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Calculating S Corp Stock and Debt Basis: Avoiding Loss Limitations and Excess Distributions

WEDNESDAY, JUNE 3, 2015, 1:00-2:50 pm Eastern

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Calculating S Corp Stock and Debt Basis

June 3, 2015 Robert S. Barnett Capell Barnett Matalon & Schoenfeld rbarnett@cbmslaw.com Anthony Nitti WithumSmith+Brown anitti@withum.com Darren J. Mills Alvarez & Marsal Taxand dmills@alvarezandmarsal.com

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

DARREN J MILLS STOCK BASIS: MECHANICS; LOSS LIMIT A TIONS; & SALE TRANSACTION

DISCLAIMER

The views/content, typos, errors, etc. expressed herein are solely those of the presenter and do not necessarily represent the views/content, etc. of Alvarez & Marsal T

• axand. The content herein is based on

the Internal Revenue Code of 1986 (as amended) and the regulations thereunder. This material will not be updated for any changes in law and does not address any foreign or state and local tax issues. Please consult your individual advisor regarding any tax, legal or accounting advice with respect to your personal situation.

1

CONTENTS

I. II. III. IV. Stock Basis: Mechanics Stock Basis: Loss Limitations Stock Basis: Sales Transactions Bio

STOCK BASIS: MECHANICS

STOCK BASIS: MECHANICS

It is important that a shareholder know his/her stock basis when:

– The S corporation allocates a loss and/or deduction item to the shareholder.

» In order for the shareholder to claim a loss, they need to demonstrate they have adequate stock and/or debt basis. The S corporation makes a non-dividend distribution to the shareholder. » In order for the shareholder to determine whether or not the distribution is non-taxable they need to demonstrate they have adequate stock basis. The shareholder disposes of their stock.

– –

» As with any asset, including C corporation stock, when the asset is sold or disposed of, basis needs established in order to reflect the proper gain or loss on the disposition.

Since shareholder stock basis in an S Corporation changes every year, it must be computed every year. Increases Basis.

to be

– – – –

Ordinary Income Separately Stated Income Items Tax Exempt Income Excess Depletion - the excess of the deductions for depletion over the basis of the property subject to depletion

Decreases Basis

– – – – –

Ordinary Loss Separately State Loss Items Nondeductible Expenses Non-Dividend Distributions In no event may a shareholder’s stock basis be reduced below zero

4

STOCK BASIS: MECHANICS CONT’D

Starting point: Substituted basis - Sec. 358 Cost basis – Sec. 1012 Gift/inheritance – Sec. 1014/1015 Substituted basis Incorporation of either a sole proprietorship or partnership (including partnership) – The basis of the stock received (or deemed received in a transaction) is the same as the adjusted basis of the property transferred. an LLC taxed as a meaningless gesture If money (including an assumed liability) or other property is received by the transferor then special basis adjustment rules apply . Such basis is first decreased by the amount of money received, the fair market value of any

• ther property received, and any loss recognized on the exchange. The basis is then

increased by any amount that is treated as a dividend and by the amount of any gain recognized as a result of the exchange (excluding that portion of the gain that is treated as a dividend) .

5

STOCK BASIS: MECHANICS CONT’D

Holding Period In a “Sec. 351” transaction, the holding period generally “tacks” Loss Duplication Issues Policy – A single economic loss should not give rise to two tax deductions. This result can

• ccur as a result the mechanical application of the substituted basis rules. Generally

, under

• Sec. 362, the transferee (e.g., an S Corporation) would take a “carryover basis” in the assets

transferred to it. As such, if a shareholder transferred built-in loss assets in a Sec. 351 transaction, the S/H would take a substituted basis in the stock received under Sec. 358 and the Corporation would take a carryover basis under Sec. 362; therefore, as a result of the mechanical application of the basis rules, two built-in losses arose from the same economic loss. According, with the AJCA Congress rectified this result with the enactment of Sec. 362(e)(2). If aggregate AB > aggregate FMV then basis is limited to aggregated FMV . Election available to reduce stock basis in lieu of the transferee’s basis in the built-in loss

• asset. See Sec. 362(e)(2)(C) and the regulations thereunder.

6

STOCK BASIS: MECHANICS CONT’D

Loss Duplication Issues – cont’d A, an individual, owns Asset 1 (basis $90, value $60) and Asset 2 (basis $1 10, value $120). In a transaction to which Code Sec. 351 applies, A transfers Asset 1 and Asset 2 to X, a domestic corporation, in exchange for a single outstanding share of X stock representing all the outstanding X stock immediately after the transaction. A's transfer of Asset 1 and Asset 2 is a Code Sec. 362(a) transaction. For purposes of Code Sec. 362(e)(2), X's aggregate basis in those assets would be $200 ($90 + $1 10), which would exceed the aggregate value of the assets $180 ($60 + $120) immediately after the transaction. Accordingly , the transfer is a loss duplication transaction and A has a net built-in loss of $20 ($200 - $180). Asset 1 is loss duplication property since X's basis in Asset 1 would be $90, which would exceed Asset 1's $60 value immediately after the transaction. X's basis in Asset 2 would be $1 10, which would not exceed Asset 2's $120 value immediately after the transaction, so Asset 2 is not loss duplication property . X's basis in Asset 1 is $70, computed as its $90 basis under Code Sec. 362(a), reduced by A's $20 net built-in loss. X has a transferred basis of $1 10 in Asset 2. Under Code Sec. 358(a), A has an exchanged basis of $200 in the X stock it receives in the

• transaction. Treas. Reg. §1.362-4(h), Example 1(i).

