IRC 1375: S-Corp Passive Investment Income Tax and the Excess Passive Earnings Termination Trigger

By Americas Tax | Last reviewed: July 2026 | Practitioner Reference Series

IRC 1375 imposes a corporate-level tax on an S-corp's excess net passive income when accumulated C-corp earnings and profits remain on the books. This guide covers the statutory scope, the passive investment income definition, the ENPI formula, the 25% gross receipts threshold, E&P elimination strategies, the three-year S election termination trigger under IRC 1362(d)(3), inadvertent termination relief under IRC 1362(f), and the interaction with IRC 1374 in the C-to-S conversion year -- at the depth C-to-S conversion planning demands.

1. Why IRC 1375 Matters: The C-to-S Conversion Passive Income Trap

When a C-corporation elects S-corp status, its operational history does not disappear. Any earnings and profits accumulated during the C-corp years remain on the corporation's books after the S election takes effect. Those accumulated E&P do not pass through to shareholders, are not distributed by the S election itself, and cannot be reduced by ordinary S-corp losses or deductions. They sit on the balance sheet as a silent liability -- one that activates IRC 1375 the moment the S-corp's investment income crosses a statutory threshold.

The mechanics are straightforward: if an S-corp with accumulated C-corp E&P earns passive investment income (rents, royalties, dividends, interest, annuities, gains on stock and securities dispositions) that exceeds 25% of its total gross receipts for the year, IRC 1375 imposes a corporate-level tax on the excess net passive income. That tax is paid by the S-corp itself before any income flows through to shareholders -- it is not a shareholder-level tax, and it does not reduce the S-corp's AAA on the same basis as deductible expenses.

The exposure compounds over time. If the S-corp fails to address its C-corp E&P and the 25% threshold is breached in three consecutive tax years, the S election terminates automatically under IRC 1362(d)(3) on the first day of the fourth year. The termination occurs by operation of law; no IRS notice is required. Practitioners advising any S-corp with a C-corp history must model IRC 1375 exposure every year and address the E&P balance before the three-year clock completes its run.

The One Big Beautiful Budget Act (OBBBA), signed into law in 2025, has made S-corp status substantially more attractive by permanently retaining lower individual rates on pass-through income and enhancing the Section 199A deduction (verify current rate and deduction parameters at IRS.gov; subject to ongoing regulatory interpretation). The resulting wave of C-to-S conversions has placed IRC 1375 squarely at the center of post-conversion planning for a large cohort of newly-minted S-corps. Practitioners who complete the S election under Form 2553 without first modeling the IRC 1375 exposure are setting up post-conversion compliance problems that can be expensive to resolve.

2. Statutory Scope: IRC 1375(a) and the Two-Condition Test

IRC 1375(a) imposes a tax on the S-corp's excess net passive income for the tax year if, for that tax year:

  1. The S-corp has accumulated earnings and profits carried over from any C-corp taxable year at the close of the tax year; and
  2. The S-corp's passive investment income exceeds 25% of its gross receipts for that year.

Both conditions must be present simultaneously. If the S-corp has eliminated all accumulated C-corp E&P by year end, IRC 1375 cannot apply for that year regardless of the passive income level. If PII is 25% or less of gross receipts, IRC 1375 cannot apply for that year regardless of how much C-corp E&P remains. The two-condition structure gives practitioners two independent paths to eliminate the tax: reduce E&P to zero, or reduce the PII-to-gross-receipts ratio below 25%.

The Tax Rate

The IRC 1375 tax is imposed at the highest rate of tax specified in IRC 11 -- the corporate tax rate. As of the date of this guide, the applicable corporate tax rate is 21%. Confirm the current rate at IRS.gov and in the current Form 1120-S instructions before computing a client's IRC 1375 liability. The rate applicable to the ENPI is the corporate rate, not the shareholder's individual rate. This is a corporate-level tax imposed on the S-corp entity, separate from any shareholder-level income tax on the same passive income items that flow through to shareholders via IRC 1366.

