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Determining Tax Treatment of S Corporation Distributions: Applying Section 1368 for Optimal Tax Results

WEDNESDAY , JULY 20, 2016, 1:00-2:50 pm Eastern

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July 20, 2016

Determining Tax Treatment of S Corporation Distributions

Anthony J. Nitti, Tax Partner WithumSmith+Brown, Aspen, Colo. anitti@withum.com Craig Kish, CPA, Tax Supervisor WithumSmith+Brown, Orlando, Fla. ckish@withum.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.

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)

5

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)

6

A Quick Primer-the “Why” of Distributions S Corporations generally do not pay tax at the entity level.

Instead, the income or loss of the S corporation is computed at the entity level, but then is allocated among the shareholders

• n Schedule K-1.

The income or loss is then reported – and tax paid – at the individual shareholder level. Upon the distribution of previously earned income, the distribution is tax-free.

7

• 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.

Thus, the defining characteristic of S corporations is:

A Quick Primer

8

FORM 1040

Concept #1: Shareholder Basis

A

A invests $500 into a wholly-owned S corporation. S Co. uses the $500 to generate $100 of taxable income.

The $100 of income is allocated to A on Schedule K-1; A pays tax on the $100 on Form 1040.

Presumably, the value of S Co. is now $600.

If A did NOT adjust his initial $500 basis to reflect the $100 of income earned, a sale of the stock for $600 would generate $100 of gain ($600 - $500 basis) Thus, A would effectively be taxed twice on the SAME $100 of income earned by S Co.

9

Shareholder Basis and Single Level of Tax By increasing A’s basis, the single- level of taxation has been preserved.

Thus, a sale of the S Co. stock for $600 would generate no further gain or loss. A’s basis goes from:

$500 to $600

To avoid this result, Section 1367 requires A to increase his stock basis to reflect the $100 of income allocated to him from S Co.

STOCK BASIS INCREASE BASIS

$600 $600

10

Basics of S corporation Basis -§1367

S corporation shareholders get basis in both stock of the S corporation and amounts loaned by the shareholder to the S corporation (debt). Only stock basis is taken into consideration for determining the taxability of distributions, debt basis is not. The amount of losses and deductions taken into account by a s/h can’t exceed the basis of stock and debt. (Section 1366) Any loss not allowed is treated as incurred in the corporation’s next tax year and subsequent tax years (i.e., unlimited carryover). §1.1366-2

11

Initial Basis in S Corp Stock

• Purchase of shares: basis is cost (§1012)
• Incorporation: usually basis of property transferred to

corporation (§358)

• C corp electing S status: basis is basis in C stock at the

time of conversion.

• Stock acquired by gift: donor’s basis (§1015)
• Stock acquired be inheritance: usually FMV (§1014)

12

Basis Adjustments: §1367(a)(1)

Capital contributions (cash and adjusted basis of property contributed)

Non- separately stated income

(ex: Line 1 of K-1)

Separately stated income Tax-Exempt income

Basis is increased by:

13

Basis Adjustments: §1367(a)(2)

After increases, basis is decreased by:

Distributions (cash and FMV of property)

Non- separately stated loss Separately stated items of loss or deduction Non- deductible expenses

(ex: M&E M-1)

14

FIRST

Increase for income items

Order of Adjustments to Stock Basis

NORMALLY MADE AT END OF THE TAX YEAR

• IMPORTANT: Under §1.1367-1(f), stock basis is adjusted in the following order:

SECOND

Decrease for distributions

THIRD Decrease by nondeductible expenses

FOURTH

Decrease for items of loss and deduction

15

Problem 1: Ordering Rules

A OWNS 100% OF S CO.

1 2 Beginning Basis $5000 $5000 Operating Inc./(loss) $2000 $2000 LTCL ($7000) ($7000) Distributions None $5000

16

Solution: 1A

ONE Start by increasing basis for income to highest point: TWO Next, reduce for distributions: THREE Lastly, reduce for losses: FOUR

Losses are fully utilized. No suspended losses. $5,000 $2,000 $7,000

+

$7,000 $0 $7,000

• $7,000

$7,000 $0

• 17

Solution: 1B

ONE Start by increasing basis for income to highest point: TWO Next, reduce for distributions: THREE Lastly, reduce for losses: FOUR

Losses are limited. $5,000 of suspended losses. $5,000 $2,000 $7,000

+

$7,000 $5,000 $2,000

• $2,000

$2,000 $0

• 18

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

• n AAA.

