The Section 1375 Sting Tax: How S Corporations Trigger the 21% Passive Income Tax and a Three-Year Termination Cliff

Imagine running a profitable S corporation for fifteen years, parking some retained cash in a brokerage account, and then discovering that the dividends and interest you earned just triggered a 21% corporate-level tax—on a company that was supposed to be a pass-through entity. Worse, if it happens three years in a row, the IRS quietly revokes your S election entirely. This is the world of the Section 1375 "sting tax," and it ambushes more business owners than you might expect.

The sting tax is one of the least understood traps in Subchapter S. It punishes a very specific combination of facts, and most owners never realize they are exposed until a CPA spots it during return preparation. The good news: once you understand how it works, the tax is almost entirely avoidable. This guide walks through who is at risk, how the tax is calculated, the three-year termination cliff that lurks behind it, and the practical moves that defuse the problem for good.

Who Is Actually at Risk

The Section 1375 tax only applies if two conditions are both true at the close of the tax year:

The S corporation has accumulated earnings and profits (E&P).
More than 25% of its gross receipts are passive investment income.

If either condition is missing, there is no sting tax. That single sentence is the most important thing to take away from this article, because it tells you exactly where to focus.

Most S corporations have no accumulated E&P at all. E&P is a C corporation concept—it represents earnings that were taxed at the corporate level and never distributed. A business that was formed as an S corporation from day one, or that elected S status before it ever accumulated retained earnings as a C corp, simply has no E&P. Those companies are immune to the sting tax no matter how much passive income they earn.

The exposed group is narrower and specific: former C corporations that converted to S status while still carrying undistributed C-corporation earnings on their books. If your company operated as a C corp for years, built up retained earnings, then elected S status without cleaning out that old E&P, you are a candidate. The other common path is an S corporation that absorbed a C corporation through a tax-free reorganization and inherited its E&P.

So before you worry about anything else, answer one question: Does my S corporation have accumulated E&P from C-corporation years? If the answer is a clean no, you can stop reading and relax. If the answer is yes—or "I'm not sure"—keep going.

What Counts as Passive Investment Income

The second condition turns on passive investment income, a term defined by cross-reference to Section 1362(d)(3). It includes gross receipts from:

Royalties
Rents
Dividends
Interest
Annuities
Gains from the sale or exchange of stock or securities

Note that this is measured in gross receipts, not net profit. A corporation that collects $200,000 of rent and spends $190,000 maintaining the property still has $200,000 of passive investment income for the 25% test, even though it only nets $10,000.

The definition has several important carve-outs that frequently rescue businesses from the test:

Active rents. "Rents" do not include rents earned in the active trade or business of renting property. If the corporation provides significant services or incurs substantial costs in operating the rental—think a hotel, a parking garage, or a property where the owner handles maintenance, leasing, and tenant services—the rent is active and not passive investment income. A triple-net lease where the tenant pays everything and the landlord does nothing, on the other hand, is classic passive rent.
Active royalties. Royalties earned in the ordinary course of a franchising or licensing business are not passive. A company whose actual business is licensing its intellectual property is not generating passive income from that activity.
Interest from financing inventory. Interest on notes received from selling the corporation's inventory is excluded, as is income from the active and regular conduct of a lending or finance business.
Dividends from active C corporation subsidiaries. If the S corporation owns a controlling interest in a C corporation and receives dividends attributable to that subsidiary's active business earnings, those dividends are not passive investment income.

These exceptions matter enormously. The same dollar of rent can be passive or active depending entirely on how involved the corporation is in producing it. If you are near the 25% line, a careful facts-and-circumstances analysis of your rental or royalty activity is the first place to look.

There is also a coordination rule with Section 1374: gains and losses that are treated as recognized built-in gains under the built-in gains tax rules are excluded from the passive investment income calculation, so the same gain is not hit by two corporate-level taxes.

How the Sting Tax Is Calculated

Once you confirm both conditions are met, the tax itself is computed on excess net passive income (ENPI). The formula has three moving parts.

Step 1: Net passive income. Start with passive investment income, then subtract the deductions directly connected with producing that income. Certain deductions are not allowed in this step, so net passive income is not simply the bottom-line profit from the investments.

Step 2: The excess ratio. Determine how much passive investment income exceeds the 25%-of-gross-receipts threshold, and express that as a fraction of total passive investment income:

                  Passive investment income − (25% × gross receipts)
Excess ratio  =   ───────────────────────────────────────────────────
                            Passive investment income

Step 3: Apply the ratio. Multiply net passive income by the excess ratio. The result is excess net passive income:

ENPI  =  Net passive income  ×  Excess ratio

ENPI is then capped at the corporation's taxable income for the year (computed as if it were a C corporation, with certain modifications). A corporation with no taxable income owes no sting tax even if it has excess passive income—the cap reduces the tax to zero.

Finally, the tax equals ENPI multiplied by the highest corporate tax rate under Section 11(b)—currently a flat 21%.

