S Corporations which have previously been C Corporations and have earnings and profits accumulated from years in which they had C status wish to avoid having excessive passive income, since two undesirable events may occur. The corporation may have to pay tax at the corporate level on the excessive net passive income, and, if the corporation has excessive passive income for three consecutive tax years, it may lose S status.

The following is a review of the definitions of passive income that have evolved from judicial and administrative rulings. Also discussed are the rules for computing excessive passive income and some tax planning thoughts for avoiding excessive passive income.

Loss of S Status

As mentioned, if an S Corporation has previously been a C Corporation, and also has accumulated earnings and profits for those years, too much passive income can cause the loss of S status. If passive investment income exceeds 25% of gross receipts for three consecutive tax years, the S status is terminated as of the first day of the first taxable year beginning after the third consecutive tax year of excessive passive investment income.

Example 1. Blink, Inc. converted to S Corporation status on January 1, 1987, at which time it had accumulated earnings and profits. For the years 1987, 1988, and 1989, it had passive investment income comprising 32%, 28%, and 29% of gross receipts, respectively. The S election is terminated effective January 1, 1990.

"Passive investment income" is defined as gross receipts from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities but only to the extent of gains. Not counted as rental receipts are activities where significant services are provided by the lessee, such as in a hotel, warehouse, or parking lot. Generally, the courts have not been sympathetic to taxpayers in this area. For example, the operator of a mobile home was not considered to provide significant services even though utility hook-ups were provided and a full-time resident manager was employed. Barge charter income (where control and possession of the vessel is turned over to the charterer) was also not considered to be in conjunction with significant services. Also, services provided to luxury apartments' tenants such as full-time maintenance, individual parking spaces, recreation and laundry rooms, and so on, were not considered significant; similarly, the rental of video cassettes where the only service provided was to ship the cassettes did not constitute significant services.

On the other hand, the receipt of principal payments on installment obligations transferred to the corporation in exchange for its stock did not result in passive income.

The IRS has issued a number of rulings in this area. Generally, these rulings have been favorable to providers of short-term rental items if services are provided. For example, income from the operation of a coin operated car wash was not considered to be passive income. The employees performed such functions as removing coins, adding soap and chemicals, and bookkeeping. Similar amounts received for leasing glassware, silverware, and other items were not considered passive income where the corporation performed delivery and pickup functions and washed, polished, repaired, and stored the items. A similar conclusion was reached for the rental of dress suits.

If no services are provided, the income will be deemed passive. Income received from the dry lease of aircraft is considered passive, but amounts received from the full-service charter of an aircraft are not passive. Amounts received from either short-term or long-term automobile leases were not passive income where maintenance, repair, and other significant services were provided.

Again, the presence of significant services was critical to the designation of warehouse rentals. Generally, payments for the warehousing of goods will not be passive income. However, where the renter was entitled to specific space for a fixed term and did its own storing, loading, and unloading, the payments were deemed rent.

From the above discussion, it is apparent that to have any share of income considered non-passive, a significant level of services must be performed, well above the level of incidental services. Further, the courts and the IRS appear to apply stricter criteria to long-term rents than to such short-term rentals as dress suits.

"Gross receipts" are not the same as gross income. Gross receipts are similar to gross sales, as they are defined as the total amount received or accrued from sales, services, or investments before reductions for cost, returns, and allowances.

Example 2. Johnson, Inc. had gross sales of $80,000, returns and allowances of $1,500, and cost of sales of $32,000. It also had gross rental income of $25,000, and receipts from the sales of two stocks, stock A$10,000 with a cost of $12,000, and stock B-$7,000 with a cost of $4,500. The gross receipts would amount to $80,000 from sales, $25,000 from rents, $7,000 from the stock sold at a gain, but nothing from stock A sold at a loss. Total gross receipts would be $132,000. If the rent is passive income, then the corporation has excess passive income for the year.

Penalty Tax on Excessive Passive Income

As previously mentioned, the presence of excessive passive income can result in the loss of S status. However, in addition, a penalty may be imposed on S Corporations with excessive passive income. The tax is imposed in any taxable year in which at year's end an S Corporation has earnings and profits accumulated from "C" years, and in which gross receipts exceed 25% of passive investment income. Thus, a corporation which has always been an S Corporation is not subject to this tax. The amount subject to tax (the excess net passive income) is computed as follows:

EXCESS NET PASSIVE INCOME =

Passive investment Income

in Excess of 25% of Gross

Receipts for the Year

________________________ X Net Passive Income

Passive Investment Income

The amount subject to tax is limited to the taxable income. The terms gross receipts" and "passive investment income" have the same meanings as in Sec. 1362 (relating to loss of S status if the corporation has excess passive investment income). "Net passive income" equals passive investment income less deductions directly connected with the production of such income (not including the dividends received deduction and the net operating loss deduction).

Example 3. Garbo, Inc., an S Corporation, has $100,000 accumulated earnings and profits from C years. During the year it had gross receipts from its business of $150,000, dividends of $60,000, and interest income of $40,000. Deductions attributable to the dividend and interest income amounted to $5,000. Excess net passive income (ENPI) is as follows:

ENPI =

(60,000 + 40,000) - .25 (150,000 + 60,000 +

40,000) x (100,000 - 5,000)

___________________________________________

100,000

= $35,625

The tax would be $35,625 x .34 = $12,112.5.

Tax Tips and Pitfalls

As is true of the tax on built-in gains, the excess passive income tax is levied at punitive rates. Some possible strategies to avoid its implementation are:

1. Securities that have built-in losses could be sold and the proceeds distributed to the shareholders.

2. Savings accounts could be used to purchase municipal bonds or low- yielding common stocks.

3. If an S election is contemplated, excessive passive income is anticipated, and accumulated earnings and profits are not too large, one should consider distributing the E&P before the election.

4. If a new corporation is being formed and excessive passive income is likely, an S election could be made immediately.

5. Since the amount taxed is limited to the taxable income, realizing Sec. 1231 losses may be appropriate if there will be excessive passive income.

6. If there is a sufficient balance in the corporation's accumulated adjustable account (AAA), the corporation may be able to distribute the assets giving rise to the passive income. However, if the assets have appreciated, taxable income will flow through to the shareholders.

7. It may be possible to increase gross receipts by accelerating the recognition of sales or by increasing advertising or decreasing prices. To the extent that gross receipts are increased, the likelihood of having excessive passive income is lessened.

Conclusion

Excessive income has no impact on corporations which have always had S status, but it can drastically affect corporations with earnings and profits from C years. Hence, the corporation should plan to reduce its passive income so that it does not exceed 25% of gross receipts. The corporation should avoid dry leases, but instead should structure rental activities so that a significant level of service is provided.