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Avoiding involuntary termination of S status from excess passive investment income.



Facts: Parks Square, Inc. is a C corporation whose sole asset is a 12-year-old office building; Gene Parks is the corporation's sole shareholder. His retail proprietorship is the primary tenant in the building, although there are four other businesses that also pay rent to the corporation. Parks Square renders no significant or extensive services in connection with its rental operation, and leases space only on a "net lease" basis. The corporation has consistently operated near the breakeven breakeven

1. The level of output or sales necessary to cover fixed expenses. Companies in industries that have high fixed costs and, consequently, high breakevens, such as automobile and steel manufacturing, are likely to exhibit large fluctuations
 point in its tax returns. The building and various improvements are being depreciated Depreciated may refer to:
  • Depreciation, in finance, a reference to the fact that assets with finite lives lose value over time
  • Depreciated is often confused or used as a stand-in for "deprecated"; see deprecation for the use of depreciation in computer software
 on the straight-line method Noun 1. straight-line method - (accounting) a method of calculating depreciation by taking an equal amount of the asset's cost as an expense for each year of the asset's useful life
straight-line method of depreciation
, with the annual depreciation expense about equal to the mortgage principal payments. However, the interest expense deductions are gradually declining, and a portion of the depreciation deduction will drop off within a year or two. Gene knows the corporation will begin to generate taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer.  soon, and when the mortgage is paid off, there will be significant cashflow in the corporation. Gene was about to liquidate To pay and settle the amount of a debt; to convert assets to cash; to aggregate the assets of an insolvent enterprise and calculate its liabilities in order to settle with the debtors and the creditors and apportion the remaining assets, if any, among the stockholders or owners of the  the corporation until his attorney explained the excessive tax cost that would be incurred on liquidation The collection of assets belonging to a debtor to be applied to the discharge of his or her outstanding debts.

A type of proceeding pursuant to federal Bankruptcy
 (because of the high appraised value An appraised value (USA) or mortgage valuation (Australia) pertains to the assessed value of real property in the opinion of a qualified appraiser or valuer. It is usually used as a pre-qualification & risk-based pricing factor related to the issuance of mortgage loans by a  of his building). The attorney suggested that an S election would solve the problem, by allowing Gene to withdraw the corporate net income as tax-free distributions without incurring double taxation or payroll tax Payroll Tax

Tax an employer withholds and/or pays on behalf of their employees based on the wage or salary of the employee. In most countries, including the U.S., both state and federal authorities collect some form of payroll tax.
 on salaries. The attorney has filed the S election for Parks Square for the current calendar year. As the corporation now approaches the end of its first S year, the attorney has referred Gene to a tax adviser for further assistance. The tax adviser notes that accumulated earnings and profits (AE&P) at the time of conversion from C to S status were $5,000. Issue: Is Parks Square in danger of losing its newly elected S status because of its passive rental income Noun 1. rental income - income received from rental properties
income - the financial gain (earned or unearned) accruing over a given period of time
?

Analysis

Under certain circumstances, an S corporation may face two problems from having passive investment income (PII See Pentium II. ): (1) imposition of a separate corporate-level tax on excess passive income and (2) eventual termination of S status if excess passive income is received for three consecutive years.

Parks Square had AE&P at the close of its status as a C corporation. Because of this, the corporation will incur a tax at the top corporate rate (35%) if it has more than 25% of its gross receipts the total of the receipts, before they are diminished by any deduction, as for expenses; - distinguished from net profits.
- Bouvier.

See under Gross,

a. os>

See also: Gross Receipt
 from PII while it is in S status. The sources of PII that trigger this tax include rents, as well as dividends, interest, royalties, annuities and gain on sales or exchanges of stock or securities. Under Regs. Sec. 1.1362-2(c)(5)(ii)(B), rent does not include rents derived in the active trade or business of renting property. Rents are "derived in an active trade or business of renting property" only if the corporation provides significant services or incurs substantial costs in the rental business. Whether significant services are performed or substantial costs are incurred is determined based on the facts and circumstances, including (but not limited to) the number of persons providing services and the types and amounts of expenses incurred.

Unfortunately, Regs. Sec. 1.1362-2(c) (5)(ii)(B) specifically states that significant services are not rendered and substantial costs are not incurred in connection with net leases. Because Parks Square leases space only on a "net lease" basis (and because Parks Square performs no significant services), it will be subject to the tax on PII.

