IRC 1375: S Corp Tax on Excess Passive Investment Income

An S corporation owes the IRC 1375 excess passive investment income tax when it still carries accumulated earnings and profits from its C corporation years and more than 25% of its gross receipts for the year come from passive investment income. The tax is a flat 21% applied to the portion of net passive income that corresponds to receipts above the 25% line, and the S corporation pays it directly rather than passing it through to shareholders. Left unaddressed, the same conditions that trigger the tax can also terminate the S election if they persist for three consecutive years.

The Two Conditions That Trigger the Tax

Both conditions must be present at the same time during the taxable year. The corporation must have accumulated earnings and profits left over from a prior C corporation period at the close of the year, and its passive investment income must exceed 25% of gross receipts for that year.¹ Miss either one and the tax cannot apply.

A corporation that has been an S corporation since formation has no C corporation earnings and profits, so this tax will never reach it. A former C corporation that has already distributed all of its old earnings and profits before year-end is also outside the tax, no matter how heavily its receipts skew toward investment income. The entire tax depends on whether those legacy earnings still sit on the books.

What Counts as Passive Investment Income

Section 1375 uses the definition from IRC 1362(d)(3): royalties, rents, dividends, interest, and annuities.² Gains from sales of stock or securities are included, but only the net gain counts toward gross receipts, not the full proceeds. Other capital asset sales are netted the same way.

Several categories of income that look passive at first glance are carved out because they come from active operations:

Interest earned in the active conduct of a lending or finance business, if the corporation meets the personal holding company exception for such businesses.
Interest on notes received from selling inventory in the ordinary course of business.
Dividends from a C corporation subsidiary that the S corporation owns at least 80% of, but only to the extent those dividends trace back to the subsidiary’s active business earnings.
Interest income earned by a bank or depository institution holding company.

These exceptions matter because they keep operating companies from being penalized simply because their revenue arrives labeled as interest, rent, or dividends. A hotel that provides substantial services to guests earns active business income, and a finance company whose core business is making loans is doing the same.

How the Tax Is Calculated

The IRS taxes only the passive income that exceeds the 25% safe harbor, not the whole amount. The calculation moves in three steps.

Net Passive Income

Start with total passive investment income and subtract the deductions directly connected with producing it. Net operating losses and the special deductions under Part VIII of Subchapter B, including the dividends-received deduction, are not allowed in this calculation.¹ What remains is net passive income.

Excess Net Passive Income

Excess net passive income is the slice of net passive income that lines up with the amount of passive investment income above 25% of gross receipts. The formula is a ratio:

Excess Net Passive Income = Net Passive Income × (Passive Investment Income − 25% of Gross Receipts) ÷ Passive Investment Income

Take an S corporation with $400,000 in gross receipts, $200,000 in passive investment income, and $150,000 in net passive income after $50,000 of directly connected expenses. The 25% threshold is $100,000. The excess ratio is ($200,000 − $100,000) ÷ $200,000, or 0.50. Excess net passive income is $150,000 × 0.50, or $75,000.

Applying the 21% Rate

The tax equals excess net passive income multiplied by 21%, the highest corporate rate under IRC 11(b). In the example, that produces a tax of $15,750.

The Taxable Income Cap

Excess net passive income for any year cannot exceed the corporation’s taxable income for that year, computed as if it were a C corporation and ignoring net operating loss deductions and most special deductions.¹ If the corporation had minimal or zero taxable income, the tax shrinks accordingly. Excess amounts blocked by this cap do not carry forward.

Credits Are Almost All Off the Table

The only credit that can offset the Section 1375 tax is the credit for certain federal fuel taxes under IRC 34. General business credits and other common offsets cannot be used.

Effect on Shareholder Pass-Through Income

The S corporation pays the tax at the entity level. Shareholders do not owe it directly, but each item of passive investment income that passes through to them is reduced in proportion to the tax the corporation paid on that income.³ The adjustment prevents the same dollars from being fully taxed at both levels and shows up automatically in K-1 reporting.