7

STOCK BASIS: MECHANICS CONT’D

Timing

– –

Adjustments are made as of the close of the corporation’s tax year If a S/H disposes of stock during the year, the adjustments are effective immediately before the disposition (but note election) Ordering Rules for calculating basis post August 18, 1998 (Treas. Reg. §1.1367-1(f))

– First, basis is increased for both separately stated and non-separately stated income items

and the excess of the deductions for depletion; Next, basis is decreased with respect to a distribution by the corporation described in §1367(a)(2)(A) (i.e., a distribution that was not includible in the income of the S/H); Next, basis is decreased by items that are noncapital, nondeductible expenses and the oil and gas depletion; and Finally , any decrease attributable to separately stated loss, deduction or credit items as well as non-separately computed loss items

– – –

Separate Basis Rule

– Under this rule, stock basis is computed on a share-by-share basis in the same manner as

that of a S/H in a C corporation The basis of a share of stock is increased or decreased by an amount equal to the S/H’s pro rata portion of the items described in §1367(a)(1) or (a)(2) that is attributable to that share

–

8

STOCK BASIS: MECHANICS CONT’D

Other Considerations

– A distribution may be tax free to the S/H, but Sec. 31

1(b) continues to apply to a distribution

• f appreciated property (i.e., any gain recognized on the deemed sale under Sec. 31

1(b) will pass through to all S/Hs) A S/H’s stock basis at the time of a distribution is irrelevant in determining the tax treatment of the distribution;

–

• Basis at the close of the tax year determines the tax treatment of the distribution

Under the stock basis adjustment rules, distributions made during a tax year are taken into account before applying any loss limitation for the year Note that, under Sec. 1367(b)(2)(A), basis from indebtedness may only be used to deduct losses; it may not be used to receive tax-free distributions (cash received in connection with such loans must take the form of a loan repayment)

• – S corporation rules adopt a separate basis approach for determining the basis adjustments in

S stock, computing stock basis on a share-by-share basis in the same manner as stock basis is computed for a S/H in a C corporation

9

STOCK BASIS: LOSS LIMITATIONS

LOSS LIMITATIONS

Amount of losses that can be deducted by the S/H is limited to his/her adjusted basis in the stock A loss that cannot be deducted due to a lack of basis is a “suspended loss” A suspended loss is an attribute of the individual S/H and cannot be used by other S/Hs If a shareholder transfers some but not all of the shareholder's stock in the corporation, the amount of any disallowed loss or deduction under this section is not reduced and the transferee does not acquire any portion of the disallowed loss or deduction. If a shareholder transfers all of the shareholder's stock in the corporation, any disallowed loss or deduction is permanently disallowed. Treas. Reg. §1.366-2(a)(6) No basis obtained in debt simply by guaranteeing a loan, etc. made by the S/H to get basis. Payment on the loan must be

11

LOSS LIMITATIONS – CONT’D

“Example: T is the sole shareholder of X, an S corporation. During 2005, X incurred and passed through to T $6,000 in nonseparately stated loss and $4,000 in capital loss. However, T was unable to deduct any of the losses due to a lack of basis. In this situation, both losses are suspended, carry forward to 2006, and pass through again with respect to T . In 2006, X incurred and passed through $5,000 in nonseparately stated income and $2,000 in capital gain. This means that T is deemed to have $1,000 in ordinary loss ($6,000 − $5,000) and $2,000 in capital loss ($4,000 − $2,000) from X in 2006. These amounts must be compared with T’s basis at the end of 2006 to determine if any of these amounts may be deducted. If not deductible, those amounts again carry forward and are combined with 2007’s passthrough results.” Starr and Sobol, 731-2nd T .M., S Corporations: Operations “Example: T is the sole shareholder of X, an S corporation. During X’s first three years of

• perations, it incurred losses totaling $100,000 that passed through to T

. However, because T

• nly had basis of $20,000 in X, $80,000 of the losses were suspended. In the fourth year of
• perations, T sold his stock to B. In this situation, T’s suspended losses are lost forever (nor are

they available to offset any gain from the sale of X stock).” Id.

12

STOCK BASIS: SALES TRANSACTION

THE SEC. 338(H)(10) ELECTION

Introduction

When Available – Available to any corporation that makes a Qualified Stock Purchase (QSP) of a Target Corporation – Target is an S corporation or an 80% or greater corporate subsidiary member of a consolidated group – Also, Sec. 336(e) may be a viable alternative as it does not require a “corporate purchaser” in a qualified stock disposition (“QSD”) Requirements – Corporate Purchaser – QSP: at least 80% (vote and value) must be acquired – Joint election by buyer and seller: filed by the 15th day of the 9th month following the month in which the acquisition occurs

14

THE SEC. 338(H)(10) ELECTION

Mechanics

• Treatment of T

arget Corporation: – T arget Corporation is deemed to sell all of its assets for an amount equal to the Aggregate Deemed Sales Price – T arget Corporation reports gain or loss from deemed sale on its final tax return

• In the S Corporation context, gain or loss flows-through to selling shareholders

(generally no federal entity-level tax is imposed on S corporations).

