Avoid Passive Income! The S Corp Passive Income Rules

S corporations (S corps) are a popular choice for many small businesses due to their tax benefits and liability protection. However, one of the key factors to consider when opting for an S corp is its passive income rules. These rules can significantly impact the tax status of your business, especially if a large portion of your income comes from passive sources such as rental properties or investments.

In this post, we’ll break down the S corp passive income rules, why they matter, and how to navigate them to ensure your business remains compliant with IRS regulations. 

What is Passive Income?

Before diving into the specifics of the S corp rules, it’s important to understand what qualifies as passive income. The IRS generally categorizes income as passive if it comes from activities in which you do not materially participate. Common examples include:

• Rental Income: Earnings from leasing real estate properties.
• Dividends: Earnings from investments in stocks.
• Interest Income: Earnings from bonds, savings accounts, or loans made to others.
• Royalties: Earnings from intellectual property or natural resources.

The S Corp Passive Income Limitation

S corps must be careful with the amount of passive income they generate. The IRS imposes strict rules to prevent S corps from becoming passive investment vehicles, which include:

• 3 Year Excessive Passive Income Test: If an S corp has accumulated earnings and profits (E&P) from when it was a C corporation, it cannot have more than 25% of its gross receipts come from passive income for three consecutive years. If this limit is exceeded, the IRS revokes the S corp’s tax status and converts it back to a C corporation, which is subject to double taxation.

• Accumulated Earnings and Profits (E&P) “Sting” Tax: Not all S corps have E&P, which only exists if the company was once a C corporation or received E&P through a merger or acquisition. If your S corp has no E&P, the passive income rules do not apply. However, if it does, exceeding the 25% passive income threshold leads to an additional tax, referred to as the “sting tax”. 

Why These Rules Matter

The primary reason for the passive income rules is to prevent shareholders from using S corps purely as holding companies for passive investments while enjoying the tax benefits meant for active businesses. By imposing these limitations, the IRS ensures that S corps are primarily used for active income-generating businesses.

Navigating the S Corp Passive Income Rules

If you’re a real estate investor or business owner considering or already using an S corp structure, it’s crucial to understand how these rules apply to your situation:

1. Monitor Your Income Sources

   • Regularly review your income streams to ensure that passive income does not exceed 25% of your gross receipts if your S corp has E&P. This is especially important if you have rental properties or other passive investments under the S corp.
     
     

2. Consider Reclassifying Your Business Activities

   • If your S corp is approaching the 25% threshold, you might need to consider reclassifying some activities as active rather than passive. For instance, materially participating in the management of rental properties might help categorize that income as active.
     
     

3. Distribute Earnings and Profits

   • If your S corp has accumulated E&P, consider distributing them to shareholders, which can reduce the risk of triggering the excessive passive income tax. Consult with a tax advisor to determine the most tax-efficient way to do this.
     
     

4. Evaluate Other Business Structures

   • If passive income is a significant portion of your business, it might be worth considering other structures like Limited Liability Companies (LLCs) or partnerships, which do not have the same passive income restrictions as S corps.
     
     

5. Regularly Consult with a Tax Professional

   • The rules surrounding passive income and S corps can be complex and are subject to change. Working with a knowledgeable tax professional ensures you stay compliant and make informed decisions that benefit your business.

Conclusion

Understanding the S corp passive income rules is essential for any business owner or real estate investor considering this structure. While the tax benefits of an S corp can be significant, navigating the passive income limitations requires careful planning and ongoing monitoring. By staying informed and proactive, you can maximize the benefits of your S corp while avoiding potential pitfalls.

The regulatory and compliance aspects of an S corp may seem daunting, but S Corp Advantages takes care of all of this for you, so you can save on taxes and focus on growing your business.