Only C-Corp E&P Triggers IRC 1375

Not all E&P triggers IRC 1375 -- only accumulated E&P from C-corp taxable years. An S-corp does not generate the kind of E&P that triggers IRC 1375 through its S-corp operations; S-corp distributions reduce AAA first, then OAA, then E&P in the ordering rules under IRC 1368. An S-corp that has always been an S-corp from inception carries no accumulated C-corp E&P and cannot be subject to IRC 1375 under any circumstances. The statute is specifically targeted at former C-corps with retained historical earnings.

3. Passive Investment Income: The IRC 1375(b)(1) Definition

IRC 1375(b)(1) defines passive investment income by reference to IRC 1362(d)(3)(C). The items included are:

What Is Not Passive Investment Income

Income from active business operations is not PII. If an S-corp operates a hotel and generates income from room rentals plus significant hotel services (housekeeping, concierge, food service), the rental component is likely active income, not PII. Similarly, income from professional services, product sales, manufacturing, and ordinary trade or business activities is excluded from the PII definition. The PII definition is intentionally narrow: it captures the categories of income that an investor receives without significant business involvement, and excludes the income an operator earns through active work.

Practitioners should separately state each PII item on Schedule K of Form 1120-S. Under IRC 1366 and 1367, passive income items are separately stated and pass through to shareholders on Schedule K-1, so the characterization of each income item as PII or active income affects both the IRC 1375 corporate-level computation and each shareholder's individual return.

4. The Excess Net Passive Income Formula

The IRC 1375 tax is not imposed on all passive investment income -- it is imposed on the excess net passive income (ENPI). The ENPI formula under IRC 1375(b)(1)(B) scales the taxable amount proportionally to how far the S-corp's PII exceeds the 25% gross receipts threshold.

ENPI = Net Passive Income x [ (PII - 25% of Gross Receipts) / PII ] Where: Net Passive Income = Passive Investment Income minus directly allocable deductions PII = Total Passive Investment Income for the year Gross Receipts = Total gross receipts for the year (all sources)

The fraction (PII minus 25% of gross receipts) divided by PII represents the percentage of net passive income that is "excess" -- i.e., attributable to the portion of PII that pushed the total above the 25% floor. When PII is only slightly above 25% of gross receipts, the ENPI fraction is small and the tax is modest. When PII is far above the 25% threshold -- for example, when an S-corp's business has contracted but its investment portfolio has grown -- the ENPI fraction approaches 1.0 and the tax approaches the full corporate rate on net passive income.

Worked Example

Assume an S-corp has the following for its tax year:

Step 1: Check the 25% threshold. 25% of $1,000,000 gross receipts = $250,000. PII of $500,000 exceeds $250,000, so IRC 1375 applies.

Step 2: Compute the ENPI fraction. PII minus 25% of gross receipts = $500,000 minus $250,000 = $250,000. Divide by PII: $250,000 / $500,000 = 0.50.

Step 3: ENPI = $400,000 x 0.50 = $200,000.

Step 4: IRC 1375 tax = $200,000 x 21% = $42,000 (verify current rate at IRS.gov).

Note that the IRC 1375 tax reduces the S-corp's income available for passthrough to shareholders. The $42,000 tax is a corporate-level deduction that affects the net income reported on Schedule K. The shareholder-level impact of the IRC 1375 tax on AAA and basis tracking is addressed in Section 8 of this guide.

5. The Three-Year Termination Trigger: IRC 1362(d)(3)

The IRC 1375 tax is serious, but the more consequential risk is the automatic termination of the S election under IRC 1362(d)(3). If an S-corp's passive investment income exceeds 25% of gross receipts for three consecutive taxable years and accumulated C-corp E&P was present at the close of each of those years, the S election terminates effective on the first day of the fourth consecutive year.

The three-year clock is cumulative and year-over-year: each successive year in which PII exceeds 25% of gross receipts advances the clock by one. A single year in which the S-corp brings PII below the threshold resets the clock to zero. This means a practitioner who catches the problem in year two has a full year to cure the E&P balance or restructure the income mix before the irreversible third-year strike. A practitioner who misses the problem through year three has no room: the termination is effective on January 1 of the following year.

Practical Year-End Monitoring

Effective monitoring requires tracking two figures at year end for every S-corp with any C-corp history: (1) the accumulated C-corp E&P balance, and (2) the PII-to-gross-receipts ratio. If both figures are present and the ratio exceeds 25%, note the year as a strike against the three-year clock. Keep a running count in the client file. Engage the E&P elimination strategies in Section 7 before the second consecutive year closes if both conditions are present in year one.

