Avoiding S corporation tax on investment income.

• Author: O'Connell, Frank J., Jr.

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.

Strategies

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...