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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
FOR LIVE PROGRAM ONLY
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FOR LIVE PROGRAM ONLY
July 20, 2016
Determining Tax Treatment of S Corporation Distributions
Anthony J. Nitti, Tax Partner
WithumSmith+Brown, Aspen, Colo.
Craig Kish, CPA, Tax Supervisor
WithumSmith+Brown, Orlando, Fla.
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:
ON
E
Shareholder basis in S corporation stock (Subchapter S)
TW
O C Corporation Earnings and Profits (E&P, Subchapter C)
TH
RE
E
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
on 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 O
NE
Start by increasing basis for income to highest point:
TW
O
Next, reduce for distributions: T
HR
EE
Lastly, reduce for losses:
FO
UR
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
ON
E
Start by increasing basis for income to highest point:
TW
O
Next, reduce for distributions: T
HR
EE
Lastly, reduce for losses:
FO
UR
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 on 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 over)
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))
ST
EP
ON
E
Distributions are tax-free to the extent of stock basis. (and basis must be reduced)
ST
EP
TW
O
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
of $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.
DISTRIBUTES
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 of $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
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
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
Inc
rea
se
fo
r:
De
cre
as
e fo
r:
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”
or “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
of E&P and $200
of 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 on 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 of E&P and ($7,000)
of AAA on 1/1/2015.
During 2015, S corporation has $30,000 of ordinary
income, has an operating loss of ($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 0
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.
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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 on 1/1/2013.
During 2013, S corp has $16,000
of 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
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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
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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 or loss and redeems 40% of its
stock in a Section 302 transaction.
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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%
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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. 80
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
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 of A’s stock basis, capital gain for excess),
Then from PTI of $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 85
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: [email protected]
• Forbes: http://www.forbes.com/sites/anthonynitti/
• Twitter: @nittiaj
Craig Kish
• Email: [email protected]
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