Can Rental Income Cause an S Corporation to Lose Its S Election? Passive Investment Income Rules
Rental income does not normally cause an S corporation to lose its S election merely because the corporation owns real estate or receives rent.
A much narrower rule applies to certain S corporations that have accumulated earnings and profits from C corporation years and also receive substantial passive investment income.
If an S corporation has accumulated earnings and profits at the end of the taxable year and more than 25 percent of its gross receipts are passive investment income, Section 1375 can impose a corporate level tax for that year.
If those conditions continue for three consecutive S corporation taxable years, Section 1362(d)(3) can terminate the S election beginning on the first day of the following taxable year.
Rental real estate requires additional analysis because rent is included in the statutory definition of passive investment income, but rent derived from an active trade or business of renting property is excluded when the corporation provides significant services or incurs substantial costs in the rental business.
For broader guidance on real estate ownership and tax planning, see my Real Estate Tax Planning resource page.
Key Tax Takeaways
- Rental income does not automatically threaten an S corporation election.
- The special passive investment income rules generally matter only when the S corporation has accumulated earnings and profits.
- An S corporation that has always been an S corporation generally does not create accumulated C corporation earnings and profits merely by retaining S corporation income.
- Passive investment income generally includes rents, royalties, dividends, interest, annuities, and certain gains from stock or securities.
- Rent from an active trade or business of renting property can be excluded from passive investment income.
- The active rental test is based on significant services, substantial costs, and all facts and circumstances.
- The active rental test is not the Section 469 material participation test and does not use the 750 hour real estate professional test.
- Net leases generally present a weaker position under the active rental exception.
- Hiring a property management company does not automatically make rent passive investment income.
- One qualifying year can create Section 1375 tax exposure.
- Three consecutive qualifying years can terminate the S election.
- Eliminating accumulated earnings and profits or breaking the three year sequence can be important planning strategies.
Does Rental Income Automatically Threaten an S Corporation Election?
No.
The passive investment income termination rule is much narrower than many S corporation owners assume.
Section 1362(d)(3) requires two conditions to exist for each of three consecutive taxable years:
- The corporation has accumulated earnings and profits at the close of the taxable year.
- More than 25 percent of the corporation's gross receipts for that year are passive investment income.
If either condition is absent for a taxable year, that year does not satisfy the two part test required for the three consecutive year termination rule.
Most S Corporations With Rental Income Do Not Face This Rule
An S corporation does not generally develop accumulated C corporation earnings and profits merely because it earns income while operating as an S corporation and leaves that income in the business.
The issue is most commonly associated with corporations that previously operated as C corporations or acquired accumulated earnings and profits through certain corporate transactions.
What Are Accumulated Earnings and Profits?
For this purpose, accumulated earnings and profits generally refers to earnings and profits arising from taxable years in which a valid S corporation election was not in effect.
A common fact pattern is a corporation that operated for many years as a C corporation, accumulated earnings and profits, and later elected S corporation status.
The corporation can continue carrying that accumulated earnings and profits balance after the S election.
The balance can also arise in certain corporate acquisitions or reorganizations involving corporations with earnings and profits.
Check the Corporate History Before Analyzing the Rental Income
A current year profit and loss statement does not establish whether accumulated earnings and profits exist.
The analysis can require reviewing prior C corporation returns, prior S corporation returns, Schedule M 2 history, corporate reorganizations, distributions, and prior earnings and profits computations.
Can an S Corporation That Was Never a C Corporation Have This Problem?
An S corporation that has always been taxed as an S corporation generally will not have accumulated C corporation earnings and profits merely because it retained operating profits.
However, corporate history still matters. Certain acquisitions, reorganizations, or other transactions can bring accumulated earnings and profits into an S corporation.
Therefore, the correct question is not simply whether the corporation once filed Form 1120. The corporation's complete tax history should be reviewed when the passive investment income rules may be relevant.
What Counts as Passive Investment Income?