• Seller is responsible for any tax due on the deemed asset sale.

15

THE SEC. 338(H)(10) ELECTION

Mechanics

• Treatment of T

arget Corporation (continued): – T arget Corporation is deemed to liquidate at the end of the acquisition date

• If T

arget S Corporation is deemed to engage in a taxable liquidation. See Sec. 331 and 336. However, the gain or loss from the deemed asset sale flows through to the selling shareholders, increasing or decreasing their tax basis in their stock, respectively . As such, there generally is no incremental taxable gain upon the deemed liquidation of T arget Corporation. At the beginning of the day after the acquisition date, T arget Corporation is deemed to reconstitute itself as a new corporation and purchase the assets. T arget Corporation receives a tax basis in the assets equal to the Adjusted Grossed Up Basis.

• T

arget Corporation uses the Residual Method to allocate the Adjusted Grossed Up Basis. – –

16

THE SEC. 338(H)(10) ELECTION

Mechanics

• Treatment of Buyer

– – – – – Receives a cost basis in the stock of T arget Corporation. T ax basis step up in target assets Increase in after-tax cash flow T akes the form of a stock sale for non-tax reasons Note: historical business & tax exposures carryover

17

THE SEC. 338(H)(10) ELECTION

Mechanics

• Treatment of Sellers

– – The stock sale is ignored for federal income tax purposes Single level of tax (no shareholder level gain). The gain or loss from the deemed sale of the T arget Corporation’s assets flows through to the shareholders and is reported on their federal income tax returns. May be additional taxes (federal + state) – for which seller may require “gross ups” Complications in rolling shareholders – rollover is taxable as if stock was sold – –

18

THE SEC. 338(H)(10) ELECTION

Summary

• Note that in the case of a Sec. 338(h)(10) election, there is only one level of tax.

Because the deemed asset sale generally results in ordinary income, while the sale

• f stock results in capital gain or loss, the sellers may

, in certain cases, pay more tax under a Sec. 338(h)(10) election than under a stock sale. – Individual capital gain tax rates vs. ordinary income tax rates (23.8% vs. 39.6%), although, see Sec. 1231. State taxes (including entity-level taxes), Sec. 1374 BIG tax, etc.

• rder to make the sellers whole, the purchaser can Gross Up the sellers by

– In

• increasing the purchase price to accommodate for the incremental tax that the

sellers must suffer as a result of making the Sec. 338(h)(10) election. – The Gross Up Payment is included in the computations for Aggregate Deemed Sales Price and Adjusted Grossed Up Basis. – May result in additional depreciation or amortization deductions. A Sec. 338(h)(10) election generally makes sense if the present value of the additional depreciation and amortization deductions that result from making the election exceed the amount of the Gross Up Payment.

• 19

THE SEC. 338(H)(10) ELECTION

Summary

$300 Seller (“S”) Step 2 uidates “DEEMED”

Assumptions  Seller’s outside stock basis = $100  T’s inside asset basis = $200  T’s liabilities = $100  Buyer Pays $300 for stock

$300 + $100 Assumption of Debt

Cost Basis in T Stock = $300 Stock = $300 Carryover Basis up to $400

20

Stock Sale 338(h)(10) Buyer “B” Seller “S” Target “T” Cost Basis in T Capital / Ordinary Gain = $200 ($300 + Capital Gain = $200 $100 - $200) on deemed sales is passed through from Target; No gain on liquidation No Gain; Gain passed through to S; Basis is stepped

Ste Old T Liq “DEE OLD T (S Corp) Corporate Buyer (“B”) “ACTUAL” Stock Step 1 Assets New T (C Corp) (basis=$200) “DEEMED”

THE SEC. 338(H)(10) ELECTION

The Malpractice Transaction

Historical S/H PE PE

Cash

Historical S/H

Holdco Holdco

Stock

• Buyer purchases the stock of T

arget from Historical S/H for cash, and both parties make a Sec. 338(h)(10) election. Historical S/H rolls part of his proceeds (7%) into Holdco, such that after the transaction is consummated he is a partner in Holdco along with PE. The Sec. 338(h)(10) election was invalid because Historical S/H would be viewed as a related party , and you can’t do a Sec. 338(h)(10) election with a related party . A very harsh and unfair result. Had Historical S/H rolled his interest into Buyer, it would not have been a problem. The Sec. 336(e) rules partially address this issue.