6. Interaction with IRC 1374: Double Exposure in the Conversion Year

IRC 1374 and IRC 1375 are separate statutes imposing separate corporate-level taxes, and both can apply in the same tax year to the same S-corp. This double exposure is most acute in the year of C-to-S conversion and the years immediately following, when the S-corp is simultaneously within the IRC 1374 five-year recognition period and carrying accumulated C-corp E&P that activates IRC 1375.

The IRC 1374 built-in gains tax applies when the S-corp recognizes a gain during the five-year recognition period on an asset that had a built-in gain at the time of the S election. The BIG tax is imposed at the corporate rate on the recognized built-in gain, up to the Net Unrealized Built-In Gain (NUBIG) ceiling.

The IRC 1375 tax applies when PII exceeds 25% of gross receipts and C-corp E&P exists. For S-corps that hold investment assets (securities portfolios, rental properties, royalty-generating intangibles), the same assets that generate recognized gains subject to IRC 1374 also generate current-year investment income subject to IRC 1375. The taxes are computed separately and both are paid at the entity level before income flows to shareholders.

Coordination on the Form 1120-S

On Form 1120-S, the IRC 1374 built-in gains tax is reported on Schedule D (via the built-in gains tax worksheet in the instructions) and flows to the total tax line. The IRC 1375 tax is separately computed (using the excess net passive income worksheet in the Form 1120-S instructions) and also flows to the total tax line. Both taxes reduce the S-corp's distributable income before passthrough to shareholders. Confirm the current-year Form 1120-S line locations and worksheet mechanics in the current instructions at IRS.gov before preparing any return subject to either tax.

7. E&P Elimination Strategies

The cleanest way to eliminate the IRC 1375 risk permanently is to eliminate the accumulated C-corp E&P. Once E&P reaches zero, IRC 1375 cannot apply regardless of the S-corp's passive income profile. Three principal strategies are available.

Strategy 1: Actual Cash Distributions from E&P

Under the distribution ordering rules of IRC 1368, distributions from an S-corp are applied first to the Accumulated Adjustments Account (AAA), then to the Other Adjustments Account (OAA), and then to accumulated C-corp E&P. A distribution that reaches the E&P layer is treated as a taxable dividend to the shareholder under IRC 301, reduces E&P dollar for dollar, and is reported by each shareholder on Schedule K-1 as dividend income subject to qualified dividend rates (verify current rates at IRS.gov). The corporation does not deduct the dividend; it simply reduces the E&P balance.

Because the distribution ordering rules apply AAA first, a substantial AAA balance can prevent a cash distribution from ever reaching the E&P layer without a specific election. Practitioners relying on this strategy must either (a) distribute amounts large enough to exhaust the AAA balance and reach the E&P layer, or (b) use the deemed-dividend election described below.

Strategy 2: IRC 1368(e)(3) Deemed-Dividend Election

IRC 1368(e)(3) permits the S-corp and all shareholders to elect, on a timely filed return, to treat all or part of a distribution as coming from accumulated C-corp E&P first -- before exhausting the AAA. This "bypass AAA" election, sometimes called the deemed-dividend election, allows the corporation to direct a distribution specifically at the E&P layer without first depleting the AAA balance. The election is made at the corporate level and requires the consent of all shareholders for the year.

Timing the IRC 1368(e)(3) Deemed-Dividend Election

The IRC 1368(e)(3) election to treat a distribution as coming from C-corp E&P (bypassing the AAA) must be made on a timely filed Form 1120-S for the year of distribution, including extensions. A late-filed election is invalid; the normal AAA-first ordering rules apply if the election is not made by the return's due date (with extensions). Practitioners who identify an E&P balance mid-year should calendar the Form 1120-S due date and coordinate with the client on the distribution and election before the deadline. Do not assume an extension of time to file automatically extends the election window; confirm the current procedural requirements in the current Form 1120-S instructions.

