Can S Corporation Income Be Considered Passive Income? | USTaxAid

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Can S Corporation Income Be Considered Passive Income?

Written by Diane Kennedy, CPA on June 12, 2022

There is a potential for a powerful tax strategy with S Corporation income or losses. But first you need to determine what type of income you have from your S Corporation.

Three Types of Income

There are three types of income, according to the IRS:

Earned Income: This is income that you receive from work you do. It could be your paycheck from a job or it could be the net income from your Schedule C, Sole Proprietorship. You will pay federal and state income tax on that income, plus be subject to payroll taxes or self-employment tax of 15.3% in most cases.

Portfolio Income: This is income you receive from paper assets (interest and dividends) or when you sell an asset. If you held the asset for one year or less, you will have short term capital gains/loss. If you held the asset for over a year, you will have a long term capital gains. If your modified adjusted gross income is over $200,000 (single) or $250,000 (married, filing jointly), some portfolio income will be subject to an additional 3.8% tax.

Passive income: The final type of income is passive income. You can only offset passive losses against passive income. Frequently real estate investors are trying to find ways to offset their real estate passive losses against other income.

If you’re looking for a strategy to help you deduct real estate passive losses, please check out this article: Real Estate Professional Status & Your Tax Return.

There are other rules if you have an S Corporation. Your share of business income or loss will be reported on a Schedule K-1 and you then report that on your personal tax return.

S Corporation Passive vs. Non-Passive Income

If the S Corporation has certain types of income such as dividends, interest and rent, these will be reported separately on the Schedule K-1 for the shareholder to report.

But what about the rest of the income of the S Corporation? Is this passive or non-passive?

There is a simple answer, but the strategy to use it is rather involved.

It all depends on whether you have material participation. That’s where it starts to get a little more complicated.

Defining Material Participation for an S Corporation Shareholder

Material participation occurs when the shareholder’s involvement in the business is substantial, regular and continuous.

Unlike real estate material participation, there are more possibilities to have material participation with a business. The possible tests are:

Participation in related activity is more than 500 hours per year

Your participation constitutes nearly all the participation by everyone, including non-owners.

Significant participation activity & you are active more than 100 hours

Materially participated in activity for any 5 years during the prior 10 tax years.

If personal service activity, material participation is for any 3 years preceding current tax year.

You participate on a regular & substantial basis throughout the year.

The taxpayer only has to pass one of these to show material participation.

The regulations make it difficult for a taxpayer to convert nonpassive business income into passive income. For example, if the shareholder has materially participated for any 5 out of the previous 10 tax years, they would need to wait 6 full years to turn this into nonpassive income.

There are good tax planning opportunities to use passive losses to offset passive income, but it can get tricky to change the characterization of the income for an existing S Corporation.

Recent Tax Court Case for Shareholder Who Wants Passive Income

In a recent case (Rogerson), the Tax Court didn’t approve a shareholder’s scheme to create passive income from the S Corporation. The reason why he would want to are pretty obvious. He could offset the S Corporation passive against passive losses that are otherwise suspended. In other words, the S Corp income is not taxable. If it’s nonpassive, it would be taxable.

The problem is that the shareholder clearly worked in his business. So he reorganized his business so that there were two separate S Corporations. He treated one of the S Corporations as passive and one as nonpassive. However, he continued to materially participate with both S Corporations. That means both should have been nonpassive.

Sometimes “easy” strategies take a lot of advance planning. And if you don’t follow up, the whole thing could fail. That’s why ongoing tax information can be so important. Tax planning isn’t just something you do when you get your tax return prepared. If you’re serious about saving money and protecting your assets, join Wednesday Coaching.

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