S corporation tax treatments come with some clear advantages but also some limitations on passive income. Should an S corp receive a majority of its income from passive sources, including interest, dividends, rents and royalties, some of the tax benefits may be compromised. In some circumstances, the entity's status as an S corp can be revoked. S corporations, like LLCs, are structured to encourage material involvement by owners, not for passive stockholders seeking dividends.
S Corporations Versus C Corporations
S corps differ from standard C corporations in one overwhelming area: S corps pay no taxes. No, they are not legal nonprofit entities; S corp profits are distributed to stockholders to be included in their personal income tax calculations. Conversely, C corporations are taxed at the current tax level for their state of incorporation. Should they distribute profits to stockholders in the form of dividends, there is the dreaded "double taxation" issue. However, the IRS (Internal Revenue Service) restrictions mandating a maximum of 100 stockholders -- all of whom must be U.S. citizens -- makes S corps attractive for smaller businesses, not major corporations.
The term "passive income" is accurate. Activities generating passive income include receiving interest, dividends, royalties and some revenue from rents. Passive income relates to revenue generated from activities outside the normal operating purposes of the company. For example, an auto parts manufacturing company that generates more income from interest and dividends than from operations has significant passive income. However, a bank or credit union generates most of its income from interest as well, but lending and investing money is its primary operation, eliminating the passive income designation.
Passive Income Restrictions
While IRS rules and regulations can change from year to year, they impose a tax on "excessive passive income" for S corporations. S corps that fall into this category are taxed at the current corporate rate, typically higher than personal tax rate structures. However, greater dangers are on the horizon. Should an S corporation have three years of excessive passive income, its status as a "pass through" entity -- moving all net income to individual stockholders -- can be revoked. This forces it to become a standard C corporation.
S corporations are designed to function like LLCs, partnerships and other small businesses, encouraging "material participation" by owners. The IRS penalizes those entities that exist for purely passive income purposes. S corporation regulations permit smaller business owners to enjoy the limited liability protection and other advantages of incorporation, along with tax savings desired by owners (stockholders). This status tries to discourage those wishing to invest solely for tax benefits or passive income reasons. These investors are better served by purchasing stock in publicly traded corporations.