S Corporation Sting Tax
- Hayley Davis
- Jun 27
- 5 min read
Updated: Nov 6
S Corp taxation might not be the most exciting topic, but here you are, reading up on the excess net passive income (ENPI) tax. So, let's cover this issue quickly and as painless as possible.
If an S Corp was converted from a C Corp (and thus it has an AE&P account), you may potentially get into an unpleasant situation - additional tax (which stings!) on passive income. This is something the IRS checks on, especially if amounts are material.
How can the IRS say that the S Corp may have potential ENPI tax, which is worth pursuing in their audit? Well, they look at the following details on the S Corp tax return:
Interest, dividends, royalties, capital gains, or rental income exceed 25% of gross receipts, and
There is evidence of C corporation AE&P
How can anyone guess that AE&P exists without looking at the S Corp tax work-papers? Here are possible indicators of AE&P that the IRS agents are trained to look at:
Form 1120-S, Page 1 shows a large gap between the date of incorporation (Box E) and the effective date of the S election (Box A).
Schedule M-2, Line 1(c) reports a positive balance in accumulated earnings and profits.
A large discrepancy exists between beginning retained earnings (Schedule L, Line 24) and accumulated adjustments account/opening accumulated adjustments (Schedule M-2, Line 1(d)) that can’t be explained by book/tax differences.
Now that I got you officially worried, let's figure out when this tax can apply, how it is calculated and what bad things that can happen to your S Corp if things stay unchanged.
When Does the Excess Net Passive Income Tax Apply?
Under IRC § 1375, an S corporation may be a subject to "the sting tax" if both of the following conditions are met:
The corporation has accumulated earnings and profits (AE&P) at the end of the tax year (usually from prior C corporation years), and
The corporation’s passive investment income exceeds 25% of its gross receipts for that year.
If both conditions apply, a 21% tax is charged on the lesser of the corporation’s taxable income or its excess net passive income. This means that the tax won't apply if an S Corp does not have regular taxable income even if it has lost of passive income.
Let's zoom in on a couple of parts of this formula: let's define passive investment income and the corporation's gross receipts.
Passive investment income:
In the context of this type of tax, passive investment income includes the following types of income:
Dividends
Interest
Royalties
Annuities
Rents
However, there's an important nuance: rental income is not considered passive under IRC § 1375 if the corporation provides significant services along with the rental of tangible property. However, keeping a rental property in an S Corp is never a good idea because of "the trapped assets" problem.
Also noteworthy: capital gains from the sale or exchange of stock or securities were once considered passive income, but this rule was repealed for tax years beginning after May 26, 2007. So, stock dividends may cause trouble. However, selling those stocks should resolve the issue without any adverse consequences.
Another detail: under the classic passive activity rules of IRC §469, dividends and rental losses can never “breed.” However, for the purposes of this tax, dividends and rental income are both considered passive investment income, and you are allowed to offset income from dividends with a rental loss when calculating net passive income under §1375.
The corporation's gross receipts.
For an S corporation, gross receipts include all income from its own business operations plus its share of gross receipts from any partnerships or other flow-through entities it owns.
Example: Suppose an S corporation owns 40% of a partnership. The partnership reports $1,000,000 in gross receipts and $1,000 in ordinary income.
For tax purposes, the S corporation reports $400 of ordinary income (40% of $1,000).
However, you must include $400,000 (40% of $1,000,000) when calculating its total gross receipts.
Key point: Gross receipts are based on total inflows, not profits.
How Is the ENPI Tax Calculated?
Let's take Tracy's Corporation as an example:
Passive investment income: $40,000
Passive expenses: $10,000
Total gross receipts: $100,000
If passive income exceeds 25% of gross receipts, the tax is applied to a portion of the net passive income or taxable income (whatever is less).
Step 1: Check Eligibility for Tax:
In our example: Passive income is $40,000 and it is more than 25% of gross receipts, since 25% of gross receipts is only $25,000 ($100,000 *.25)
Since we clearly now see that we have enough passive income, we can now move to the calculation of the ENPI tax.
Step 2: Calculate Net Passive Income:
Net passive income = Passive investment income – Passive expenses
In our example: Net passive income=40,000−10,000=30,000
Step 3: Calculate Excess Net Passive Income
The formula:
Plug in the numbers:
Step 3: Calculate the Tax:
Assuming the corporation's taxable income is higher than the ENPI of $11,250. the tax is based on the ENPI. 11,250*.21= 2,362.5
Why This Matters: The Termination Risk
Under IRC § 1362(d)(3), an S corporation with AE&P that consistently exceeds the 25% passive income threshold for three consecutive tax years will have its S election terminated on the first day of the fourth year. This is true even if there is no taxable income and "the sting tax does" not apply. So yes — this tax issue isn’t just a nuisance. It’s a potential S corporation killer.
How to Fix the Mess
One common way to avoid the S corporation passive income tax is by paying a dividend to the S Corp shareholders and treating it as a distribution of the old C corporation earnings. If this dividend wipes out the undistributed C Corp earnings, the S Corp passive income tax can be avoided. Keep in mind, though, the dividend itself will likely be taxable to the shareholders. So you’ll want to weigh the potential tax savings from avoiding the ENPI tax against the cost of paying tax on the C Corp distribution.
If your S Corp isn’t going anywhere anytime soon, another approach is to generate some active business income within the corporation. For example, if you provide consulting services, you could run those services through the S Corp. Since the passive income tax only kicks in if passive income exceeds 25% of gross receipts, adding enough active income can help keep you under that threshold and sidestep the tax altogether.
Final Thoughts
The excess net passive income tax is often overlooked until it causes problems — including termination of S status. Understanding the thresholds, accurately categorizing income, and tracking AE&P are crucial steps for protecting the S Corp status of your corporation.
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