• 21

Buyer Target Buyer Target (S Corp)

THE SEC. 338(H)(10) ELECTION

Other Considerations

Rollovers where the Seller ends up with more than 20% are not good QSPs S Corp status must be valid as a 338(h)(10) can’t be made on a stand-alone “C” corp. Gross-up for Incremental taxes Built-in gains taxes (S corporations) State taxes Character of taxable gains (ordinary versus capital)

22

BIO

A&M TAX AND PROFESSIONALS

• Darren J Mills is a Managing Director with Alvarez & Marsal Taxand in New York, with more than 20

years of international tax, M&A and ASC 740 experience. He assists multinational organizations assess and improve their global tax strategies. His most recent leadership experiences include, assisting two large multinationals in implementing the fair market value election and analysis of overall foreign loss/overall domestic loss; successfully assisted a Fortune 500 Company with the integration of a $400 million acquisition; provided both buy side and sell side tax due diligence and structuring to both strategic and financial investors; identification of a missed gain recognition agreement prior the filing of a timely tax return resulting in the preservation of a $500 million gain; identification of a missed tax deduction related to an investment unit and the associated tax implications of a debt restructuring resulting in a $10 million cash refund to the client; and structuring an acquisition to result in a tax-free step-up in inside basis

• Mr. Mills is frequently involved in helping companies respond to tax demands from boards of directors

and shareholders, as well as in fostering cross-functional communication between tax, operations, finance and treasury teams. He has worked closely with CEOs, CFOs and private equity investors. Before A&M, he was the partner responsible for developing the tax advisory practice in both Metro New York and DC for a Top 20 accounting firm. Mr. Mills was also at KPMG LLP where he participated in KPMG’s National ASC 740 team as a local resource. He began the early part of his career with Arthur Andersen LLP.

• Mr. Mills earned a juris doctor from Seton Hall Law School; a Masters of Science in Taxation at Fairleigh

Dickinson University and a Bachelor of Science in Accounting, also from Seton Hall University. Mr. Mills is a licensed attorney in the State of New Jersey (inactive in Pennsylvania) and a licensed CPA in the States of New Jersey & Florida as well as the Commonwealth of Virginia.

• Mr. Mills has served as an Adjunct Professor in the graduate tax programs at both Seton Hall University

and the University of Baltimore. He serves as a national speaker, and has written articles and provided comments on proposed regulations and other topics related to corporate and international taxation.

Darren J Mills

• Managing

Director

• Direct: +1 212 763 1925

Mobile: +1 908 612 8145 dmills@alvarezan

• NOTE: Alvarez & Marsal employs CPAs

but is not a licensed CPA firm.

24

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31

Basis and Distribution Ordering Rules

S CORPORATIONS:

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32

General Rules

A distribution of cash or property from an S corporation to a shareholder can result in one of three tax consequences:

Tax-free return of capital, Taxable dividend, Capital gain as if the shareholder sold the stock (even though they did not)

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33

Three Concepts

In order to determine the consequences, we must understand three concepts:

ONE

Shareholder basis in S corporation stock

(Subchapter S)

TWO

C Corporation Earnings and Profits

(E&P, Subchapter C)

THREE

Accumulated Adjustments Account

(AAA, Subchapter S)

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34

• Distributions of previously taxed S

corporation income should not be taxed a second time.

• In contrast, C corporation income should

be taxed twice; once when earned, once when distributed.

• Distribution rules preserve this difference.

The defining characteristic of S corporations is:

A Quick Primer

Continued

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35 Stock Basis versus Accumulated

Adjustments Account

Note, stock basis and AAA may not be the same thing. AAA is a corporate attribute. Stock basis is personal to a shareholder. Stock basis is increased for tax-exempt income and decreased for expenses attributable to tax-exempt expenses, AAA is NOT. AAA can go negative, stock basis cannot. If a shareholder buys an interest in an S corporation for a premium, it has no effect on AAA.

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36

Taxability of Distributions

Must ask two questions FIRST:

• Was the S corporation ever a C corporation?
• If so, does the S corporation still have C corporation “earnings and

profits?”

Quick hint:

• If an S corporation:
• Has been an S corporation since formation;
• Was formed after 1982, and
• Has never acquired a C corporation’s assets in a Section 381 transaction,
• Then the S corporation CANNOT have E&P.

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37 Distributions From an S Corporation

With No E&P

Taxability of distributions if no E&P (Treas. Reg. Section 1.1368-1(c))

STEP ONE

Distributions are tax-free to the extent of stock basis. (and basis must be reduced)

STEP TWO

Distributions in excess of basis generate capital gain to the s/h.

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38 Distributions From an S Corporation

With No E&P

WHY IS THIS THE RULE?

If an S corporation has no E&P, then all income available for distribution must have been earned while an S corporation. If that’s the case, because S corporation income should only be taxed ONCE, a distribution of that income should not be taxed a second time. As a result, a distribution is treated first as a tax- free return of basis to preserve the single level

• f taxation.

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39

If an S corporation: AAA is irrelevant to determining the taxability of distributions. However, you should still maintain the AAA balance on the return so you can distribute it tax-free during a post-termination transition period.

What is the Lesson?

Has never been a C corporation and Has never acquired a C corporation in a Section 381 transaction, then it can’t have corporate E&P.

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40

A OWNS ALL THE STOCK OF S CO. A’S BASIS IN S CO. STOCK IS $30,000 ON 1.1.2013.

