Avoiding the 25% passive gross receipts problem by using a stock redemption to remove excess investments.

• Author: Ellentuck, Albert B.

Facts: Jack Excesso Corp. has been operating a highly successful manufacturing business that produces a unique automotive equipment item. This product has a limited market life. The company now finds the sales of this product dropping, primarily because the major automobile manufacturers now include a similar item as original equipment on new vehicles. Excesso anticipated the limited life span of its primary product and invested its profits from this product while developing new ones.

The corporation was originally a regular C corporation and has substantial accumulated earnings and profits (AE&P). The corporation elected S status 12 years ago and now files as a calendar-year S corporation.

Excesso's stock is held equally by five family members (father, mother and three children). Each shareholder has a $100,000 stock basis. The father and two of the children are active in the business; the mother and one child have been passive investors since making their initial investment a number of years ago.

Excesso is advised by its tax adviser that it faces a risk of excessive passive receipts. As sales have declined, the corporation's investment income is projected to exceed 25% of gross receipts for the tax year. Excesso's accumulated adjustments account (AAA) is zero, because it distributed all current net income following its conversion to S status. Issue: How might a stock redemption be structured to eliminate the tax on excess net passive income (ENPI)?

Analysis

An S corporation faces a corporate-level tax at the top corporate rate (currently 35%) on its ENPI. An S corporation is subject to this tax if it meets two criteria:

1. The entity has AE&P as of the close of its current S tax year.

2. More than 25% of the corporation's gross receipts are from passive invest-merit income (PII).

According to Sec. 1375(b)(1)(A), the corporation's NPI subject to the top corporate tax rate is determined by the ratio of PII in excess of 25% of gross receipts divided by PII for the tax year. The corporation can avoid this tax if it maintains a ratio of passive receipts to gross receipts of 25% or less. As a further strategy, the ENPI subject to tax is limited to the corporation's current-year taxable income; if the corporation has no taxable income for the current year, the passive income tax is not applicable, according to Sec. 1375(b)(1)(B).

ENPI carries a significant additional risk, in that it may eventually cause termination of S status. When an entity...