Closely Held C Corporations: Do the Passive Activity Rules Limit Purchased Credits?

A widely held C corporation generally uses purchased credits against its regular tax, subject to §38(c). A closely held C corporation or personal service corporation faces an extra layer: the passive activity rules.

What the IRS says

IRS Transferability FAQ Q15: individuals, estates and trusts, closely held C corporations and personal service corporations may purchase and claim credits, but "will be subject to the passive activity rules for any purchased credits." Generally this means they can only use purchased credits to offset passive income tax liability, and most taxpayers do not have much of that.

Who is "closely held"?

Under §469(j)(1), a closely held C corporation is a C corporation in which, at any time during the last half of the taxable year, more than 50% of the stock value is owned directly or indirectly by or for five or fewer individuals. Personal service corporations are defined in §469(j)(2). Check your ownership under the attribution rules with your CPA.

Why a closely held company may still use credits

§469(e)(2) lets a closely held C corporation (not a personal service corporation) treat net active income as passive income for purposes of the passive loss limit, and states that a similar rule applies to the passive activity credit. In practice, that can allow purchased credits to offset tax attributable to the corporation's net active income. The IRS provides Form 8810 for corporate passive activity loss and credit limitations. How the numbers flow, and how the purchased credit interacts with other credits, is where you need a CPA.

Personal service corporations

A personal service corporation (for example, a professional firm) does not get the §469(e)(2) benefit, so credit use is generally limited to tax on passive income. If you own one and wonder whether credits can offset tax on professional income, the careful default answer is no, subject to your own analysis.

Checklist for a closely held company

1. Determine whether the company is closely held and whether it is a personal service corporation.
2. Estimate net active income and the tax allocable to it.
3. Model §38(c) after the §469 step (details).
4. Confirm which forms carry the credit (Form 8810, then Form 3800).
5. Document the analysis in your file.

Example: is it closely held?

Three founders own 70% of a C corporation's stock by value for the last half of the year. Five or fewer individuals own more than 50%, so the corporation is closely held under §469(j)(1). If instead 200 unrelated shareholders each owned a fraction, it would not be. Indirect ownership through entities and family attribution can change the count, so confirm with your CPA.

Questions to ask your CPA

1. Are we closely held, a personal service corporation, or neither?
2. How much of our tax is attributable to net active income?
3. How does §469(e)(2) apply to a credit we buy rather than earn?
4. Should we also model the §38(c) limit and any alternative minimum tax?

The answers differ from one company to the next, which is why the IRS tells these taxpayers to consult a tax professional (FAQ Q15).

Educational only, not tax advice. We did not verify Form 8810 line mechanics; consult its instructions.