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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 point in its tax returns. The building and various improvements are being depreciated on the straight-line method, 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 soon, and when the mortgage is paid off, there will be significant cashflow in the corporation. Gene was about to liquidate the corporation until his attorney explained the excessive tax cost that would be incurred on liquidation (because of the high appraised value 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 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?

Analysis

Under certain circumstances, an S corporation may face two problems from having passive investment income (PII): (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 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 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) 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) 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 ruled that distributions from an S corporation in lieu of 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: This case study has been adapted from "PPC Tax Planning 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
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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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