Example 1

• S Co had $10,000 of AAA on 1.1.2013
• S Co. was never a C corporation, has no E&P
• During 2013, S Co. had:

Ordinary income $50,000 LTCL ($5,000) Made a $40,000 distribution to A on 6.1.2013

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41

Example 1

Continued

Because S Co. has no E&P, AAA is irrelevant.

The entire $40,000 distribution is tax free

Must look to stock basis:

• Starting basis:

$30,000

• Add: income:

$50,000

• Basis before distribution

$80,000

• Next: distributions:

($40,000)

• Remaining basis

$40,000

• Reduce for losses:

($5,000)

• End of year basis

$35,000

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42

A OWNS ALL THE STOCK OF S CO. A’S BASIS IN S CO. STOCK IS $30,000 ON 1.1.2013.

Example 2

• S Co. had $10,000 of AAA on 1.1.2013
• S Co. was never a C corporation, has no E&P
• During 2013, S Co. had:

Ordinary income $20,000 LTCL ($5,000) Made a $60,000 distribution to A on 6.1.2013

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43

Example 2

Continued

Only $50,000 of the $60,000 distribution is tax-free $10,000 results in capital gain The $5,000 loss is suspended

• Starting basis:

$30,000

• Add: income:

$20,000

• Basis before distributions

$50,000

• Next: distributions, but not below zero:

($50,000)

• Remaining basis

$0

• Reduce for losses:

$0

• End of year basis

$0

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44

BECAUSE OF THE BASIS ORDERING RULES, AN S CORPORATION WILL ALWAYS BE ABLE TO DISTRIBUTE ANY STOCK BASIS THAT EXISTS AT BEGINNING OF YEAR

Example 3

• A owns all the stock of S Co. A’s basis in S Co.

stock is $10,000 on 1.1.2013.

• During 2013, S Co. had:

Ordinary loss ($30,000) Made a $10,000 distribution to A on 6.1.2013

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45

Example 3

Continued

Even though S Co. has a net loss of $30,000 for the year, it can still distribute the $10,000 of beginning stock basis to A (this allows for a distribution of cash to cover tax on prior year income):

• Starting basis:

$10,000

• Add: income:

$0

• Next: distributions:

($10,000)

• Remaining basis

$0

• Reduce for losses:

$0

• End of year basis

$0

The entire $10,000 distribution is tax-free The $30,000 loss is suspended

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46

S Corporations With E&P

Not all S Corporation distributions should only be subject to a single level of tax under the Subchapter S

• rules. Why?

When a C corporation makes a distribution out of E&P, the distribution is taxed a second time as a dividend (Section 317/301) A C corporation should not be able to avoid this result by converting to an S corporation and then distributing the C corporation earnings

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47

S Corporations With E&P

• If a C corporation with E&P makes an S

election, the E&P survives the election and continues on.

• If the S corporation subsequently distributes the

C corporation E&P, it will be taxed as a dividend, just as it would have if distributed while a C corporation.

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48

S Corporations With E&P

When will an S corporation have E&P?

• If it was a prior C corporation and had accumulated E&P on the date
• f S election
• If it had no E&P on election date, but subsequently acquired a C

corporation in a Section 381 transaction.

When will an S corporation never have E&P?

• Has been an S corporation since formation.
• Formed after 1982.
• Has never acquired a C corporation in a Section 381 transaction.

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49

S Corporations with E&P

Important:

• An S corporation can have accumulated E&P on the date of an S

election, but cannot have current E&P while an S corporation.

• Effectively, the E&P of the C corporation gets “frozen” on the S

election date and will get reduced when the S corporation distributes the E&P.

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50

Concept #2: What Is E&P?

• Not defined anywhere in the Code or regulations.
• Meant to represent the measure of a corporation’s ability to

make distributions to its shareholders out of earnings rather than by returning contributions to capital.

• As a result E&P is not concerned with tax policy or financial

accounting considerations, rather, it is concerned with quantifying a corporation’s economic income.

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51

S Corporations with E&P

• On S election date, accumulated E&P from prior C corporation

years survive.

• However, the S corporation is still entitled to distribute S

corporation earnings tax-free BEFORE it is deemed to distribute C corporation E&P.

• How do we decide whether an S corporation’s distributions

are from S corporation earnings or C corporation E&P?

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52 Concept #3: Accumulated Adjustment

Account

The AAA measures the taxable income that was previously earned by the S corporation.

This is income that was previously taxed to shareholders and thus should be permitted to be distributed without a second level of tax.

Sales of stock do not impact AAA, because it is a corporate attribute.

An account of the S corporation – as opposed to basis, which belongs to an individual shareholder.

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Accumulated Adjustment Account

Account starts at zero on the effective date of an S election.

AAA, unlike basis, can be reduced below zero, but NOT by distributions. Non-separately stated income Separately stated income Do NOT increase for tax- exempt income Non-separately stated loss Separately stated loss Do NOT decrease for expenses attributable to tax-exempt income Distributions

Increase for: Decrease for:

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When and in What Order Do You Adjust AAA?

