Under the S corporation rules,
the S corporation election of a corporation that has accumulated earnings and
profits because it was once a C corporation will terminate if, for a period of
three consecutive tax years, its passive investment income exceeds 25% of its
gross receipts. In addition, the S corporation is subject to a tax on passive
investment income for any year in which it exceeds the 25% limitation.
Say that for the past few years,
your S corporation has narrowly avoided exceeding the 25% limitation. However,
because the maximum individual tax rate on dividends has been reduced to 15%,
it may now be feasible to eliminate your S corporation's accumulated earnings
and profits by making a dividend distribution equal to the amount of the
accumulated earnings and profits. Alternatively, if you prefer not to have the
corporation make an actual distribution, the corporation may (with the consent
of the affected shareholders) elect to distribute a deemed dividend, which
would cause the corporation and the shareholders to be treated as if the
corporation distributed a taxable dividend to the shareholders. Once you have
eliminated the accumulated earnings and profits, there will no longer be any
restriction on the amount of passive investment income that can be earned by
the corporation.
The down side is that the
shareholders will be subject to a tax on the dividend distribution. However,
the maximum tax rate on dividends has been reduced to 15%. This may be
acceptable to the shareholders as a cost of removing the passive investment
income limitation on the corporation's activities. We can help you determine the
amount of accumulated earnings and profits in the corporation and the amount of
tax that the shareholders will have to pay.
If you have any further questions
please call our firm.