Section 1362(d)(3) generally defines passive investment income as gross receipts derived from:
- Royalties
- Rents
- Dividends
- Interest
- Annuities
- Certain gains from sales or exchanges of stock or securities
The statute and regulations contain additional exceptions and special rules for particular types of income and businesses.
Passive Investment Income Is Not the Same as Passive Activity Income
The word passive is used in both Section 1362 and Section 469, but the two provisions apply different rules for different purposes.
An item can be excluded from passive investment income under Section 1362 while still being passive to a shareholder under the Section 469 passive activity loss rules.
How Does the 25 Percent Test Work?
The threshold is based on gross receipts.
The corporation compares its passive investment income for the taxable year with its total gross receipts for that year.
If passive investment income is more than 25 percent of total gross receipts, the threshold is exceeded.
Exactly 25 percent does not satisfy the statutory phrase more than 25 percent.
Example: Passive Investment Income Exceeds 25 Percent
Assume an S corporation has:
| Item | Amount |
|---|---|
| Total gross receipts | $1,000,000 |
| Passive investment income | $300,000 |
| 25 percent of total gross receipts | $250,000 |
| Passive investment income above threshold | $50,000 |
Passive investment income represents 30 percent of gross receipts, so the corporation exceeds the 25 percent threshold.
If the corporation also has accumulated earnings and profits at the end of the taxable year, Section 1375 must be considered.
Does One Year Above 25 Percent Cause the S Election to Terminate?
No.
This is one of the most important distinctions in the rules.
One year can create a Section 1375 tax. Termination of the S election requires three consecutive qualifying taxable years.
| Consequence | General Requirement |
|---|---|
| Section 1375 tax | Accumulated earnings and profits at year end and passive investment income greater than 25 percent of gross receipts for that taxable year |
| S election termination | Accumulated earnings and profits at the close of each of three consecutive S corporation taxable years and passive investment income greater than 25 percent of gross receipts in each of those three years |
| Termination effective date | First day of the first taxable year beginning after the third consecutive qualifying taxable year |
How Is the Section 1375 Tax Calculated?
The tax is not simply 21 percent of the amount by which passive investment income exceeds 25 percent of gross receipts.
Section 1375 uses an excess net passive income formula.
First, passive investment income is reduced by deductions directly connected with producing that income to determine net passive income.
The corporation then determines the proportion of passive investment income that exceeds the 25 percent threshold:
Passive investment income minus 25 percent of gross receipts, divided by passive investment income
That percentage is applied to net passive income.
Excess net passive income is also limited by the corporation's taxable income calculated under the special Section 1375 rules.
The resulting amount is taxed at the highest corporate income tax rate under Section 11(b), currently 21 percent.
Example: Simplified Section 1375 Calculation
Assume:
| Item | Amount |
|---|---|
| Total gross receipts | $1,000,000 |
| Passive investment income | $300,000 |
| Directly connected expenses | $100,000 |
| Net passive income | $200,000 |
| 25 percent of gross receipts | $250,000 |
| Excess passive investment income | $50,000 |
The excess percentage is $50,000 divided by $300,000, or approximately 16.67 percent.
Applying that percentage to $200,000 of net passive income produces approximately $33,333 of excess net passive income.
Assuming the taxable income limitation does not reduce that amount, a 21 percent Section 1375 tax would be approximately $7,000.
This example is simplified. The actual computation is performed using the Excess Net Passive Income Tax Worksheet and the applicable Form 1120S instructions.
Is Rental Income Always Passive Investment Income?
No.
The regulations begin with a broad rule that rent received for the use of corporate property is rent for purposes of the passive investment income rules.
The regulations then provide an important exception for rents derived in an active trade or business of renting property.
Rent is excluded from passive investment income when, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business.
What Qualifies as an Active Rental Business?
There is no single numerical test.
The regulations direct taxpayers to consider all facts and circumstances, including:
- The number of persons providing services
- The types of services being provided
- The amount and nature of operating costs
- Management activities
- Repairs and maintenance
- Tenant relations
- Leasing activity
- Property inspections
- Renovations and improvements
- Utilities and other operating responsibilities
- Other costs and activities associated with operating the rental business
Depreciation expense is specifically disregarded when evaluating the amount of costs incurred for purposes of this active rental test.