Net positive: income and gain exceeds loss and deduction (not distribution) items. Net negative: loss and deduction items exceed the income and gain items.

Depends on if you have a “net positive”

• r “net negative” adjustment.

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How and When Do You Adjust AAA?

• If you have a net positive adjustment, adjust AAA BEFORE

figuring out taxability of distribution.

• If you have a net negative adjustment, DO NOT adjust AAA

before figuring out taxability of distribution.

• This keeps AAA higher and allows more distribution to be a

tax-free return of basis rather than a taxable dividend.

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S Corp with AEP §1368(c)

• To the extent of Accumulated Adjustment Account (AAA), the

distribution is treated as if made by a S corp WITHOUT AEP. Tier 1

• Distributions in excess of AAA are treated as a dividend up to

AEP. Tier 2

• Distributions in excess of AEP are treated as if made by S corp

without AEP. (i.e., same as Step 1) Tier 3

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Example 7

Net Positive Adj.

Tom owns 100% of S Co. S Co. has AAA of $2,500 and E&P of $7,500. Tom’s stock basis on 1.1.2013 is $10,000. During the year, S Co. has the following:

Income $9,000 Loss: $2,000 Distribution: $11,000

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Solution, Example 8

AAA E&P S Corp. Dist. C Corp Dist. Starting $2,500 $7,500 Increase AAA: net positive adjustment $7,000 AAA balance before distribution $9,500 Decrease: distribution ($9,500) $9,500 Ending AAA $0 Distribution from E&P ($1,500) $1,500 Ending E&P $6,000

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Solution, Example 8

Basis Starting $10,000 Increase for income $9,000 Basis before distribution $19,000 Decrease for distribution not taxed as dividend ($9,500) Decrease for losses ($2,000) Ending basis $7,500

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Example 8

What’s the Lesson? AAA is the dividing line between distributions made from S corporation income (which are tax-free to extent of shareholder basis) and those made from C corporation E&P (which must be taxed as a dividend).

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Example 9

Net Negative Adj. A

X is the sole s/h in S corp. X has basis of $1,000

• n 1/1/2013

S corp has $500 of E&P and $200 of AAA

• n 1/1/2013.

During 2013, S corp has $200 of capital gain, has an operating loss of ($900)

S corp makes a $1,000 distribution.

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Net Negative Example 9, Solution

Do you have a net positive or net negative adjustment? AS A RESULT You determine the taxability of the distribution BEFORE you adjust AAA. THERE IS A NET NEGATIVE ADJUSTMENT.

($200 LTCG - $900 loss). This rule means that you can always distribute out the beginning balance in AAA under the S corporation rules, even if the current year is a huge net loss.

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Solution, Example 9

AAA E&P S Corp Dist. C Corp Dist.

Starting

$200 $500

Decrease: distribution (not below zero)

($200) $200

AAA balance after distribution

$0

Decrease AAA: net negative adjustment

($700)

Ending AAA

($700)

Distribution from E&P

($500) $500

Ending E&P

$0

Distributions in excess of AAA/E&P

$300

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Solution, Example 9

Basis

Starting Basis $1,000 Increase for income $200 Decrease for distribution not taxed as dividend ($500) Basis after distributions $700 Decrease for losses ($700) Ending basis $0 Suspended losses $200

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Example 9

What’s the lesson?

Even though the S corporation had a net loss of $700 for the year, the beginning AAA balance of $200 can be distributed tax free. AAA can go negative from losses; here it ends the year at ($700). Basis CANNOT go negative; any losses that cannot be used carry forward. AAA is reduced by the full loss, even though the loss may be suspended at the shareholder level. VERY IMPORTANT: in this example, we reduced E&P to zero. It will NEVER be a problem again. From this point on, all distributions will simply be tax-free to extent of s/h basis and capital gain for any excess.

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Post-Termination Transition Period

If a corporation’s S election terminates and the corporation reverts to a C corporation, does that mean that all future distributions are taxed as dividends?

NO.

• The corporation may

distribute all of its AAA in cash – and only cash – under the S corporation rules during the post- termination transition period. PERIOD IS LATER OF:

• One year from date S

election terminates,

• Due date of final S

corporation tax return, including extensions

• Also 120 days from

any later determination that S status ended THIS IS WHY

• We must maintain AAA

even when no E&P!

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PTTP Example 13

S Co.’s S status ended on 1/1/2013. On 1/1/2013, S Co. had:

AAA of $20,000 E&P of $10,000 A, the sole shareholder, has basis of $20,000

Even though S Co. is now a C corporation, S Co. has until 12/31/2013 to distribute $20,000 of AAA under the S corporation rules (tax-free to extent of basis, then capital gain). The distributions must be in cash.

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Other Adjustments Account (OAA)

Is not mentioned anywhere in the Code or regulations. Ultimately has no tax significance. Is meant to measure those items that increase or decrease shareholder basis (tax-exempt income and expenses related to tax-exempt expenses) but don’t increase or decrease AAA. Thus, you cannot make non-dividend distributions from this account.

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Previously Taxed Income (PTI)

• Only exists for corporations that elected S status prior to

1983.

