An S corporation (passthrough entities for which income is generally taxed to the shareholders) that was previously a C corporation (income is taxed to the corporation) may have undistributed earnings from the time it was a C corporation. In some cases, the S corporation can be subject to a penalty tax, but the tax can be avoided by distributing the accumulated C corporation earnings. In some cases, the S election can be terminated as a result of being subject to the tax. 2012 may be the last opportunity to make that distribution at a 15% federal tax rate.
(This issue does not apply to corporations that have been S corporations from the beginning of their existence.)
The 35% penalty tax (based on the maximum federal corporate income tax rate) applies when an S corporation has passive investment income exceeding 25% of gross receipts for the year. Passive investment income includes certain royalties, certain rents, dividends, interest and annuities.
If the S corporation has passive investment income exceeding 25% of gross receipts for three consecutive years, the S election is terminated.
Since the penalty tax and threat of election termination only apply when the S corporation has undistributed C corporation earnings and profits, these issues can be eliminated by distributing those earnings and profits. The distribution can be “deemed” to be made without making a distribution of cash or assets by election of the S corporation’s shareholders.
Distributions of C corporation earnings and profits are taxable to the shareholders as dividends. Under the Bush tax cuts, “qualified” dividends are subject to a maximum 15% federal income tax rate. After 2012, the maximum regular individual income tax rate that applies to dividends is scheduled to increase to a maximum of 39.6% and a 3.8% Medicare tax is scheduled to apply to investment income of certain high-income taxpayers. That’s 43.4% total, or a 189% increase!
Distributing any accumulated C corporation earnings and profits now can provide more flexibility for S corporations in their operations later.
S corporation shareholders should consult now with their tax advisors about making a distribution during 2012.