Strategy 3: Reducing the PII-to-Gross-Receipts Ratio

Even if E&P cannot be eliminated immediately, the IRC 1375 tax and the three-year termination clock can be halted in any given year by bringing PII below 25% of gross receipts. Approaches include: (a) shifting investment assets to a separate entity structure so that PII flows to a different entity rather than the S-corp; (b) converting passive income sources to active business income (e.g., providing management services in connection with rental property); (c) increasing active business revenue so that the PII percentage falls below the threshold even if PII itself stays constant; or (d) disposing of high-PII assets before year end. Each of these strategies has independent tax and operational implications that must be analyzed on the client's specific facts.

State-Level Passive Income Taxes for S-Corps

Several states impose their own passive income taxes on S-corps with C-corp E&P history. The state-level rules are not uniform: some states conform to the federal IRC 1375 computation, others impose different thresholds or different tax rates, and some states do not impose any analogous tax. Practitioners advising an S-corp with C-corp E&P on its books must independently verify the applicable state law for every state in which the S-corp files a return. A federal-level fix that eliminates the IRC 1375 exposure does not automatically eliminate exposure under non-conforming state statutes. Confirm current state law treatment at the applicable state revenue department before advising on E&P elimination strategies.

8. Form 1120-S Reporting and the AAA Impact of the IRC 1375 Tax

The IRC 1375 tax is a corporate-level tax computed on the excess net passive income worksheet in the Form 1120-S instructions. The computed tax flows to the total tax line on page 1 of Form 1120-S. Practitioners should locate the current worksheet reference in the current-year instructions, as the IRS has periodically revised the layout of Form 1120-S and the worksheet positioning.

Impact on AAA

The IRC 1375 tax reduces the S-corp's Accumulated Adjustments Account. Under IRC 1368(e)(1)(A), the AAA is reduced (but not below zero) by any tax imposed on the S-corp under Subchapter S -- which includes the IRC 1375 tax. This means the IRC 1375 tax at the entity level shrinks the AAA available for future tax-free distributions to shareholders, compounding the economic cost of the tax for shareholders who plan to take distributions.

Shareholder-Level Passthrough of PII Items

Even after the corporate-level IRC 1375 tax is paid, the underlying passive income items flow through to shareholders on Schedule K-1 as separately stated items under IRC 1366. Each shareholder includes their pro-rata share of dividends, interest, rents, and capital gains in gross income on their individual return. The entity-level tax does not eliminate the shareholder-level income; it layers a corporate-level tax on top of the individual-level tax that the shareholder also pays. This stacking effect makes the IRC 1375 scenario economically similar to double taxation under the C-corp model -- the very treatment the S election was intended to avoid.

Basis Adjustments Under IRC 1367

The IRC 1375 tax reduces the corporation's income for the year, which affects each shareholder's basis adjustment under IRC 1367. Specifically, the IRC 1375 tax is treated as a non-separately-stated deduction at the entity level for basis-computation purposes. The net effect is that each shareholder's stock basis is reduced by their pro-rata share of the IRC 1375 tax cost, in addition to any basis-reducing distributions. For detailed basis-tracking mechanics, see the companion guide on IRC 1366 and 1367.

Form 1120-S Reporting: Verify Current Instructions

The IRC 1375 excess net passive income tax is reported on Form 1120-S as a corporate-level tax. The IRS periodically revises the worksheet location and line numbers on Form 1120-S. Always use the current-year Form 1120-S instructions from IRS.gov to identify the correct line, worksheet, and computation sequence. Do not rely on prior-year returns or software defaults without confirming the current-year form layout. The Form 1120-S instructions include an excess net passive income worksheet that walks through each step of the IRC 1375 computation; use it as the authoritative reference for each year's computation.

9. IRC 1362(f): Inadvertent Termination Waiver

If the S election terminates under IRC 1362(d)(3) because of three consecutive years of excess passive income with C-corp E&P, the corporation does not automatically lose the ability to operate as an S-corp forever. IRC 1362(f) gives the IRS discretionary authority to grant a waiver and treat the corporation as if the S election had never terminated, provided the IRS determines that the termination was inadvertent and the corporation takes corrective action.

