S Corporation Tax on Excess Net Passive Income
- S Corp Expert
- Jun 27
- 3 min read
If you're working with S that were converted from C Corps, you need to be aware of the problem with excess net passive income tax.
This often-overlooked provision can trigger significant tax liability and potentially jeopardize an S corporation’s status if left unchecked.
Let’s break down when this tax applies, what counts as passive income, how the tax is calculated, and what red flags might alert you to a potential issue.
When Does the Excess Net Passive Income Tax Apply?
Under IRC § 1375, an S corporation may be subject to a tax on excess net passive income 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
Passive investment income exceeds 25% of the corporation’s gross receipts for that year
IRC § 1375
Treas. Reg. § 1.1375-1
Citations:
What Is Passive Investment Income?
Per IRC § 1375(b)(3) and IRC § 1362(d)(3)(C), passive investment income includes:
Dividends
Interest
Royalties
Rents
Annuities
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 (see Treas. Reg. § 1.1362-2(c)(5)(ii)(B)).
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capital gains from the sale or exchange of stock or securities were once considered passive income, but this rule was repealed for tax years beginning after May 26, 2007.
Net Passive Income Defined
"Net passive income" simply means passive income minus the expenses directly associated with generating that income.
What Counts Toward Gross Receipts?
Gross receipts for the S corporation include all income from its own operations, plus its share of gross receipts from any flow-through entities, such as partnerships.
For example:If an S corporation owns 40% of a partnership that reports $1,000,000 in gross receipts and $1,000 of ordinary income, the S corporation would report only $400 of ordinary income for tax purposes, but it must include $400,000 of gross receipts (40% of $1,000,000) when computing the 25% passive income threshold.
How Is the Excess Net Passive Income Tax Calculated?
If passive income exceeds 25% of gross receipts, the tax is applied to a portion of the net passive income. Here's the calculation formula:
Excess Net Passive Income
= (PassiveInvestmentIncome–25(Passive Investment Income – 25% of Gross Receipts) ÷ Passive Investment Income(PassiveInvestmentIncome–25 × Net Passive Income
Then, the tax on excess net passive income is:
Lesser of: Excess net passive income, or Taxable income computed as if a C corporation × the corporate tax rate (21% for tax years beginning on or after January 1, 2018; 35% for prior years)
Example: Tracy Corporation
Let’s walk through a simplified example:
Passive investment income: $40,000
Passive expenses: $10,000
Net passive income: $30,000
Total gross receipts: $100,000
Since 25% of gross receipts = $25,000, Tracy Corporation has excess passive income of:
($40,000 – $25,000) ÷ $40,000 × $30,000 = $11,250
Applying the 21% corporate tax rate:
$11,250 × 21% = $2,363 tax on excess net passive income
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.
So yes — this tax issue isn’t just a nuisance. It’s a potential S corporation killer.
Red Flags to Watch For
You should be on alert when:
Interest, dividends, royalties, capital gains, or rental income exceed 25% of gross receipts, and
There is evidence of C corporation AE&P
Possible indicators of AE&P include:
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.
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 your clients and minimizing risk.
Make sure you’re not just looking at income statements — dig into gross receipts, flow-through entity ownership, and historical C corporation data. As always, proper documentation and a proactive approach will help avoid costly surprises.
Citations:
IRC § 1375
Treas. Reg. § 1.1375-1
