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S corporation planning after discontinuing active trades or businesses (or penalty taxes to be wary of).

As a result of changes made by the Tax Reform Act of 1986, many regular corporations (C corporations) have elected S status. A number of these companies had significant earnings and profits (E&P) at the time of their conversions. Normally, accumulated earnings and profits (AE&P) are not a problem while the corporation is in an active trade or business. However, once an S corporation with AE&P discontinues (or substantially curtails) its business activity, there are a number of provisions that prohibit the corporation from continuing to produce passive investment-type income without incurring some penalty-type of tax.

Passive investment income tax

One penalty-type tax an inactive S corporation will probably encounter is the passive investment income tax. Under Sec. 1375, a corporate-level tax is imposed on the excess passive investment income of S corporations that have subchapter CE&P and gross receipts more than 25% of which are passive investment income. The corporate-level tax is imposed at the highest corporate tax rate (35% under the Revenue Reconciliation Act of 1993).

For purposes of Sec. 1375, gross receipts include tax-exempt interest. Generally, passive investment income includes dividends, interest, rents, royalties, annuities and gains from the sale or exchange of stock or securities. Income from the rental of real property is classified as passive unless significant services are performed and the services are rendered to the occupant of the property in return for rental payments (Prop. Regs. Sec. 1.1362-3(d)(5)(ii)(b)(2)). The furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, and the collection of trash are not considered services rendered to an occupant (Prop. Regs. Sec. 1.1362-3(d)(5)). Therefore, it would appear that the rents from commercial property would normally be considered passive income.

The term "excess net passive income" is equal to net passive income for a tax year multiplied by a fraction, the numerator of which is passive investment income in excess of 25% of gross receipts and the denominator of which is the amount of passive investment income. However, the amount of excess net passive income for any tax year is generally limited to the corporation's taxable income before special deductions and net operating loss deductions for the year.

Example 1: Corporation X has $3,000,000 of tax-exempt income and $600,000 of passive rental income for a tax year; the passive income is net of deductions related to such income. Excess net passive income equals $2,700,000:

$3,600,000 x /3,600,000-(25% x 3,600,000)/$3,600,000/

However, this amount would be limited to X's taxable income of $600,000 for purposes of the passive investment income tax.

Two methods of reducing or eliminating the passive investment income tax are investing in tax-exempt securities and/or having a deferred compensation plan in place to reduce taxable income. This tax can also be avoided by producing gross receipts of which less than 25% are from passive investments. This can be done by investing in an active business that generates gross receipts at least three times the amount of passive receipts. The shareholders would not necessarily have to be active in the new business. For example, a company could purchase an interest in a that generates gross receipts from an active business. The company would compute its gross receipts with respect to the partnership interest by taking into account its distributable share of the partnership's gross receipts (Rev. Rul. 71-455). From a practical standpoint, the company would need to insure that it would have access to the partnership's gross receipts information in order to determine its exposure to the passive investment income tax under Sec. 1375.

Alternatively, a company could get involved in the active business of lending and finance. This type of business may require less shareholder time and produce suitable rates of return with commensurate risk. Another technique that will prove helpful in some situations is the sale of the original business on an installment basis. The proceeds from the sale of inventory and gain on capital assets will be treated as nonpassive (active) gross receipts. Generating enough active business income to avoid the passive income tax also provides the benefit of keeping the corporation's S status alive.

S status

Under Sec. 1362(d)(3), a corporation's S status is terminated when it has subchapter C E&P at the close of each of three consecutive tax years, and has gross receipts for each of such tax years more than 25% of which are passive investment income. Passive investment income under Sec. 1362 is defined the same as passive income under Sec. 1375.

As previously stated, S status can be maintained if a company invested in an active business that generated sufficient gross receipts such that passive investment income was less than 25% of gross receipts. ff a company's S status were to terminate, it would become a regular C corporation. A company would have one year from the time of S termination to make distributions of its accumulated adjustments account (AAA). Note that tax-exempt income does not increase the AAA such that those earnings could not be distributed tax free when prior C corporation E&P exists. After the loss of S status the company must beware of the personal holding company (PHC) rules.

Special C corporation taxes

If a company were to become a C corporation either by voluntarily terminating its S status or by terminating according to Sec. 1362(d), it could be subject to the PHC tax under Sec. 541. The PHC tax is equal to 39.6% of undistributed personal holding company income. If at least 60% of adjusted ordinary gross income for a tax year is PHC income, the company will be subject to the PHC tax. PHC income includes dividends, interest, royalties, annuities, rents, etc. However, rental income is not included if the rental income constitutes 50% or more of adjusted ordinary gross income and the sum of the dividends paid for the year is greater than the amount by which PHC income for the year exceeds 10% of ordinary gross income.

Example 2: C corporation Y has $3,000,000 of taxable interest and $1,000,000 of rental income. Y would be subject to the PHC tax because at least 60% of its gross income is PHC income. However, if the interest income were tax-exempt, Y would not be subject to the PHC tax. Taxexempt interest is not included in gross income for PHC tax purposes and the rental income would then constitute more than 50% of the adjusted ordinary gross income. However, while the PHC tax could be avoided in this manner, Y would be subject to the alternative minimum tax (AMT) because the tax-exempt interest would be an accumulated eamings adjustment for AMT purposes.

The PHC tax can also be avoided by investing in an active business that produces sufficient gross income such that PHC income is less than 60% of adjusted ordinary gross income. Similar to the passive investment income tax rules, gross income from a partnership should flow through for the purpose of testing for PHC status.

If the PHC tax is avoided by reducing PHC income such that a company would not be characterized as a PHC, the company may then be subject to the accumulated earnings tax (AET) under Sec. 531. The AET does not apply if a company is a PHC. Both the AET and the PHC tax can be avoided by paying out current year income as dividends to the shareholders. Both the PHC tax and the AET are imposed on a company's taxable income (before net operating loss deductions) with certain adjustments. Thus, these taxes can be reduced or eliminated by deductions for such items as deferred compensation. Note that for both the PHC tax and the AET, the corporation is not allowed the special deduction for dividends received fvom other corporations.

Planning

The best course of action is dependent on a number of factors, including (1) the cost, risk and rates of return of investing in another active trade or business; (2) the rates of return on taxable and tax-exempt securities; (3) shareholders' needs for distributions from the company; (4) the viability of a deferred compensation plan; and (5) changes in tax rates. Careful planning is necessary in order to reduce total tax costs to the company and its shareholders.
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Article Details
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Author:Stone, Howard A.
Publication:The Tax Adviser
Date:Oct 1, 1993
Words:1402
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