What must be done to avoid excessive passive investment income in an S corporation?

To avoid excessive passive investment income in an S corporation, it is crucial to manage the levels of taxable income in relation to net passive income. Excessive passive investment income is typically considered to be passive income exceeding 25% of gross receipts for an S corporation. If an S corporation has too much passive investment income over time, it risks undergoing taxation at the corporate level or losing its S corporation status.

Reducing taxable income below net passive income effectively helps prevent the S corporation from exceeding these thresholds, thus avoiding potential penalties and maintaining its favorable tax status. This approach requires careful planning and monitoring of income sources and expenses to ensure compliance with the IRS rules governing S corporations and their passive income.

The options that involve increasing capital contributions or changing the accounting method may not directly address the issue of passive income generation and compliance with the S corporation requirements. Similarly, limiting distributions to shareholders does not necessarily mitigate the income classification but could affect shareholders' individual tax situations. Therefore, focusing on the relationship between taxable income and passive income is the most effective strategy for adherence to the S corporation regulations.