There Is No 750 Hour Test for This Rule
The Section 1362 active rental business exception does not use the real estate professional 750 hour test.
It also does not use the Section 469 material participation tests.
Those rules may be relevant elsewhere on the shareholder's return, but they do not determine whether rent is passive investment income under Section 1362.
Are Triple Net Lease Rents Passive Investment Income?
Net lease arrangements deserve particular attention.
Treasury Regulation Section 1.1362-2 states that significant services generally are not rendered and substantial costs generally are not incurred in connection with net leases.
A lease under which the tenant bears property taxes, insurance, repairs, maintenance, and most other operating costs therefore generally presents a weaker factual position for the active rental business exception.
This does not mean every triple net lease automatically produces passive investment income. The regulation remains a facts and circumstances test.
Review What the Corporation Actually Does
The lease label is not the entire analysis.
The corporation's services, expenses, management responsibilities, tenant involvement, and operational activities should be documented before concluding that rental receipts either are or are not passive investment income.
Does Hiring a Property Manager Make the Rental Income Passive?
Not automatically.
Hiring an outside property manager can still involve substantial rental business costs and significant services performed in operating the corporation's properties.
The complete facts matter, including the scope of the management agreement, the services actually provided, expenses incurred by the corporation, and the corporation's own involvement in managing the properties.
A 2026 IRS private letter ruling provides a useful illustration.
What Did PLR 202614002 Say About S Corporation Rental Income?
In Private Letter Ruling 202614002, the corporation had accumulated earnings and profits and had previously operated a business using real estate that it owned.
The corporation later sold the operating business but retained certain properties and leased them to the buyer.
The corporation incurred operating expenses that included management fees, legal and professional fees, repairs and maintenance, utilities, and mortgage interest.
Its management company performed extensive services involving:
- Tenant communications
- Remodeling and renovation matters
- Supervising renovations
- Building permits and zoning matters
- Finding new tenants
- Negotiating and executing leases and renewals
- Collecting rent
- Enforcing lease obligations
- Property inspections
- Maintenance, landscaping, snow removal, and repairs
Two management company employees were assigned to the corporation's matters.
The shareholders also communicated daily with the management company regarding income, expenses, tenant issues, renovations, and other business matters, and they regularly searched for new properties to acquire and develop.
Based on the submitted facts and representations, the IRS concluded that the rental income was not passive investment income under Section 1362(d)(3)(C)(i).
A Private Letter Ruling Is Not Precedent
PLR 202614002 was issued only to the taxpayer that requested it.
Section 6110(k)(3) provides that a private letter ruling may not be used or cited as precedent.
Its value for other taxpayers is that the factual discussion illustrates how the IRS applied the existing active rental business regulation to one specific set of facts.
Section 1362 Passive Investment Income Is Different From Section 469
The IRS expressly emphasized this distinction in PLR 202614002.
The passive investment income rules of Section 1362 are independent of the passive activity rules under Section 469.
Therefore, rental income can be excluded from passive investment income because the corporation conducts an active rental trade or business while the rental activity can still be passive to the shareholder under Section 469.
Conversely, satisfying a Section 469 material participation test does not automatically prove that rent is excluded under the Section 1362 significant services and substantial costs test.
| Rule | Section 1362 Passive Investment Income | Section 469 Passive Activity |
|---|---|---|
| Primary purpose | Protects S corporation qualification and can trigger Section 1375 entity level tax | Determines whether losses and credits from passive activities are currently allowed |
| Rental test | Significant services or substantial costs in active rental business | Rental activities generally passive unless statutory and regulatory exceptions apply |
| Real estate professional rules | Not the governing test | Can be central to determining whether rental real estate is nonpassive |
| Material participation | Not the regulatory test for excluding rents | Generally required for nonpassive treatment when applicable |
For additional discussion of Section 469, see Suspended Passive Rental Losses: Four Ways Real Estate Investors Can Use Them and Real Estate Professional Status: How Rental Property Owners Qualify and Deduct Losses .
