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

• Author: Stone, Howard A.

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...