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

• Author: Ellentuck, Albert B.

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...