How Does the Three Consecutive Year Termination Rule Work?
The S election termination rule requires the accumulated earnings and profits condition and the greater than 25 percent passive investment income condition to exist for each of three consecutive S corporation taxable years.
Example: Three Consecutive Years
| Taxable Year | Accumulated E&P at Year End | Passive Investment Income Percentage | Result |
|---|---|---|---|
| 2026 | Yes | 31 percent | Potential Section 1375 tax and Year 1 of termination sequence |
| 2027 | Yes | 29 percent | Potential Section 1375 tax and Year 2 |
| 2028 | Yes | 35 percent | Potential Section 1375 tax and Year 3 |
| January 1, 2029 | Three consecutive qualifying taxable years completed | S election terminates beginning on the first day of the new taxable year | |
Can One Clean Year Prevent Termination?
Yes, because the statute requires three consecutive taxable years satisfying both conditions.
Suppose the corporation has qualifying years in 2026 and 2027 but does not satisfy the test in 2028.
That sequence does not produce a termination under the three consecutive year rule.
A later qualifying year begins a new sequence for purposes of counting consecutive years.
Ways a Year May Fail the Termination Test
Depending on the facts, the corporation might:
- Have passive investment income at or below 25 percent of gross receipts
- Establish that rental receipts qualify for the active rental business exception
- Eliminate accumulated earnings and profits before the end of the taxable year
Do Not Wait Until the Third Year to Review the Problem
A corporation approaching the passive investment income threshold should identify the issue while planning options remain available.
Waiting until after three taxable years have closed can turn a manageable earnings and profits issue into an S corporation termination problem.
Can Eliminating Accumulated Earnings and Profits Prevent the Section 1375 Tax?
Potentially, yes.
Treasury Regulation Section 1.1375-1 states that the Section 1375 tax is not imposed if the S corporation has no accumulated earnings and profits at the close of the taxable year, even if passive investment income exceeds 25 percent of gross receipts.
Because the termination rule likewise requires accumulated earnings and profits at the close of each of the three consecutive taxable years, eliminating accumulated earnings and profits can also affect the termination analysis.
Can the Corporation Distribute Accumulated Earnings and Profits?
Yes, subject to the S corporation distribution rules.
An S corporation with accumulated earnings and profits generally has to coordinate its accumulated adjustments account, accumulated earnings and profits, shareholder stock basis, and the ordering rules under Section 1368.
Simply distributing cash does not always mean the first dollars distributed reduce accumulated earnings and profits.
What Is the Election to Distribute Earnings and Profits First?
Section 1368(e)(3) and Treasury Regulation Section 1.1368-1 permit an S corporation with accumulated earnings and profits to elect to treat distributions as coming from earnings and profits before the accumulated adjustments account.
The required shareholder consent and return statement requirements must be satisfied.
When the election applies, distributions attributable to accumulated C corporation earnings and profits generally constitute dividend income to shareholders to the extent required under the applicable distribution rules.
The Election Can Solve One Problem While Creating Current Shareholder Tax
Eliminating accumulated earnings and profits can remove future Section 1375 and S election termination exposure, but distributing accumulated earnings and profits can create dividend income for shareholders.
The current shareholder tax cost should therefore be compared with the future risk of retaining the accumulated earnings and profits.
What Is a Deemed Dividend Election?
Treasury Regulation Section 1.1368-1 also permits an S corporation to elect to distribute all or part of its accumulated C corporation earnings and profits through a deemed dividend.
Under the election, the amount is treated for federal income tax purposes as though:
- The corporation distributed cash to its shareholders in proportion to their stock ownership.
- The shareholders received the distribution.
- The shareholders immediately contributed the same amount back to the corporation.
The deemed transaction occurs on the last day of the corporation's taxable year.
This can eliminate accumulated earnings and profits without requiring the corporation to physically distribute the same amount of cash.
The shareholders can nevertheless recognize dividend income as a result of the deemed distribution.
A Deemed Dividend Is Not a Tax Free Accounting Entry
The absence of an actual cash payment does not prevent the deemed dividend from creating taxable dividend income for shareholders.
