 Hello and welcome to this session in which we will discuss S-corporation taxes at the corporate level and specifically we are discussing here the passive investment income penalty tax. It's where the S-corporation itself pay the taxes, huh? A little bit unusual, of course it is because the S-corporation are not tax-paying entities. S-corporation are flow-through, it means any revenues, any and all revenues and expenses the net of them which is profit or losses are passed through the shareholders. Therefore the corporation should not have a tax liability but under certain circumstances like what we saw in the built-in gains tax and the prior session the corporation might have to pay some taxes. In this session we'll focus on the passive investment income penalty tax. Well first we need to know what that tax is and after we discuss this tax we still have two situations where the S-corporation might have to pay taxes on a corporate level and that's life or recapture and the general business credit recapture and I will focus on those and I will create one recording for those two. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead start your free trial today. No obligation, no credit card required. So what is passive investment income tax penalty? Well what is passive investment? That's the first thing we need to know. Passive investment is when you own investments, a portfolio income, stocks, bonds. You might have some rental property in which you don't participate like maybe an apartment building in Florida you are just an investor. You could have royalty income from your books from your innovation so on and so forth. A passive investment is generated from an activity in which the taxpayer is not actively engaged. What does that mean? It means you are on the beach somewhere in Hawaii and you're getting paid. Why? Because your money is working for you. You have investments in stocks, royalty income, interest income, dividend income, rental income. Notice if the taxpayer does not actively participate, well if you actively participate then that's your job, that's your business. Then you are no longer passive, you are active. If you are not passive, you are active. Well that's not the case. It's rental income where you are passive. You are not really managing the business. A management company is taking care of the decisions. So here's what happened. The passive investment income tax is imposed on the S corporation that has earnings and profit at the close of the tax year. That's not the only thing. Maybe every year you might have accumulated earnings and profit and notice here and you generated passive investment income. I'm going to be abbreviating this as PII, an access of 20% of the gross receipt. What does that mean? It means your passive investment income is large enough to represent 25% of your gross profit. So if your gross profit is, let's just make it simple, just kind of illustrate the concept. If your gross profit is 100,000 and you have 20,000 in passive investment that's 20%. Well if you have 25,000 of the 100,000 well you're at the 25%. Now once you exceed 25% or more, an access of 25% is an access, not an access of 25% more than 25%. Now this tax will be imposed. Now let's take a look at a little bit more detail about this. The passive investment tax is 21%. Well what's special about 21%? Well it's the corporate tax. You have to pay the corporate tax, it's 21%. Now you could be watching this recording in 2026, 2027 and the corporate tax could be different. So this 21% is not written in stone. It's usually the highest corporate tax rate. In addition the tax is applied to the excess net investment income. So we're going to learn about something called ENPI, access investment net passive income. How do we compute this excess net investment passive income? We're going to take the PII, the passive investment income in excess of 25% divided by the PII, passive investment income times net PII. What's net PII? You're going to have certain deductions from your passive investment. You might be incurring if you invest in stocks, you might have to borrow some money, you have interest expense. Well that's part of your expenses to invest. Therefore NPII is the difference between your PII. You're going to have passive investment income. Simply put you're going to have income of $10,000 from dividend and the deduction and you might have to pay $1,000 to borrow money to buy the stocks. So your NPII is 9,000. So simply put this is your income from the dividend and this is your expenses that's related to the investment. Gives you NPII. Every time you hear the word net something it means you are deducting something from the gross. So for the purpose of determining the PII tax the ENPI the excess net passive investment income may not exceed the S corporation income. In other words the PII is imposed on the lesser of the corporate's ENPI or its net income. The best is to look at couple examples to illustrate these concepts. The first example during 20x4 target is an S core generated gross receipt without passive income of 301. So that's the gross receipts without no passive income. In addition it generated passive investment income of 110 and incurred 32,000 of expenses related directly to the production of passive investment income. Usually it could be interest expense if you want to borrow money to invest. It could be a management fee. You have to pay someone to manage your money. That's also cost or expenses related to the production of passive investment income. Now we're going to compute the passive investment income tax penalty for the year if it exists. Well let's find out. Well what's the total receipt? The total receipt for the company 301 let I'm going to put this in quote called active. It's not really active it's just the gross receipt and this is the passive and together they will give us 411,000. The first thing we want to find out is do we have, do they exceed 25% of your gross receipt passive income? Well target passive income exceeds 25% by 7250. How did I find this out? Well let's think about it. If you take 411,000 and you multiply it by 25% to find out what is 25% of your gross receipts. 25% is 102750. So if you have more than 102750 in passive then you exceed 25%. It indeed you have 110. You exceeded the passive investment income by 7250. On the other hand what's NPII net passive investment income? Remember it's 110 and we have to deduct certain expenses. Again could be interest expense, management fee to someone to manage your money equal to NP net is 78,000. Now let's use the formula. We're going to take the amount and access of 25% divided by PII the passive investment income overall let's see 7250 divided by 110,000 so the amount and access represent approximately 6.5% multiply this by the NPII which is the net which will give us access net passive investment income of 5141. Simply put they give you a chance to deduct your passive investment income to reduce your taxes because you are incurring a cost and that's only fair. Okay you made that passive investment income but that did not come free. You had to pay some money for it while they allow you to deduct this expense. Now if that's the access then you the net access basically the true access then you have to pay 21% and you have a tax bill. This is again this tax bill is for the corporation itself of $1080. Let's take a look at another example at the close of the tax year 2006 Glory and S corporation has accumulated EMP of 320. During 06 or x6 Glory reported operating income of 520. Taxable interest income of 220 again what is taxable interest passive operating expenses of 210 and deductibles related to the interest of 50,000 which is well you incurred $50,000 to generate the taxable interest. You have to borrow money maybe to buy those bonds that's interest expense. Determine passive investment income for 220x4 well let's first let's add up all the gross receipts to see where we are. We have 520 again of active and 220 of passive total of 740. The passive investment income applies as Glory's PII of 220 exceeds 25% of the gross receipts of 740. Well if we take 740 times 0.25 and that's equal to 185 so if your gross if your PII exceeds 185 then guess what we might have this passive investment passive investment penalty tax does it exceed sure it does you have 220 well now we have to compute not PII and PII because you are allowed to deduct your expenses well it's 220 that's your PII all interest minus 50,000 so this is basically this is interest income which is passive income and this is interest expense that's related so the reason you have this interest expense because you have this interest income again how does this work you borrow money to buy bonds you borrow money you have interest the bonds pay you interest well you net them out the net is 170,000 now we are ready to compute the access and PII well how do we compute this well it's 220 minus 185 divided by 220 remember 220 is the net so the the numerator is the access so what's 220 minus 185 that's going to give us so you are 35,000 above the 25,000 so 35,000 divided by 220 and that's approximately 15.9% so this ratio is 15.9% now since you can deduct your expenses you are allowed to reduce it a little bit times 170 so your ENPI is 27,045 what do you do now you have to pay a tax on this 27,045 what is the tax rate again why is it 21% because that's the corporate tax rate that's that's the corporate so who pays this tax the corporation itself which is the S corporation which is a little bit unusual but guess what that's that's how it works it's one of those special circumstances where the corporation itself will have to pay taxes what's left in this topic is the life or recapture and the general business credit recapture which we'll talk about in the next session what should you do now go to far have lectures and work mcqs through falls look at additional resources that's gonna help you whether you are a CPA candidate or enrolled agent the passive investment income penalty tax or the passive investment income tax is an important topic on the CPA exam take it seriously good luck study hard and of course stay safe