A Worked Example

Suppose Maple Holdings, a former C corporation with $80,000 of accumulated E&P, has a quiet year:

Gross receipts: $400,000
Passive investment income (interest and dividends): $160,000
Deductions directly connected to that passive income: $10,000

Run the numbers:

25% of gross receipts: $400,000 × 25% = $100,000
Passive income over the threshold: $160,000 − $100,000 = $60,000
Net passive income: $160,000 − $10,000 = $150,000
Excess ratio: $60,000 ÷ $160,000 = 0.375
ENPI: $150,000 × 0.375 = $56,250
Sting tax: $56,250 × 21% = $11,812.50

Maple Holdings owes nearly $12,000 of corporate-level tax—and the income that generated it still flows through to the shareholders' personal returns, where it is taxed again. The only credit allowed against the sting tax is the Section 34 credit for certain fuel taxes, so there is essentially no way to offset it.

The Three-Year Termination Cliff

The financial cost of the sting tax is annoying. The loss of S status is potentially catastrophic, and it is governed by a separate provision—Section 1362(d)(3).

If an S corporation has accumulated E&P and passive investment income exceeding 25% of gross receipts for three consecutive tax years, its S election terminates automatically at the beginning of the fourth year. The company becomes a C corporation, with a second layer of entity-level tax on all its income going forward, not just the passive portion.

This is why the sting tax should never be treated as a one-year inconvenience. The first year it appears, treat it as a flashing warning light. You have a limited window to fix the underlying structure before the termination clock runs out. Many owners pay the tax once, shrug, and pay it again—then are blindsided when year four arrives and their pass-through entity has silently become a double-taxed C corporation.

How to Defuse the Sting Tax

Because the tax requires both triggers, you only have to eliminate one of them. There are two strategic directions.

Option 1: Eliminate the Accumulated E&P

If you remove the C-corporation E&P, the sting tax can never apply again—regardless of how much passive income the corporation earns. There are two ways to do this:

Distribute the E&P as a dividend. Pay the accumulated E&P out to shareholders as an actual cash dividend. Shareholders report it as dividend income, but once it is gone, the corporation is permanently out of sting-tax range. There is even an election to distribute E&P before the Accumulated Adjustments Account, which lets you target the C-corp earnings specifically.
Make a deemed dividend election. If the corporation does not have cash to distribute—or the shareholders would rather not pull cash out—Treasury regulations allow a deemed dividend election under Reg. 1.1368-1(f)(3). With all shareholders consenting, the corporation is treated as if it distributed the E&P and the shareholders immediately contributed it back as capital. No cash actually moves. The shareholders still report dividend income, but their stock basis increases by the same amount. The election is made by attaching a statement to a timely filed (original or amended) Form 1120-S identifying the election and the deemed dividend allocated to each shareholder.

Eliminating E&P is the cleanest permanent fix. After it is done, the corporation can hold whatever investments it likes.

Option 2: Manage the 25% Gross Receipts Test

If you would rather keep the E&P intact—perhaps deferring the dividend tax to the shareholders—you can instead keep passive investment income at or below 25% of gross receipts:

Increase active gross receipts. Because the test is a ratio, growing the operating side of the business shrinks the passive percentage even if passive income stays flat.
Reduce passive holdings. Sell or reallocate investment assets so they generate less interest, dividend, and capital-gain income.
Reclassify rents and royalties as active. If the corporation provides meaningful services tied to its rental or licensing activity, that income may not count as passive at all. Document the services carefully.
Time investment sales. Because the test is annual, spreading securities sales across tax years can keep any single year under the threshold.

Option 2 requires ongoing attention every year. Option 1 solves the problem once. For most owners, eliminating the E&P is the better long-term move.

The Good-Faith Waiver

Section 1375 includes a relief valve. If a corporation, in good faith and with due diligence, determined it had no accumulated E&P—but a later IRS audit found that it did—the IRS may waive the sting tax, provided the corporation distributes the newly discovered E&P within a reasonable time after the audit. This waiver is a backstop for honest mistakes, not a planning tool. Do not rely on it; rely on knowing your E&P balance.

Keeping Your Books Audit-Ready

Every defense against the sting tax depends on numbers you can prove: your accumulated E&P balance, your gross receipts, and a clean split between passive and active income. Those figures should never be a year-end scramble. An S corporation that tracks investment income in dedicated accounts, separates active rental revenue from passive rent, and maintains a running E&P schedule can see the 25% ratio coming months before the return is due—while there is still time to make a distribution or an election.

This is exactly where disciplined bookkeeping pays for itself. Tagging each revenue stream by category as transactions are recorded turns the passive-income test from an annual guess into a number you can read off your books any day of the year. The same records support a deemed dividend election or a good-faith E&P position if the IRS ever asks.

Keep Your Finances Organized from Day One

Whether you are managing a former C corporation's lingering E&P or simply want to know your passive-income ratio before tax season, clear financial records are what make smart tax planning possible. Beancount.io provides plain-text accounting that gives you complete transparency and control over your financial data—every account, every category, version-controlled and AI-ready, with no black boxes and no vendor lock-in. Get started for free and see why developers and finance professionals are switching to plain-text accounting.

This article is for general educational purposes and is not tax or legal advice. The sting tax depends on facts specific to your corporation—consult a qualified tax professional before acting on any strategy described here.