S corporation have always had issues with the risk of becoming a C corporation by accident. One of the key problems for an S corporations is the risk of having excess passive income (as defined by §1362(d)(3)(C)(i)) if the S corporation is determined to have accumulated earnings and profits as of the end of the tax year. If the corporation has such excess passive income for three straight years, the S election terminates at the end of the third year. [IRC §1362(d)(3)]
Generally, excess passive income is defined as the corporation having passive investment income in excess of 25% of its gross receipts for 3 consecutive years. Despite the use of the word “passive” the income being discussed here is not generally income related to the passive activity rules of IRC §469. Rather, passive income is generally defined as gross receipts from royalties, rents, dividends, interest, and annuities. [IRC §1362(d)(3)(C)(i)] Various special exceptions apply to the inclusion of these types of income, most importantly related to rents derived in the active trade or business of renting property. [IRC Reg. §1.1362-2(c)(5)(ii)(B)(2)]
There are two issues that arise for an S corporation with excess passive income. One of them is the imposition of a tax on the excess passive income under IRC §1375. In that case, ignorance may be bliss. Pursuant to §1375(d) the tax is waived if the S corporation establishes that it believed it had no earnings and profit as of the end of the year in question and within a reasonable period of time after it is determined the entity had such earnings and profits they are distributed.
However no such special “I didn’t know I had earnings and profits” provision applies for the termination of S status pursuant to §1362(d)(3). Rather, in that case the corporation must formally request (via filing a private letter ruling request) the IRS grant inadvertent termination relief pursuant to IRC §1362(f).
In Private Letter Ruling 201538010 the IRS granted such relief to an S corporation that found its election had been terminated. However getting such relief first requires that the corporation pay a user fee in order to make the request. As well, the process of shepherding a private letter ruling request through the IRS generally requires a not insignificant amount of professional time (and therefore additional expense).
Finally the IRS imposes conditions on granting the waiver. In this case the IRS required the corporation to make a payment for an adjustment under IRC §1362(f)(4). The ruling does not tell us what this adjustment was for specifically, but it is possible that this corporation did not meet the conditions for relief under §1362(d).