19

Election to Change Ordering Rules IMPORTANT! S/H can elect to reduce basis by loss and deduction before nondeductible

• expenses. (§1.1367-1(g)) The election is

permanent and must be followed every year. Must agree to carry over unused nondeductible expenses to future years (normally don’t carry

• ver)

20

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.

21

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

• f stock
• basis. (and

basis must be reduced)

STEP TWO

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

22

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 of taxation.

23

Distributions From an S Corporation With No E&P

COMMON MISTAKES

Notice, there is no mention of AAA in these two steps. This is because if there is no E&P, the AAA does NOT impact the taxability of distributions, you look solely to stock basis. As mentioned, stock basis and AAA are NOT the same thing. This can only get you in trouble.

24

What is the Lesson?

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.

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.

25

Example 1

• A owns all the stock of S Co. A’s basis
• in S Co. stock is $30,000 on 1.1.2015.
• S Co had $10,000 of AAA on 1.1.2015
• S Co. was never a C corporation, has

no E&P

• During 2015, S Co. had:

Ordinary income

$50,000

LTCL

($5,000)

Made a $40,000 distribution to A on 6.1.2015

26

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

27

A OWNS ALL THE STOCK OF S CO. A’S BASIS IN S CO. STOCK IS $30,000 ON 1.1.2015.

Example 2

• S Co. had $10,000 of AAA on 1.1.2015
• S Co. was never a C corporation, has

no E&P

• During 2015, S Co. had:

Ordinary income

$20,000

LTCL

($5,000) Made a $60,000 distribution to A on 6.1.2015

28

Example 2

• 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

29

Example 3

• Because of the basis ordering rules, an S corporation will ALWAYS be able to

distribute any stock basis that exists at beginning of year

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

in S Co. stock is $10,000 on 1.1.2015

• During 2015, S Co. had:

Ordinary loss

($30,000)

Made a $10,000 distribution to A on 6.1.2015

30

Example 3 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

31

Example 4

EFFECT OF CARRYOVER LOSSES

• Continue example 3, where $30,000 of

losses are suspended

• During 2016, S Co. had:

Income

$20,000

Makes a $15,000 distribution

32

Example 4

Continued

Even though S Co. has a c/o loss of $30,000, because the loss is treated as newly incurred in the next year, it reduces basis AFTER distributions:

• Starting basis:

$0

• Add: income:

$20,000

• Next: distributions:

($15,000)

• Remaining basis

$5,000

• Reduce for losses:

($5,000)

• End of year basis

$0

The entire $15,000 distribution is tax-free $25,000 of loss remains suspended

33

Thus, if an S corporation distributes appreciated property, the S corporation recognizes gain as if it sold the property for FMV.

Property Distributions

The amount of the distribution is the FMV of the property less any liabilities. The gain flows through and increases the shareholder’s basis. Section 311(b) applies to an S corporation.

INCREASES SHAREHOLDER’S BASIS GAIN

>

34

Example 6: Property Distributions

A

A has basis in S Co. stock of $200. S Co. distributes property with a FMV

• f $1,000 and a

basis of $100. S Co. recognizes gain of $900 on the distribution. This increases A’s basis from $200 to $1,100.

The amount of the distribution is $1,000, and is a tax-free distribution that reduces A’s basis From $1,100 to $100.

35

Example 6: Property Distributions

• What if property has a FMV < than basis.
• The amount of the distribution is $20, and is a tax-free distribution that reduces A’s

basis From $200 to $180.

A has basis in S Co. stock of $200. S Co. distributes property with a FMV

• f $20 and

a basis of $100. S Co. recognizes no loss on the distribution under Section 311(a). Thus, there is no adjustment to A’s basis.

36

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

• f 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

37

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.

38

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 of 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.

39

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.

40

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.

41

Definition of E&P E&P is not taxable

• income. Taxable income

is driven by tax policy considerations: for example: tax-free muni bond interest or nondeductible penalties. E&P is an attempt to compute economic income.