Requirements for IRC 1362(f) Relief

To obtain an inadvertent termination waiver, the corporation must demonstrate:

  1. Inadvertence: The termination was not a deliberate tax-planning step. A corporation that intentionally allowed passive income to exceed the threshold to engineer a C-corp reversion will not qualify. The inadvertence standard is fact-intensive; consult current IRS guidance and private letter rulings on the topic.
  2. Corrective steps: The corporation must have taken steps to address the condition that caused the termination. In the IRC 1362(d)(3) context, this typically means eliminating the accumulated C-corp E&P through distributions and committing to future compliance.
  3. Agreed adjustments: The corporation, its shareholders, and the IRS must agree on the adjustments that would have been required during the termination period had the S election been valid throughout.

The waiver request is typically submitted via a private letter ruling request. The IRS user fee for PLR requests is substantial; confirm the current fee schedule in Rev. Proc. 2026-1 (or its current successor) before filing. The IRS has historically granted IRC 1362(f) relief in many cases where the facts support inadvertence, but relief is not automatic and should not be assumed.

If the IRS denies the waiver, the corporation is treated as a C-corp from the first day of the fourth year (the year of termination). It must file Form 1120 for that year and subsequent years until a new S election is made (after the IRC 1362(g) five-year waiting period, unless the IRS consents to an earlier election). The OBBBA's enhancements to pass-through treatment make the stakes of a denied waiver significantly higher than they were before 2025 -- the economic cost of losing S-corp status has increased.

OBBBA and the Accelerated C-to-S Conversion Environment

The One Big Beautiful Budget Act (OBBBA), signed into law in 2025, permanently retained lower individual income tax rates on pass-through income and accelerated the pace of C-to-S conversions across the country. Practitioners advising C-corp clients on conversion to S status should model IRC 1375 exposure before the election takes effect -- a step that is often overlooked in the rush to secure the conversion's pass-through benefits. The OBBBA did not modify IRC 1375, the 25% gross receipts threshold, or the IRC 1362(d)(3) three-year termination trigger. However, the increased volume of C-to-S conversions in 2025 and 2026 means that IRC 1375 is a more frequently encountered issue than it was in prior years. Consult IRS.gov and the current Form 1120-S instructions for the current IRC 1375 tax rate, the excess net passive income worksheet, and any regulatory guidance issued under the OBBBA that may affect S-corp passive income planning.

10. IRC 1375 Planning Checklist for Practitioners

The following checklist covers the minimum steps a practitioner should complete for any S-corp with a prior C-corp period, or for any C-corp client considering an S election.

  1. Confirm accumulated C-corp E&P balance. Before or immediately after the S election takes effect, obtain a certified computation of the accumulated C-corp E&P balance from the client's prior-year C-corp returns or have the E&P computed by a qualified preparer. Do not rely on client estimates or QuickBooks retained-earnings balances -- those figures are book E&P, not tax E&P, and the difference can be substantial.
  2. Identify all PII sources. Map every income source of the S-corp against the IRC 1375(b)(1) PII definition. Flag any income item whose PII character is arguable (e.g., rents from property where services are provided, interest on customer notes) and research the current IRS position on those items.
  3. Compute the PII-to-gross-receipts ratio annually. Every year the corporation has accumulated C-corp E&P on its books, compute the PII-to-gross-receipts ratio during the year-end planning session (not after the return is filed). If the ratio is approaching 25%, engage the income-restructuring strategies in Section 7 before year end.
  4. Track the three-year clock. If the 25% threshold was exceeded in any prior year with C-corp E&P present, mark that year as a strike and note the remaining strikes before termination in the client file. Do not allow a second or third consecutive year to pass without a deliberate plan to cure the E&P balance or bring PII below 25%.
  5. Model the E&P distribution economics before acting. Distributing accumulated C-corp E&P to shareholders triggers taxable dividend income to each shareholder (at qualified dividend rates, verify current rates at IRS.gov). Model the shareholder-level tax cost of the E&P distribution against the cost of continued IRC 1375 exposure and the risk of a three-year termination. In most cases, the dividend tax on a managed E&P distribution is cheaper than managing repeated IRC 1375 taxes plus termination risk.
  6. Calendar the IRC 1368(e)(3) election deadline. If the strategy is to use the deemed-dividend election to direct a distribution to the E&P layer, calendar the Form 1120-S filing deadline (with extensions) and ensure the election is included in the timely filed return.
  7. Coordinate IRC 1374 and IRC 1375 analyses. For any S-corp within the five-year IRC 1374 recognition period, run both the IRC 1374 and IRC 1375 computations annually. The two taxes interact at the entity level and compound the economic cost of holding appreciated investment assets in a recently-converted S-corp.
  8. Consult the IRC 1378 required tax year rules. For any newly-converted C-corp, confirm that the S-corp's tax year is a permitted year before modeling the multi-year IRC 1375 exposure. A fiscal year change that shortens or lengthens a tax period can affect the number of "years" in the three-year termination clock. See the companion guide on IRC 1378 required tax year rules.

