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.
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.
Read More: How Is Passive Income Taxable to an S Corporation Shareholder?
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.
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.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.