The shareholder tax consequences and basis adjustments should be modeled before making the election.
What if the Corporation Has No Accumulated Earnings and Profits at Year End?
If the corporation has no accumulated earnings and profits at the close of the taxable year, the Section 1375 excess net passive income tax generally does not apply for that year.
That year also does not satisfy the accumulated earnings and profits requirement of the three consecutive year termination rule.
The corporation should retain support documenting the earnings and profits computation rather than assuming that a zero balance exists merely because Schedule M 2 does not appear to show a balance.
What Happens if the S Election Terminates?
When Section 1362(d)(3) terminates the election, the corporation generally ceases to be an S corporation beginning on the first day of the taxable year following the third consecutive qualifying year.
The corporation generally becomes subject to C corporation taxation unless another applicable tax status applies.
That can introduce:
- Federal corporate income tax
- Potential shareholder dividend taxation on later corporate distributions
- Transition rules for S corporation accounts
- Changes to shareholder basis reporting
- Additional complexity if the corporation later attempts to reelect S corporation status
An unexpected termination can therefore be materially more expensive than the Section 1375 tax that may have applied during the preceding years.
Can the IRS Grant Relief if the S Election Was Inadvertently Terminated?
Potentially.
Section 1362(f) and Treasury Regulation Section 1.1362-4 allow the IRS to treat an S election as continuing when the IRS determines that the termination was inadvertent and the applicable requirements are satisfied.
The corporation generally must establish the facts surrounding the termination, take corrective steps within a reasonable period after discovery, and agree with the affected shareholders to any adjustments required by the IRS.
Under the regulation, a request for a determination of inadvertent termination generally is made through a ruling request.
Relief Is Not Automatic
The corporation bears the burden of establishing that the termination was inadvertent.
Preventing the termination through annual monitoring is generally preferable to discovering years later that relief must be requested.
Can Section 1375 Tax Ever Be Waived?
Treasury Regulation Section 1.1375-1 contains a limited waiver provision when a corporation determined in good faith that it had no accumulated earnings and profits at the end of the taxable year and later discovers that accumulated earnings and profits did exist.
Among other requirements, the corporation must establish the circumstances to the satisfaction of the IRS and distribute the accumulated earnings and profits within a reasonable period after discovering the issue.
This waiver provision should not be confused with the inadvertent termination relief available under Section 1362(f).
Why Might an S Corporation End Up With Significant Rental Income?
The issue frequently arises because the corporation changes over time.
For example:
- A former C corporation elects S corporation status but retains old earnings and profits.
- An operating company owns its building and later sells the operating business while retaining the real estate.
- A corporation moves from active business operations toward retirement and investment activities.
- A corporation receives increasing interest or investment income as operating activity declines.
- A corporation acquires property or corporate assets carrying accumulated earnings and profits.
In these situations, the percentage of passive investment income can increase even without a large increase in investment receipts because the corporation's active operating gross receipts are declining.
Example: Operating Business Becomes a Real Estate Holding Company
Assume a former C corporation elected S corporation status years ago and still has accumulated earnings and profits.
The corporation sells its operating business but retains a commercial building that it leases to the buyer.
Before the sale, the corporation generated substantial operating gross receipts, so rental and investment income represented only a small percentage of total gross receipts.
After selling the business, rent becomes the corporation's primary source of revenue.
Whether the rent counts as passive investment income can now become critical. The corporation should determine whether its rental operations satisfy the active rental business exception, whether accumulated earnings and profits remain, and whether Section 1375 or Section 1362(d)(3) applies.
Owning Rental Property in an S Corporation Creates Other Tax Issues Too
Avoiding the passive investment income termination rule does not mean an S corporation is necessarily the ideal place to own appreciating real estate.
Appreciated real estate can be difficult to remove from an S corporation because a distribution of appreciated property generally triggers corporate gain under Section 311.
Liquidation, entity classification changes, mortgages, estate planning, and former C corporation status can create additional consequences.