• Any PTI was “frozen” on 1/1/1983.
• Unlike AAA, PTI is a shareholder-level attribute.
• PTI is distributed after AAA, but before E&P.
• PTI must be distributed in cash, not property.
• Upon termination of S status, the PTI account cannot be

distributed under the S corporation rules (non-dividend).

• Because of this, PTI should be distributed as soon as possible.

Consider election to distribute PTI before AAA (see later slides)

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PTI Example 14

S Co. became an S corporation in

• 1980. On

12/31/1982 it had PTI of $35,000 allocated to its sole shareholder, A. S Co. had corporate E&P of $20,000 on the date of the S election. From 1983 through 2013, S Co. accumulates AAA of $150,000, but no distributions were made. In 2013, S Co. distributes $180,000.

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PTI Example 14

The $180,000 distribution comes first from AAA of $150,000 (tax- free to extent of A’s stock basis, capital gain for excess), Then from PTI

• f $35,000.

Thus, none of the distribution is taxed as a dividend.

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Solution, Example 14

AAA PTI E&P

Starting

$150,000 $35,000 $20,000

Increase AAA: net positive adjustment

n/a

Decrease: distribution (not below zero)

($150,000)

Ending AAA

$0

Distribution from PTI

($30,000)

Ending PTI

$5,000

Decrease E&P for dividend

n/a

Ending E&P

$20,000

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Elections

• An S corporation that wants to get rid of its C corp E&P

(perhaps to avoid §1375 or use an expiring shareholder NOL) can elect to bypass AAA and distribute E&P first. Treas. Reg. §1.1368-1(f)(2)

• Note, however, that if the corporation has PTI, a second

distribution must be made to also bypass PTI and distribute E&P first.

• Also consider, if you plan to revoke your S status, may want to

elect to distribute PTI first since you can’t distribute PTI during the post-termination transition period.

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Elections

• Election to bypass AAA applies to all distributions during the

year.

• Cannot choose specific distributions to go against E&P, the

first dollars of distribution will be a dividend until all the E&P is purged.

• Not all E&P must be distributed.
• Election applies on a year-by-year basis, all shareholders who

got a distribution must consent, and is attached to return.

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Elections

• Can also elect to make a deemed dividend under Treas. Reg.

§1.1368-1(f)(3) if no cash is available.

• Treated as a cash distribution followed by a contribution to

capital (giving a basis bump).

• Election is filed with return, so you have the benefit of

hindsight.

S CORPORATION

OPEN ACCOUNT DEBT– 2015

By Robert S. Barnett

CPA, JD, MS (TAXATION) CAPELL BARNETT MATALON & SCHOENFELD, LLP. ATTORNEYS AT LAW (516) 931-8100 rbarnett@cbmslaw.com

LOSS UTILIZATION

• IRC §1366(d)(1)
• LIMITS use of S Corp losses and

deductions to extent of shareholder’s basis in stock

• PLUS Corporate debt to shareholder.

77

LOSSES - UTILIZATION

• 1. First §1366(d)(1) Stock Basis
• 2. Then reduces Basis in debt to Corp
• 3. Remainder carried forward
• REMEMBER – basis does not include

guarantees or circular loans

• Back-to-Back – must be bona fide
• See §1.1366-2(a)(2)(i) & (iii),ex. 2

78

BASIS

• Barnes v. Comm., 111 AFTR 2d 2013 (DC Cir)
• Affirmed Tax Court, TCM 2012-80 – reduce

basis even if fail to deduct the loss

• S SHs inadequate basis
• Unable to deduct losses – limited to basis
• Basis not increased by prior losses not claimed
• Taxpayer failed to deduct suspended losses
• Statute of limitations expired

79

LOSS UTILIZATION

• Gleason v. Commissioner, TCM 2006-191 (9/11/06)

– Taxpayer won as borrower on a $6m loan – IRS re-characterized loan properly made by taxpayer because loan payments paid by Corp and stock was pledged as collateral

• Kerzener, TCM 2009-76

– CIRCULAR LOAN from p’ship to S SH to S corp did not create basis. – S Corp paid equivalent rent back to the p’ship. – Transaction lacked economic substance – MERE CONDUIT – No sufficient risk – Court distinguished Ruckriegel and Culnen

• Nathel, 105 AFTR 2 ¶ 2010-927 (2nd Cir. 6/2/10)

– Equity and debt are distinguishable – Contribution of equity increases basis of stock but does not restore loan basis – CONTRIBUTIONS TO CAPITAL ARE NOT INCOME!

80

NATHEL

• The Corp. repaid shareholder loans (reduced

basis from losses)

• Recognized Ordinary Income on repayment
• f loan
• Attempted to restore or increase loan basis
• Capital contributions do not create exempt

income (income increases loan basis)

• Supreme court denied cert.

81

BACK TO BACK LOANS

• Treas. Reg. §1.1366-2 (7/23/14)
• “Bona fide indebtedness”
• All facts & circumstances considered
• General tax principles
• MAGUIRE, TCM 2012-160
• Auto dealer and finance company
• A/R distributed then contributed
• Substitutions- State Law Formalities

82

Culnen, TCM 2000-139

• Distributions from profitable S corp (> $3mm) to

loss corp added to basis:

• i. Amounts came out of S earnings,
• ii. Always shown on corp’s books as loans

to/from shareholder, and iii.All bank financing statements showed the loans as personal, not corporate.