11. Comparison: IRC 1374 vs. IRC 1375

IRC 1374 and IRC 1375 are frequently discussed together because both apply to former C-corps operating as S-corps and both impose corporate-level taxes. The following table highlights the key differences across ten dimensions.

Dimension IRC 1374 (Built-In Gains Tax) IRC 1375 (Passive Income Tax)
What triggers the tax Recognition of a gain during the 5-year recognition period on an asset that had a built-in gain at the time of the S election Passive investment income exceeding 25% of gross receipts when accumulated C-corp E&P exists at year end
Tax rate Applicable corporate rate under IRC 11 (21% as of this guide; verify at IRS.gov) Applicable corporate rate under IRC 11 (21% as of this guide; verify at IRS.gov)
Time limit on exposure 5-year recognition period from the effective date of the S election (IRC 1374(d)(7)); expires after 5 years No expiration; applies every year in which both conditions (E&P and excess PII) are present, indefinitely
Income focus Built-in gains (pre-conversion appreciation on specific assets) Current-year passive investment income (ongoing investment returns)
E&P requirement No E&P requirement; IRC 1374 applies to any C-to-S conversion within the recognition period regardless of E&P balance Accumulated C-corp E&P at year end is a mandatory condition; no E&P means no IRC 1375 tax
Effect on AAA IRC 1374 tax reduces AAA under IRC 1368(e)(1)(A) IRC 1375 tax reduces AAA under IRC 1368(e)(1)(A)
Form 1120-S reporting Built-in gains tax computed on IRC 1374 worksheet in the Form 1120-S instructions; flows to total tax line Excess net passive income tax computed on IRC 1375 worksheet in the Form 1120-S instructions; flows to total tax line
How to avoid the tax Wait until the 5-year recognition period expires before selling appreciated assets; or keep asset sales below the annual NUBIG ceiling Eliminate accumulated C-corp E&P through distributions; or keep PII below 25% of gross receipts in each year
Termination trigger IRC 1374 does not trigger S election termination by itself Excess PII for 3 consecutive years with E&P triggers automatic S election termination under IRC 1362(d)(3)
Inadvertent termination waiver Not applicable (IRC 1374 does not cause termination) IRC 1362(f) waiver available if termination under IRC 1362(d)(3) was inadvertent; requires IRS determination (typically via PLR)

Frequently Asked Questions: IRC 1375 S-Corp Passive Investment Income Tax

What is IRC 1375 and when does it apply?

IRC 1375 imposes a corporate-level tax on an S-corp's excess net passive income when two conditions are simultaneously present: (1) the S-corp has accumulated earnings and profits carried over from a prior C-corp period at the close of the tax year, and (2) the S-corp's passive investment income exceeds 25% of its gross receipts for that year. If either condition is absent -- no C-corp E&P at year end, or PII does not exceed the 25% threshold -- IRC 1375 does not apply for that year.

What income counts as passive investment income under IRC 1375?

Passive investment income (PII) under IRC 1375(b)(1) includes: royalties, rents (subject to the significant-services exception), dividends, interest (excluding interest from ordinary business receivables and lending businesses), annuities, and gains from dispositions of stock or securities. Active business income -- from product sales, professional services, and trade or business operations -- is excluded from PII. The boundary between active rental income and passive rent can be unclear; research the current IRS position on the significant-services exception before characterizing rental income.

How is excess net passive income (ENPI) calculated?