For a detailed discussion, see Rental Property in an S Corporation: Tax Traps, Exit Costs, and Better Alternatives .
What Should an S Corporation With Rental or Investment Income Review Each Year?
An annual review should generally include:
- Whether accumulated earnings and profits exist at the beginning and end of the year
- The source and history of accumulated earnings and profits
- Total gross receipts
- Rental gross receipts
- Interest income
- Dividend income
- Royalty income
- Annuity income when applicable
- Applicable stock and securities gains
- The passive investment income percentage
- Rental services provided
- Rental operating costs other than depreciation
- Property management agreements
- Lease provisions and net lease terms
- Repairs, maintenance, utilities, and tenant services
- Whether the corporation has already had one or two consecutive qualifying years
- Potential Section 1375 tax
- Potential distributions of accumulated earnings and profits
- Whether an E&P first election or deemed dividend election should be evaluated
Document the Rental Operations While the Facts Are Current
If the active rental business exception is important, retain evidence showing the services performed and costs incurred during the year.
Useful documentation can include management agreements, invoices, repairs, maintenance records, utility expenses, tenant communications, lease negotiations, renovation records, inspection records, employee responsibilities, and shareholder management activity.
Planning Before the Passive Investment Income Threshold Becomes a Problem
The appropriate strategy depends on which element of the rule is creating exposure.
If the Rental Income May Be Active
Document the corporation's services and substantial costs and determine whether the rental activity qualifies for the active rental business exception.
If Accumulated Earnings and Profits Remain
Determine the correct E&P balance and model the tax consequences of actual distributions, an election to distribute earnings and profits first, or a deemed dividend election.
If Passive Investment Income Is Near 25 Percent
Recalculate the percentage before year end rather than waiting until the tax return is being prepared.
If the Corporation Is Already in Year Two
The third year deserves particular attention because another qualifying year can cause the S election to terminate beginning with the next taxable year.
Frequently Asked Questions About S Corporation Passive Investment Income
Can rental income terminate an S corporation election?
Rental income can contribute to an S corporation termination under Section 1362(d)(3), but only when the applicable statutory conditions are satisfied. The corporation must have accumulated earnings and profits at the close of each of three consecutive taxable years and passive investment income must exceed 25 percent of gross receipts in each of those years.
Does the passive investment income rule apply to every S corporation?
No. The Section 1375 tax and the Section 1362(d)(3) termination rule require accumulated earnings and profits. Many corporations that have always been S corporations do not have accumulated C corporation earnings and profits.
What are accumulated earnings and profits?
For this purpose, accumulated earnings and profits generally represent earnings and profits from taxable years in which an S election was not in effect. They commonly arise from prior C corporation years and can also arise through certain corporate transactions.
Can an S corporation that was never a C corporation have this problem?
It generally will not create accumulated C corporation earnings and profits merely by retaining S corporation income. However, acquisitions, reorganizations, and other corporate transactions can affect the earnings and profits analysis.
What is the 25 percent passive investment income test?
The corporation compares passive investment income with total gross receipts for the taxable year. The threshold is exceeded when passive investment income is more than 25 percent of total gross receipts.
Does the Section 1375 tax start only after three years?
No. Section 1375 can impose tax for a single taxable year when the corporation has accumulated earnings and profits at year end and passive investment income exceeds 25 percent of gross receipts. Three consecutive qualifying years are required for termination of the S election.
When does the S election actually terminate?
If the requirements are satisfied for three consecutive S corporation taxable years, the election terminates beginning on the first day of the first taxable year following the third consecutive year.
Is rental income always passive investment income?
No. Rents derived from an active trade or business of renting property are excluded when, based on all facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business.
What qualifies as an active rental business?
The regulation uses a facts and circumstances test. Relevant factors include the persons providing services and the types and amounts of costs and expenses incurred, other than depreciation. Management, repairs, maintenance, leasing, tenant services, inspections, renovations, and other operating activities can be relevant.
Are triple net lease rents passive investment income?
Net leases generally present greater risk because the regulations state that significant services generally are not rendered and substantial costs generally are not incurred in connection with net leases. The ultimate determination remains based on all facts and circumstances.