While this tax might be nominal in the short term, there may be a serious risk of termination of S status because of the combination of PII and AE&P. A corporation's S status terminates at the beginning of the fourth year if it has both earnings and profits at the close of each of three consecutive tax years and more than 25% of its gross receipts for each of those tax years from PII. (This is essentially the same definition used to figure the tax on excess net passive income under Sec. 1375.) However, to violate the three-year rule and cause termination, it is not actually necessary for a corporation to have incurred the passive income tax, but only that the corporation had more than 25% of its gross receipts from PII. (The tax may not have been incurred if, for example, deductions attributable to passive sources exceeded the PII.)

The tax adviser advises Gene of the dual risks of both the tax on PII and the termination of S status that would occur after three years. The termination would be effective as of the first day of the tax year beginning after the third consecutive tax year in which PII exceeded 25% of gross receipts. Accordingly, the corporation could operate under S status for a three-year period, although it would annually face the risk of the excess PII tax.

The tax adviser notes that the AE&P is relatively nominal (only $5,000) and recommends that Parks Square declare a dividend to extract its subchapter C earnings and profits. This would negate ne·gate  
tr.v. ne·gat·ed, ne·gat·ing, ne·gates
1. To make ineffective or invalid; nullify.

2. To rule out; deny. See Synonyms at deny.

3.
 the risk of the annual excess PII tax under Sec. 1375, as well as the risk of termination of S status under Sec. 1362. Both of these restrictive rules apply only if the corporation has AE&E

Because the corporation is now in S status, any distribution normally would first come out of its accumulated adjustments account (AAA AAA: see American Automobile Association.


(Triple A) A common single-cell battery used in a myriad of electronic devices of all variety. Like its double A (AA) cousin, it provides 1.5 volts of DC power. When used in series, the voltage is multiplied.
) and would not be considered a dividend. This framework makes it difficult for Parks Square. To make a dividend distribution, it must first distribute enough funds to exhaust its AAA before it is considered to have distributed AE&E

However, there is a special election under which shareholders can consent to have distributions considered to come from AE&P before being considered a distribution from the AAA. The tax adviser recommends that Parks Square issue a check for $5,000 as a dividend to Gene (or declare a "deemed dividend" distribution, if cash is scarce). In preparing the initial S tax return, the tax adviser will include an election to have the $5,000 distribution applied first from AE&P and then from AAA. The individual shareholders who receive distributions must sign a consent to this corporate election. (A second election statement to "bypass" previously taxed income (PTI PTI - Portable Tool Interface ) should also be filed for any shareholder with PTI from a pre-Subchapter S Revision Act year (i.e., before 1983).)

The individual shareholder, Gene, will be required to report the $5,000 dividend as ordinary income, but this represents a small price for removing the corporation from the risk of both the passive tax and termination of S status because of excess passive gross receipts.

As a final point, the tax adviser would also caution Gene about the need to draw reasonable compensation from the corporation. In Rev. Rul. 74-44, the IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws.  ruled that distributions from an S corporation in lieu of Instead of; in place of; in substitution of. It does not mean in addition to.  adequate salaries would be treated as wages for payroll tax purposes. However, Parks Square holds only a rental building and renders no significant services, indicating that only minimal officer compensation may be required.

Conclusion

An S corporation risks termination of S status if it has both C corporation AE&P and PII exceeding 25% of gross receipts for three consecutive years. For Parks Square, this is not an insurmountable risk. To alleviate it, the corporation should make an elective distribution to remove the AE&P built up during the years of C status. By making this one-time dividend distribution, Parks Square has assured itself of avoiding both the risk of termination from excess passive gross receipts, as well as the annual risk of double taxation due to excess passive net income.

Editor's note Editor's Note (foaled in 1993 in Kentucky) is an American thoroughbred Stallion racehorse. He was sired by 1992 U.S. Champion 2 YO Colt Forty Niner, who in turn was a son of Champion sire Mr. Prospector and out of the mare, Beware Of The Cat.

Trained by D.
: This case study has been adapted from "PPC See Pocket PC, PowerPC and pay-per-click.

PPC - PowerPC
 Tax Planning Tax planning

Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer.
 Guide--S Corporations," 13th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, TX 1999.

Albert B. Ellentuck, Esq.

Of Counsel King and Nordlinger, L.L.P. Arlington, VA
COPYRIGHT 2000 American Institute of CPA's
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Title Annotation:case study; S corporation status
Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Apr 1, 2000
Words:1313
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