Calculating the effects of exempt income on the excess net passive income tax.

Facts

Janco is an S corporation reporting on a calendar year. The corporation was formerly a C corporation and has accumulated earnings and profits (AE&P) from a prior C year. During the most recent calendar year, the corporation realized the following income items: $50,000 of gross receipts from operations; $50,000 of exempt interest income; and $25,000 of operating expenses.

Issue

Is Janco subject to the tax on excess net passive income, even though the only item of passive investment income is exempt from taxation?

Analysis

The definition of passive income for purposes of the tax on excess net passive income includes exempt interest income. Therefore, although exempt interest is excluded from gross income for purposes of computing taxable income, it is considered to be passive income for purposes of the tax on excess net passive income.

The tax on excess net passive income is imposed on the lesser of taxable income or excess net passive income.

The determination of excess net passive income begins with passive income minus 25% of gross receipts, divided by passive income; this amount is then multiplied by net passive income.

Janco's taxable income is $25,000 ($50,000 gross receipts from operations -- $25,000 operating expenses); its gross receipts total $100,000 ($50,000 of receipts from operations + $50,000 of exempt interest).

Thus, Janco's excess net passive income is $25,000 ([($50,000 - (25% x $100,000)) [divided by] $50,000] x $50,000).

The tax on excess net passive income is imposed at the maximum corporate tax rate on the lesser of excess net passive income (as determined above) or taxable income for the year. In Janco's case, the taxable base is $25,000 under either alternative.

The tax will be 35% of $25,000, or $8,750. The shareholder passthrough will be reduced by the tax paid at the corporate level.

Conclusion

Although Janco has no source of passive investment income other than the exempt interest, the tax on excess net passive income will apply.

In general, tax-exempt bonds are not very good investment choices for S corporations with AE&P. In addition to the corporate level tax on excess net passive income, exempt income may have other harmful effects on tax planning. Exempt income passed through to shareholders increases their bases, but does not increase the accumulated adjustments account. This means that AE&P must be distributed before exempt income can be distributed free of tax.

The tax adviser may want to suggest that the tax-exempt bonds be sold or distributed to shareholders. (However, distribution of appreciated property may cause gain to be recognized at the corporate or shareholder levels.)

Variation

Assume that Janco's total gross receipts are from interest on tax-exempt bonds. In that case, there is no tax on excess net passive income because the taxable income, computed under the C corporation rules, is zero. Thus, exempt income can be subject to the tax on excess net passive income only if there is other (taxable) income.