Does hiring a property manager make the rental passive?
Not automatically. The corporation's overall rental operations, costs, services, management agreement, and involvement must be considered. PLR 202614002 involved extensive services performed through a management company and the IRS concluded that the rents were not passive investment income based on the submitted facts.
Is the Section 1362 rental test the same as Section 469?
No. The Section 1362 passive investment income rules and the Section 469 passive activity rules are independent. The active rental exception under Section 1362 does not use the 750 hour real estate professional test or the Section 469 material participation tests.
What did PLR 202614002 conclude?
The IRS concluded that rental income received by the S corporation described in the ruling was not passive investment income because the submitted facts supported an active rental trade or business involving significant services and substantial costs.
Can PLR 202614002 be relied on as precedent?
No. The ruling applies only to the taxpayer that requested it, and Section 6110(k)(3) provides that a private letter ruling may not be used or cited as precedent.
Can accumulated earnings and profits be distributed?
Yes. An S corporation can distribute accumulated earnings and profits under the applicable Section 1368 distribution rules. The corporation should coordinate accumulated earnings and profits, its accumulated adjustments account, shareholder stock basis, and potential dividend income.
What is the E&P first election?
Section 1368(e)(3) permits an S corporation with accumulated earnings and profits to elect, with the required shareholder consent, to treat distributions as coming from earnings and profits before the accumulated adjustments account.
What is a deemed dividend election?
Treasury Regulation Section 1.1368-1 permits an S corporation to elect to distribute all or part of its accumulated C corporation earnings and profits through a deemed dividend. The shareholders are treated as receiving cash and immediately contributing the amount back to the corporation. The deemed dividend can create taxable dividend income even though no cash is physically distributed.
Can one clean year prevent S corporation termination?
Yes. The termination rule requires three consecutive taxable years satisfying both statutory conditions. A year in which accumulated earnings and profits are absent at year end or passive investment income does not exceed 25 percent of gross receipts breaks that particular consecutive year sequence.
What happens if the S election already terminated?
The corporation generally becomes taxable as a C corporation beginning with the effective date of the termination. Section 1362(f) can provide relief for an inadvertent termination when the IRS determines that the statutory requirements are satisfied.
Can the IRS grant relief for an inadvertent S corporation termination?
Potentially. The corporation must establish that the termination was inadvertent, take corrective steps within a reasonable period, and agree with affected shareholders to any adjustments required by the IRS. A ruling request can be required to obtain the determination.
Final Takeaway
Rental income by itself does not cause an S corporation to lose its S election.
The risk arises when the corporation has accumulated earnings and profits and more than 25 percent of gross receipts are passive investment income.
Rental real estate adds another layer because the corporation's rent may be excluded from passive investment income when it is derived from an active trade or business of renting property involving significant services or substantial costs.
The consequences also occur on two different timelines. Section 1375 tax can apply after one qualifying year. S corporation termination requires three consecutive qualifying taxable years.
Corporations with former C corporation history, substantial rental or investment income, or declining operating revenue should therefore monitor accumulated earnings and profits, the passive investment income percentage, and the rental activity facts annually.
If exposure exists, planning before year end can be materially more valuable than discovering the problem after the third consecutive taxable year has closed.
Review Passive Investment Income Before It Threatens the S Election
I assist S corporations with passive investment income and accumulated earnings and profits reviews, including former C corporation history, rental income classification, the 25 percent gross receipts test, Section 1375 tax exposure, active rental business documentation, net lease arrangements, accumulated earnings and profits distributions, and the three year termination test.
If the corporation may already have a termination issue, the analysis can also include reviewing prior taxable years and evaluating available inadvertent termination relief.
Schedule a ConsultationThis article provides general federal income tax information. Application of Sections 1362 and 1375 depends on the corporation's accumulated earnings and profits, gross receipts, sources of income, rental operations, services, expenses, leases, corporate history, distributions, and other facts. A private letter ruling applies only to the taxpayer that requested it and may not be used or cited as precedent.
