Distributing Taxable Dividend in order to Eliminate an S Corporation's Earnings and Profits

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.

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.