Despite the limitations imposed on “passive investment income” by the Internal Revenue Code, a subchapter S corporation is a solid choice for operations which obtain most of their income in the form of capital gains. This includes day traders, swing traders, and family offices.
The tax benefits of the S corporation to owner-operated trading firms are well known, as described in this Forbes article. An S corporation must pay the owner-operator a fair market salary for management services, which generates self-employment income for the purpose of retirement plan contributions, health insurance premium deductions, and other deductions applied to AGI. At the same time, the S corporation can pass through net operating losses which are then further deductible to the owner-operator (to the extent of the owner’s basis in the S corporation).
The combination, when implemented by a knowledgeable tax practitioner, saves thousands in taxes compared to the alternatives.
Even better, net capital gains realized by the S corporation are passed through to the owner and taxed at the preferential individual capital gains rates (as low as 0% and a maximum of 23.8% as of 2017) instead of the much higher individual or corporate income tax rates.
But there’s one potentially major problem: IRC 1362(d)(3)(A). This section provides for automatic termination of a corporation’s S status if for three consecutive tax years, more than 25% of the S corporation’s gross receipts consist of “passive investment income”. The intent seems to be to discourage the use of an S corporation as a holding company.
That caveat potentially pours cold water on using the S corporation for management of financial assets, since a corporation with terminated S status cannot re-elect S status for five years afterwards.
So what exactly is “passive investment income”? IRC 1362(d)(3)(C) provides a definition, but let’s first look at some other definitions of passive income in the tax code for context.
The basic definition of passive activity income comes from IRC 469. The rules define any income-producing activity in which the owner does not materially participate, as well as rents regardless of material participation (unless the taxpayer elects real estate professional status), as a passive activity. However, what could be called portfolio income (unearned income not derived from a trade or business), which would otherwise be considered passive by that definition, is specifically excluded from the definition in order to eliminate the possibility of using such portfolio income to unlock passive losses which would otherwise have to be suspended. The types of portfolio income excluded here are:
- interest, dividends, annuities, royalties, and capital gains (gains on property).
For passive foreign investment companies (PFIC), “passive income” is defined in IRC 1297(b) as any income that would be considered foreign personal holding company income (FPHCI) in IRC 954(c). The types of income subject to punitive anti-deferral rules in both cases are:
- dividends, interest, royalties, rents, annuities, capital gains, commodity gains, foreign currency gains, lending fees, and more, subject to exceptions.
For tax-exempt entities such as nonprofits, 401(k) trusts, and IRAs, IRC 512(b) defines the types of income which are considered not to be income from a trade or business — and thus avoid treatment as unrelated business taxable income (UBTI). (This is probably intended to limit tax-exempt entities to obtaining portfolio [unearned, non-business] income, with the presumed goal of preventing tax-exempt entities from engaging in competitive business while in possession of a tax advantage perceived to be unfair.) These categories are:
- dividends, interest, margin loan income, lending fees, annuities, royalties, rents and capital gains, and more, subject to exceptions.
For tax-exempt private foundations, a 2% excise tax is imposed on “net investment income”, defined in IRC 4940(c) as:
- interest, dividends, rents, loan payments, royalties, and capital gains.
This looks terrible for the S corporation owner. Why? In at least four other places in the tax code, the IRS groups capital gains with other forms of portfolio income. If capital gains are included in the definition of “passive investment income”, then a trading company that takes most of its entity-level income as capital gains could hardly avoid revocation of S status.
And in fact, until 2007 that was exactly the case. IRC 1362(d)(3)(C)(i), as of 2006, read:
Except as otherwise provided in this subparagraph, the term “passive investment income” means gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities (gross receipts from such sales or exchanges being taken into account for purposes of this paragraph only to the extent of gains therefrom).
So a trading company whose income consisted primarily of capital gains on real property or other non-stock, non-security property could avoid revocation of S status, but not one whose income consisted primarily of capital gains on stock or securities. Avoiding revocation of S status for a day-trading corporation would have been impossible under those terms.
Fortunately, this section was amended by a rider on the a 2007 appropriations bill. The modern language now states:
Except as otherwise provided in this subparagraph, the term “passive investment income” means gross receipts derived from royalties, rents, dividends, interest, and annuities.
Note the excision of the entire section that had previously defined capital gains as “passive investment income” for an S corporation.
This particular Internal Revenue Code attempt at a definition of passive income manages to be inconsistent with all the others. However, the inconsistency is one that happens to fall squarely in the favor of the S corporation as the entity of choice for traders.