S Corporations with earnings and profits.

• Author: Traum, Sydney S.

Under current tax law, an S corporation cannot produce earnings and profits (E&P). However, if the S corporation itself was previously a C corporation, it may have accumulated E&P from years when it was a C corporation. Similarly, if an S corporation was a party to a tax-free reorganization with another corporation that had accumulated E&P, the S corporation may have inherited the other corporation's accumulated E&P. S corporations that have accumulated C corporation E&P have both problems and opportunities. This article examines both of these, explores solutions to the problems, and discusses the opportunities.

Possible Problems

There are two possible problems that an S corporation with E&P may have: (1) the Sec. 1375 passive investment income tax (sometimes called the sting tax) and (2) the possible loss of S corporation status.

If the gross passive investment income (interest, dividends, certain types of rent, etc.) exceeds 25% of gross receipts, the corporation may be subject to the tax on its net passive investment income (gross passive investment income minus expenses of earning that income). This is not a problem if the S corporation has no accumulated E&P. However, if it does have both E&P and excess passive investment income, Some of the excess net passive investment income may be subject to the sting tax at the highest corporate income tax rate. The tax will not apply to a year in which there is no taxable income. Furthermore, the IRS can waive this tax if the corporation mistakenly determined that it had no E&P and it distributes the E&P within a reasonable time after its discovery. (1) The request to waive the passive investment income tax is made to the IRS in the district where the Form 1120S, U.S. Income Tax Return for an S Corporation, was filed.

Even if there is no taxable income and the passive investment income tax does not apply, if the S corporation has both E&P and excess passive investment income for three consecutive tax years, the S corporation status will be lost on the first day of the fourth tax year. (2)

However, the IRS may allow S corporation status to continue if convinced that the termination of S corporation status was inadvertent. (3) To obtain this relief, the corporation must submit a private letter ruling request to the IRS National Office in Washington, DC. The IRS has been reasonable in granting this type of relief. (4)

Possible Solutions to Problems

These problems exist only if the S corporation has...