E&P is not book retained earnings. Fundamental differences exist between these two concepts. NOT BOOK RETAINED EARNING NOT TAXABLE INCOME

42

Computing E&P Taxable income is generally regarded as the starting point for computing E&P.

(Revenue Ruling 79-68)

Taxable income is then increased or decreased to adjust for certain items to arrive at E&P.

43

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?

44

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.

45

Accumulated Adjustment Account

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

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:

AAA, unlike basis, can be reduced below zero, but NOT by distributions.

46

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.

47

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.

48

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

49

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 1.1.2015 is $10,000. During the year, S Co. has the following:

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

50

Net Positive Example 8, Solution Step 1: Compute ending AAA.

—Ending AAA will drive how much of the $11,000 distribution comes from S corporation earnings (and should be taxed according to the S corporation rules) versus how much of the $11,000 distribution comes from C corporation earnings (and should be taxed as a dividend according to the C corporation rules). —Is there a net positive adjustment or a net negative adjustment? —There is a net positive adjustment because income exceeds loss. ($9000 inc

• $2000 loss).

—Thus, increase AAA FIRST for the net positive adjustment.

• AAA is increased from $2,500 to $9,500 by the $7,000 net positive adjustment.
• Thus, the first $9,500 of the $11,000 distribution is taxed under the S corporation rules

(tax-free to extent of shareholder basis)

51

Net Positive Example 8, Solution

• Step 2: The next dollars of distribution come from E&P and are

taxed as a dividend.

—A dividend has no impact on shareholder basis.

• Step 3: Just because a distribution is made from AAA does NOT

mean it is tax-free. Why not?

—Because AAA and stock basis are not synonymous, and it is stock basis that ultimately determines the taxability of distributions. —Now must adjust stock basis to determine taxability for piece of distribution made from S corporation income.

52

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

53

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

54

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).

55

Example 9 : Net Negative Adj.

A

During 2015, S corp has $200 of capital gain, has an operating loss of ($900) S corp makes a $1,000 distribution. X is the sole s/h in S corp. X has basis of $1,000 on 1/1/2015 S corp has $500

• f E&P and $200
• f AAA on

1/1/2015.

56

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.

57

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

58

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

59

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.

60

Beginning Negative AAA, Example 10

• What is taxability of the distribution?

X is the sole s/h in S corp. X has basis of $0

• n 1/1/2015

S corp has $10,000 of E&P and ($7,000) of AAA on 1/1/2015. During 2015, S corporation has $10,000 of ordinary income, has an operating loss of ($4,000) S corp makes a $6,000 distribution.

61

Net Negative Example 10, Solution

• Do you have a net positive or net negative adjustment?

AS A RESULT You adjust AAA BEFORE determining the taxability of distributions. THERE IS A NET POSITIVE ADJUSTMENT.

($10,000 income - $4,000 loss). However, if AAA does not end up positive, the distribution will first come from E&P.

62

Solution, Example 10

AAA E&P S Corp. Dist. C Corp. Dist. Starting ($7,000) $10,000 Increase AAA: net positive adjustment $6,000 Decrease: distribution (not below zero) $0 AAA balance after distribution ($1,000) Ending AAA ($1,000) Distribution from E&P ($6,000) $6,000 Ending E&P $4,000

63

Solution, Example 10

Basis Starting $0 Increase for income $10,000 Decrease for distribution not taxed as dividend ($0) Decrease for losses ($4,000) Ending basis $6,000

64

Example 10: What’s the lesson? Even though you may have net income for a year, if it’s not enough to make your ending AAA positive, then any distribution will first come from E&P and be taxed as a dividend. PLANNING OPPORTUNITY: an S

corporation with E&P and negative beginning AAA that wants to make a non-dividend distribution must be sure they will generate enough income to make their AAA positive enough at the end of the year to support the full distribution.

65

Example 11

Beginning Negative AAA

X is the sole s/h in S corp. X has basis of $0 on 1/1/2015 S corp has $10,000

• f E&P and ($7,000)
• f AAA on 1/1/2015.

