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Avoiding S corporation tax on investment income.

Sec. 1375 imposes a tax on S corporations that have passive investment income (PII) when the corporation has (1) accumulated earnings and profits (E&P) at the close of a tax year; and (2) gross receipts, more than 25% of which are PII (i.e., royalties, rents, dividends, interest, annuities and net gains on sales or exchanges of stock in securities). To avoid the Sec. 1375 tax, S corporations must ensure that they do not meet at least one of these two characteristics.


The permanent way to eliminate the problem is not to have E&P at year-end, by distributing all accumulated E&P. Sec. 1368(e)(3)(A) provides that an S corporation may elect, with the consent of all affected shareholders, to make distributions from E&P first, rather than from an accumulated adjustments account. Although the decrease in the tax rate on dividends provided by the Jobs and Growth Tax Relief Reconciliation Act of 2003 has made this alternative more attractive, it is not necessarily the optimal choice for many corporations.

The next alternative is to minimize excess net passive income (ENPI), as defined in Sec. 1375(b)(1).The PII tax is imposed on ENPI. To reduce ENPI, the S corporation must increase its total gross receipts in proportion to its passive income. In Letter Ruling 200309021, the IRS illustrates how to accomplish this objective without drastically changing the entity's capital structure.

In the ruling, the taxpayer, shortly after incorporating and electing S status, purchased ownership interests in three publicly traded limited partnerships (PTLPs). These PTLPs met the Sec. 7704 qualifying income exception and, thus, were not treated as corporations for Federal income tax purposes.

Under Sec. 702, the character of any item of income, gain, loss, deduction or credit included in a partner's distributive share is determined as if the item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.

Regs. Sec. 1.702-1(a)(8)(ii) requires each pamper to take into account separately any partnership item which, if separately taken into account by any partner, would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately.

The IRS pointed to Rev. Rul. 71-455, which involved an S corporation that operated a business in a joint venture with another corporation. That ruling held that under Sec. 702(b), the character of the gross receipts generated by the joint venture in which it invested was not converted into PII on their allocation to the S corporation.

Similarly, in Letter Ruling 200309021, the Service held that the taxpayer's distributive share of the PTLPs' gross receipts, if separately taken into account, might affect its Federal income tax liability. Thus, under Regs. Sec. 1.702-1(a)(8)(ii), the S corporation had to take into account separately its distributive shares of the PTLPs' gross receipts. The character of these partnership receipts for the S corporation will be the same as that of the partnership receipts for the PTLPs.

Thus, the IRS concluded that the S corporation's distributive share of the PTLPs' gross receipts will be included ha the S corporation's gross receipts for Secs. 1362(a) and 1375(a) purposes; further, its distributive share of the PTLPs' gross receipts attributable to the purchasing, gathering, transporting, trading, storage and resale of crude oil, refined petroleum and other mineral or natural resource will not constitute PII as defined by Sec. 1362(d)(3)(C)(i).


As the ruling illustrates, an S corporation with E&P does not have to avoid investment-type income to avoid the Sec. 1375 tax. Instead, by choosing a different entity type, it can maintain diversified business holdings and keep PII below the 25% threshold.

An S corporation that wants to earn investment type income without increasing its PII should consider investing in publicly traded partnerships that generate active trade or business income. Because of the Sec. 702 and Regs. Sec. 1.702-1 lookthrough rules, the investment income would not bedeemed PII and, thus, would decrease the percentage of PII in relation to gross receipts. This could allow an S corporation to avoid the Sec. 1375 tax, as well as the Sec. 1362 termination-of-election provisions.

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Author:O'Connell, Frank J., Jr.
Publication:The Tax Adviser
Date:Sep 1, 2003
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