• Back to Back loans & Substitutions
• Treas. Reg. §1.1366-2 (7/23/14)

83

BONA FIDE DEBT

• Watch Second Class of Stock Rules
• Straight Debt Safe Harbor
• Reg. §1.1361-1(l)(5)
• Substitution- State Law Formalities

84

DEBT vs. EQUITY

• Transfers to Corp generally equity, not loan
• Capital contribution
• Payment Personal expenses - dividends
• Not repayment of loan
• No debtor/creditor indicia
• ACM Environmental Services, TCM 2012-335
• Proper documentation missing

85

NOT BONA FIDE DEBT

• No Bad Debt Deduction –Herrera v.

Comm’r, 112 AFTR2d 2013-6858 (5th Cir.)

• LLC (p’ship) Loans to related steel corp.
• No written promissory notes
• No definite maturity
• No repayment schedule
• No security – no payments

86

OPEN ACCOUNT DEBT INTRODUCTION

• Brooks v. Commissioner – TCM

2005-204 (August 25, 2005)

• Final Regulations

87

LOANS

• Assume Stock Basis $100
• If X $200 loss, shareholder deducts only $100
• §1366(d)(1) deductions limited to Basis
• Excess loss carried forward
• Basis can never be negative
• So shareholder loans $100 to Corp on 12/31
• Stock Basis & Loan Basis is $0
• Later income first restores Loan Basis

88

OPEN ACCOUNT DEBT

• Shareholder loans/advances not evidenced

by written instrument

• New Regulations –10/20/08 and thereafter
• Limit $25,000 per Shareholder
• EXAMPLE – 10 Shareholders, each can

have up to $25,000 of Open Account Debt

89

BE CAREFUL

• No single Shareholder exceeds limit
• Keep records per Shareholder
• Not day/day – END OF S YEAR
• Unless debt disposed or Shareholder

terminated ownership

90

WHAT HAPPENS

• When $25,000 limit exceeded
• Debt at end of year treated AS IF

evidenced by separate written agreement

• No longer Open Account Debt
• Debt existing on 10/20/2008 not subject to

new rules - treated as a separate loan

• Identification issues exist

91

LOSSES – ORDERING RULES

• Losses first absorb Stock Basis
• Then reduce Debt Basis
• NOT BELOW ZERO
• Multiple indebtedness – Loss Allocated
• Based upon aggregate Basis
• Intricate record keeping required

92

RESTORATION/ PRIORITY

• Distinction between Stock & Debt Basis
• “Net Income” restores Debt Basis first
• First- to any Repaid Debt
• Then proportionally to unrestored basis
• “Net Increase” §1367(a)(1) income items
• New contribution(s) - increase Stock Basis

(Nathel)

• Computations generally determined at end of

the year

93

ACCELERATION

• Termination of ownership
• Dispose of debt

94

COMPUTATION

• Advances and Repayments are netted
• At close of S Corp year
• Net Advance or Repayment is combined with

Principal balance of Open Account Debt

• Carried to next year (unless > $25,000)
• IF > $25,000 – no longer Open Account Debt
• Treated as if separate debt.

95

EXAMPLE ONE

• A’s Stock Basis is $0
• 6/1/09 A loans S $16,000 (no note)
• 12/31/09 – Open Account Debt = $16,000

96

EXAMPLE TWO – 2009 STOCK BASIS $0

• A lends $16,000 6/1/09
• 12/31/09 Loss <$8,000>
• A’s BASIS in Open Account Debt is

$8,000

• Principal Loan amount remains $16,000

97

EXAMPLE THREE – 2010

• A Stock Basis = $0 Loan Basis = $8,000

(principal $16,000)

• 4/1/10 – S Repays to A $4,000
• 9/1/10 – A Advances $1,000 (net $3,000)
• 12/31/10 – Debt Principal $13,000
• Still open Account Debt

98

EXAMPLE THREE CONTINUED

• A recognizes income $1,500

(8/16 x $3,000 Net Repayment)

• IF evidenced by a note gain is Capital Gain

(note: Tax treatment of debt treated “as if” evidenced by a note is not yet addressed)

• 12/31/10 – Open Account Debt Principal

$13,000

• Carried to 2011

99

EXAMPLE FOUR (ex. 3 FACTS)

• 2/1/11 – S Repays A $5,000
• 3/1/11 – A Advances $20,000
• Not evidenced by a written agreement
• 2011 Net Advance $15,000
• Debt $28,000 (> $25,000 – not Open Account

Debt)

• Treated as if evidenced by a separate written

agreement – maintain records

100

WHO CARES?

• The IRS & the Treasury
• $25,000 limitation eliminates Year End

Repayments

• Mixed blessing
• Gain on Repayment of Debt evidenced by

notes is CAPITAL GAIN

• Repayment of Open Account Debt with

reduced basis = ORDINARY INCOME

101