The ENPI formula is: ENPI = Net Passive Income multiplied by the fraction (PII minus 25% of Gross Receipts) divided by PII. Net passive income is PII reduced by directly allocable deductions. The fraction scales the taxable amount to reflect only the portion of net passive income attributable to PII above the 25% threshold. When PII barely exceeds 25% of gross receipts, the ENPI fraction is small and the tax is modest. When PII is substantially above the threshold, the ENPI fraction approaches 1.0 and the tax approaches the full corporate rate on net passive income. Use the current-year excess net passive income worksheet in the Form 1120-S instructions for the actual computation.

What is the 25% gross receipts test under IRC 1375?

The 25% gross receipts test is the PII-to-gross-receipts threshold that gates the IRC 1375 computation. If the S-corp's passive investment income exceeds 25% of total gross receipts for the tax year, and accumulated C-corp E&P is present at year end, the corporation must compute ENPI and pay IRC 1375 tax on it. If PII is 25% or less of gross receipts, IRC 1375 does not apply for that year. Gross receipts for this test includes all items of gross income -- active and passive. Confirm the exact inclusion rules in IRC 1375(b)(2) and the current Form 1120-S instructions.

What happens if an S-corp exceeds the 25% threshold for three consecutive years?

If PII exceeds 25% of gross receipts for three consecutive tax years and accumulated C-corp E&P was present in each year, the S election terminates automatically under IRC 1362(d)(3) on the first day of the fourth consecutive year. No IRS notice is required. The corporation becomes a C-corp on that date, loses pass-through treatment, and is subject to corporate-level income tax going forward. The only relief avenue is the inadvertent termination waiver under IRC 1362(f), which requires an IRS determination (typically via PLR) that the termination was inadvertent and that corrective steps have been taken.

How can an S-corp eliminate C-corp E&P to avoid IRC 1375?

The primary strategies are: (1) making actual cash distributions in an amount large enough to exhaust the AAA balance and reach the accumulated C-corp E&P layer -- distributions from the E&P layer are taxable dividends to shareholders under IRC 301 and reduce E&P dollar for dollar; (2) using the IRC 1368(e)(3) deemed-dividend election on a timely filed Form 1120-S to direct a distribution to the E&P layer before exhausting AAA; and (3) other E&P reduction events (redemptions, reorganizations) that reduce the E&P balance. Once C-corp E&P reaches zero, IRC 1375 cannot apply in future years regardless of PII levels.

Does IRC 1375 apply if the S-corp has no accumulated C-corp E&P?

No. Accumulated C-corp E&P at year end is a mandatory condition for IRC 1375. An S-corp that was always an S-corp from inception has no accumulated C-corp E&P and cannot be subject to IRC 1375 under any circumstances. IRC 1375 exclusively targets former C-corps that retained historical earnings after conversion. Practitioners should confirm the E&P status of any S-corp with any prior period of C-corp existence, including brief C-corp periods before a timely S election took effect.

Can the IRS waive a 1362(d)(3) termination triggered by excess passive income?

Yes, under IRC 1362(f). The IRS may grant a waiver if it determines the termination was inadvertent and the corporation has taken corrective steps. The waiver request is typically submitted as a private letter ruling request. To qualify, the corporation must show the termination resulted from an unintentional oversight (not deliberate tax planning), must demonstrate the corrective steps taken (usually E&P elimination), and must agree to adjustments the IRS determines are appropriate for the termination period. The waiver is discretionary; it is not automatic and not guaranteed. Confirm current PLR fee schedules and IRS guidance on IRC 1362(f) at IRS.gov before filing a waiver request.

IRC 1375 Planning -- Get Expert Help Before the S Election

The IRC 1375 passive income tax and the three-year termination trigger are post-conversion hazards that can be avoided with proper E&P planning. Americas Tax works with CPAs, enrolled agents, and tax attorneys on C-to-S conversion planning, E&P computation and distribution strategies, and Form 1120-S compliance for S-corps with C-corp history.

Contact Americas Tax for S-Corp Passive Income Planning

Related Practitioner Guides

This guide is for informational purposes only and does not constitute legal, tax, or accounting advice for any specific client situation. All IRC citations, regulatory references, rate figures, and planning strategies must be verified against current law, current IRS.gov guidance, and the current Form 1120-S instructions before application in practice. Tax law is subject to change; confirm all figures and procedures with your primary source materials before advising clients. Americas Tax is not responsible for client tax positions taken based on this guide without independent professional verification.