribution subject to only a 15% tax rate.
The interplay of the ordinary income tax rates and the 15% dividend tax rate is an opportunity that could be affected by future changes in tax rates.
AVOIDING THE STING
With careful planning, an S corporation can take the “sting” out of accumulated E&P and passive investment income and avoid the possible loss of S corporation status.
An S corporation may have accumulated earnings and profits (E&P) from an earlier period in which it was a C corporation, or it may inherit E&P from a C corporation as a result of a reorganization. If the S corporation also has excess passive investment income (generally, gross passive investment income that exceeds 25% of its gross receipts), it might be liable for the tax on excess net passive investment income under IRC § 1375. Sometimes referred to as the “sting tax,” it is assessed at the highest corporate marginal income tax rate—generally, 35%.
If the corporation continues to have E&P and excess passive investment income for three consecutive tax years, its S status is terminated. Relief may be available for inadvertent terminations.
To avoid these problems, an S corporation might be able to sell or distribute investment assets and so reduce its passive investment income, or increase its active business income. Alternatively, it may pay out its accumulated E&P as dividends to shareholders.
Rather than use cash dividends to pay out E&P, an S corporation may make a deemed dividend election. The distribution is treated as having been made to shareholders and recontributed by them to the corporation, all on the final day of the tax year. This method may be especially useful for S corporations that discover a sting tax liability after the end of a tax year but before their filing deadline. In either case, the S corporation issues Forms 1099-DIV, Dividends and Distributions, to its shareholders, to whom the distribution or deemed distribution is taxable.
Editor’s note: A version of this article also is available in The Tax Adviser , Dec. 2010, page 864.
Sydney S. Traum (email@example.com) is an attorney practicing in Miami Beach, Fla.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at firstname.lastname@example.org or 919-402-4434.
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