Avoiding S Corporation Passive Income Tax

Question: My S corporation, previously a C corporation, has historically received rental income from a real estate property.  Now that the company’s operating business has been sold, can the S corporation passive income tax on rental income be avoided?

Answer:     The tax on S corporation passive income is an exception to the general rule that S corporations are not subject to Federal income tax. S corporations which were previously C corporations which now have income from passive sources may be subject to this tax if they hold undistributed income from years before they became S corporations.

A common means of avoiding the S corporation passive income tax is to pay a dividend to the S corporation shareholders and treat the dividend as a distribution of C corporation earnings.  If the dividend exhausts the undistributed C corporation earnings, the S corporation passive income tax will be avoided. The dividend itself will likely be taxable to the shareholders. You will need to compare the tax savings from avoiding the passive income tax on a prospective basis to the cost of paying tax on the distribution of C corporation earnings.

If your corporation will continue in existence indefinitely, you should consider generating some active business income within the corporation. By way of example, if you perform services as a consultant, you could render these services through the corporation. Since the S corporation passive income tax only arises if passive income exceeds 25% of the corporation’s gross receipts, you may circumvent the tax by creating enough non-passive income within the corporation.

Another option is to distribute the rental property to the corporation’s shareholders. Assuming you want the rental property held in a separate entity for liability protection and other purposes, you could then retransfer the property to a new or existing entity but one which will not be subject to the passive income tax. You might instead liquidate the corporation and transfer all of the corporation’s assets to the shareholders, thereby avoiding having passive income subject to tax at the corporate level.  Bear in mind that the distribution of assets out of a corporation as well as a corporate liquidation are taxable events so you must carefully consider the consequences.

Your situation is an unfortunate one as many people choose to operate their businesses in the S corporation structure to avoid tax at the corporate level. S corporation  income, gains and other tax items flow through to the shareholders and are reported by the shareholders on their personal income tax returns. The passive income tax often comes as a surprise when S corporation assets are sold and the corporation remains in existence receiving income from passive sources.

You should also carefully examine whether the income your corporation is generating truly constitutes passive income. Passive income consists of amounts derived from royalties, rents, dividends, interest and annuities. Although conventional rental income is passive in nature, rents derived from an activity where the S corporation/lessor renders significant services or incurs substantial costs will not be treated as passive income. Significant services may include the active management of a real estate property. Substantial cleaning, repair and other services provided by lessors may also cause income to be categorized as non-passive although the facts and circumstances of each situation must be considered. Of course, rents derived from leased property where a tenant provides all of its own services will usually be treated as passive income. You might consider modifying the leases of your real estate property to impose more significant service obligations on the landlord to avoid passive income classification.  

If your S corporation is potentially subject to passive income tax, you should take a close look at the corporate structure and business arrangement to avoid this imposition. Aside from the tax,  a corporation will forfeit its S corporation election if its passive income exceeds 25% of its gross receipts for three consecutive tax years. As with many undesirable tax situations, however, careful planning can usually avoid the passive income tax problem.


The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.


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