During 2015, S corporation has $30,000 of ordinary income, has an operating loss

• f ($4,000)

S corp makes a $6,000 distribution.

66

Solution, Example 11

AAA E&P S Corp. Distr. C Corp. Dist. Starting ($7,000) $10,000 Increase AAA: net positive adjustment $26,000 AAA before distribution $19,000 Decrease: distribution (not below zero) ($6,000) $6,000 Ending AAA $13,000 Distribution from E&P $0 Ending E&P $10,000

67

Solution, Example 11

Basis

Starting $0 Increase for income $30,000 Decrease for distribution not taxed as dividend ($6,000) Decrease for losses ($4,000) Ending basis $20,000

68

Example 12: Tax Exempt Income

X is the sole s/h in S corp. X has basis of $1,000 on 1/1/2015

S corporation has $1,000 of E&P and $0 of AAA on 1/1/2015. During 2015, S corp has $500 of tax-exempt interest income. S corporation makes a $500 distribution.

69

Tax Exempt Income, Example 12, Solution

• Tax-exempt investments are NOT a good choice

for an S corporation with E&P. Why not?

Tax-exempt interest increases basis, but does not increase AAA. Thus, the interest income, when distributed, will be taxed as a dividend.

70

Solution, Example 12

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

Starting $0 $1,000 Increase AAA: net positive adjustment n/a Decrease: distribution (not below zero) $0 AAA balance after distribution $0 Ending AAA $0 Distribution from E&P ($500) $500 Ending E&P $500

71

Solution, Example 12

Basis Starting $1,000 Increase for income $500 Decrease for distribution not taxed as dividend Decrease for losses n/a Ending basis $1,500

72

Example 12: What’s the lesson?

Tax-exempt income does not increase AAA. As a result, tax-exempt investments are not a good idea for an S corporation. Even if the S corporation has no E&P, tax-exempt investments are not a good idea, because the income cannot be distributed tax free in a post-termination transition period (see discussion later) since it does not increase AAA.

73

Example 13: Multiple Distributions

X is the sole s/h in S corp. S corporation has $37,000 of E&P and $5,000 of AAA

• n 1/1/2013.

During 2013, S corp has $16,000

• f income

X sells his stock to Y on 7/1/2013. S corporation makes $42,000 in distributions; $18,000 to X, $24,000 to Y Assume X and Y have substantial basis

74

Example 13, Solution

• First, increase AAA for net positive adjustment of $16,000. Ending AAA is

$21,000.

• Because the $42,000 of distributions exceed the adjusted AAA of $21,000, the

AAA must be allocated to each distribution on a pro-rata basis.

• The timing of the distributions doesn’t matter.
• Of X’s distribution, $9,000 comes from AAA ($21,000/$42,000) * $18,000
• Of Y’s distribution, $12,000 comes from AAA ($21,000/$42,000) * $24,000
• Next, fill in the distribution from E&P in chronological order

75

Solution, Example 13

AAA E&P X Y Starting $5,000 $37,000 Increase AAA: net positive adjustment $16,000 AAA before distributions to be allocated $21,000 $9,000 $12,000 Decrease: distribution (not below zero) ($21,000 ) Ending AAA $0 Distribution from E&P ($21,000 ) Ending E&P $16,000 Distribution from E&P $9,000 $12,000 Total Distributions $18,000 $24,000

Effect of Stock Redemptions

X is the sole s/h in S corp. S corporation has $1,000 of E&P and $5,000 of AAA on 1/1/2013.

During 2013, S corp has no income

• r loss and redeems 40% of its

stock in a Section 302 transaction.

77

Effect of Stock Redemptions, Solution

Forty percent of the AAA must be reduced, so S Co. must reduce AAA by $2,000. If an ordinary distribution is made in the same year, the ordinary distribution reduces AAA BEFORE the redemption, regardless of chronological order.

40%

78

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

• nly 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

• f 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

• r 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 2015, S Co. accumulates AAA of $150,000, but no distributions were made. In 2015, 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

• f 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.

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Contact Info

Anthony J. Nitti

• Email: anitti@withum.com
• Forbes: http://www.forbes.com/sites/anthonynitti/
• Twitter: @nittiaj

Craig Kish

• Email: ckish@withum.com

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