Monday, March 03, 2003

Saving Your S

The ability of a corporation to retain its status as an S corporation is hedged by a variety of requirements. One of those is found in I.R.C. Section 1362(d)(3)(A)(i) which provides that an election under section 1362(a) is terminated if the corporation has accumulated earnings and profits at the close of each of 3 consecutive taxable years and has gross receipts for each of such taxable years more than 25 percent of which are passive investment income. PLR 200309021 shows how an S election can be retained even though the principal business of the corporation would otherwise cause it to run afoul of Section 1362(d)(3)(A)(i).

Under the facts of the ruling, the S corporation's primary source of revenue was rental income from leasing office space. This income was clearly passive investment income for the purposes of Section 1362(d)(3)(A)(i). See I.R.C. Section 1362(d)(3)(C)(i). However, the corporation purchased interests in three limited partnerships that were apparently engaged in the business of purchasing, gathering, transporting, trading, storage, and resale of crude oil, refined petroleum, and other mineral or natural resource. These sorts of business activities will not constitute passive investment income as defined by I.R.C. Section 1362(d)(3)(C)(i).

The ruling held that the corporation's distributive share of the gross receipts of the three partnerships that it purchased will be included in its gross receipts for purposes of Section 1362(a). Apparently, the amount of the corporation's distributive shares of partnership gross receipts from the three partnerships were sufficient to fall below the 25% threshold that would have put it in violation of Section 1362(d)(3)(A)(i). Just as importantly, this result holds even though there may have been little net income from the partnerships or even losses generated by them.

This ruling opens the way for some creative planning in situations where an S corporation has low basis assets that it wants to dispose of with minimal income tax impact or assets which may be subject to double tax because the corporation had been a C corporation that elected S corporation status within the previous ten years. I will post illustrations of these planning possibilities in the coming weeks.

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