Reporting and Payment

The S corporation reports the tax on Form 1120-S. The instructions direct filers to compute the liability on the Excess Net Passive Income Tax Worksheet, enter the result on line 23a, and attach the computation statement.⁴ The form has a dedicated line for excess net passive income tax.⁵

An S corporation expecting to owe Section 1375 tax, or the built-in gains tax under Section 1374, generally needs to make estimated tax payments during the year to avoid underpayment penalties.

How to Avoid or Eliminate the Tax

Two strategies work. The permanent fix is to zero out accumulated C corporation earnings and profits so the first trigger never exists. The year-by-year fix is to keep passive investment income at or below 25% of gross receipts.

Distributing the Old Earnings and Profits

Under the default rules, S corporation distributions come first out of the accumulated adjustments account (AAA), which represents income already taxed to shareholders during S years. Only after the AAA is exhausted do distributions reach the old C corporation earnings and profits. A large AAA balance can make it nearly impossible to drain the C corporation layer through ordinary distributions.

IRC 1368(e)(3) provides a way around this. With the consent of all affected shareholders, the corporation can elect to reverse the distribution order for the year and pull from C corporation earnings and profits first.⁶ The election covers only the year it is made and is irrevocable for that year. It is made by attaching a statement to a timely filed Form 1120-S identifying the election and confirming shareholder consent.

The tradeoff is that distributions from C corporation earnings and profits are taxed to shareholders as dividends, while AAA distributions are generally tax-free returns of previously taxed income. Shareholders are choosing to pay dividend tax now in exchange for permanently removing Section 1375 exposure. When the corporation lacks cash to make an actual distribution, a deemed dividend election under the regulations produces the same effect on paper.

Managing the Revenue Mix

If clearing out earnings and profits is not practical, the alternative is keeping passive investment income under 25% of gross receipts each year. That can mean growing active business revenue, restructuring holdings into assets that produce active rather than passive income, or both. This approach requires ongoing attention, and a weak year on the active side can push the ratio over 25% without warning.

The Waiver for Good-Faith Errors

The IRS can waive the Section 1375 tax if the corporation shows two things: it determined in good faith that it had no accumulated earnings and profits at year-end, and once it discovered the balance was not zero, it distributed the amount within a reasonable period.¹ The waiver is aimed at genuinely difficult cases, such as reconstructing earnings and profits from decades-old C corporation records or after mergers, not at corporations that simply ignored a known balance.

The Three-Year Termination Risk

The bigger consequence of persistent excess passive income is losing S status entirely. If an S corporation has accumulated C corporation earnings and profits and passive investment income above 25% of gross receipts for three consecutive taxable years, the S election terminates automatically on the first day of the year following that third year.² Only years the corporation actually held S status count toward the clock. After termination, the corporation reverts to C status and generally cannot re-elect S status for five years. The consequences of termination usually outweigh any single year’s Section 1375 tax, so a 1375 liability often functions as an early warning that the three-year clock is running.

Coordination With the Built-In Gains Tax

Former C corporations may also face the built-in gains tax under IRC 1374 on appreciation that existed at conversion and is recognized during the recognition period. Recognized built-in gains and losses are excluded from passive investment income for Section 1375 purposes, which keeps the same gain from being hit by both taxes at once.

1
Office of the Law Revision Counsel. 26 USC 1375 – Tax Imposed When Passive Investment Income of Corporation Having Accumulated Earnings and Profits Exceeds 25 Percent of Gross Receipts
2
Office of the Law Revision Counsel. 26 USC 1362 – Election, Revocation, Termination
3
Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders
4
Internal Revenue Service. Instructions for Form 1120-S
5
Internal Revenue Service. Form 1120-S – U.S. Income Tax Return for an S Corporation
6
Office of the Law Revision Counsel. 26 USC 1368 – Distributions