S Corporations: Dealing with Accumulated Earnings and Profits
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By C corporation income is generally subject to two levels of taxation. It is taxed at the corporate level when earned and at the shareholder level when distributed. An S corporation, on the other hand, generally is not taxed at the corporate level; its items of income and deduction flow through to its shareholders when earned. Subsequent distributions by the S corporation to the shareholders often can be made tax-free. However, the taxation of distributions is more complicated if the S corporation has C corporation accumulated earnings and profits (E&P).
An S corporation does not generate E&P. However, it can possess E&P as a result of either converting from C corporation to S corporation or acquiring a C corporation. E&P generated in a C corporation are subject to two levels of taxation – corporate and shareholder – and retain this character even if subsequently owned by an S corporation. Accumulated E&P was taxed at the C corporation level and will be taxed again as a dividend to recipient S corporation shareholders when distributed.
S corporations that have accumulated E&P are required to maintain an accumulated adjustments account (“AAA”). The AAA generally represents the earnings of the S corporation that have been previously taxed but not yet distributed to shareholders. These earnings flow through and are taxed at shareholder level when generated and, to the extent of basis, can be distributed to shareholders tax-free. The AAA, which is a corporate level account and not apportioned among shareholders, establishes the threshold at which S corporation distributions could become taxable. See Treasury Reg. § 1.1368-2.
If the S corporation has E&P, a distribution to shareholders may result in: (1) a reduction of shareholder’s basis; (2) a taxable dividend; or (3) gain from the sale of the stock. IRS § 1368. To determine which of these will result, the following attributes must be considered: E&P, AAA, and the shareholder’s basis in the S corporation stock (calculated and adjusted pursuant to Section 1367(a)(2)).
S corporations are permitted to distribute income earned while an S corporation, as reflected in AAA, before distributing E&P, regardless of when each was earned. That creates an opportunity to defer a taxable dividend to the extent of AAA. The higher the balance of the AAA, the more likely the dividend will not be taxed as a distribution. Although a distribution allocated to AAA may be tax-free as discussed below, gain may be recognized under Section 311(b) if the S corporation distributes appreciated property.
If an S corporation has accumulated E&P, tax-free distributions generally can be made to the extent of the corporation’s AAA. IRC § 1368(c)(1). The characterization of the distribution is governed by Section 1368(c). If the distribution does not exceed the AAA, the distribution is treated as if made by an S corporation with no accumulated E&P. In other words, the distribution reduces basis, and to the extent the distribution exceeds basis, is treated as gain. To the extent the distribution exceeds AAA, it is treated as a dividend to the extent of accumulated E&P. To the extent the distribution exceeds accumulated E&P, it is treated as if made by an S corporation with no accumulated E&P. In other words, the distribution reduces basis, and to the extent the distribution exceeds basis, produces gain.
An S corporation with accumulated E&P that wishes to distribute E&P before AAA may elect to do so under Section 1368(e)(3). This election allows the S corporation to distribute E&P to avoid the tax on passive income or a passive income S corporation termination.
If an S corporation does not have accumulated E&P, the distribution is treated first as a reduction in basis, and to the extent the distribution exceeds basis, produces gain. Treasury Reg. § 1.1368-1(c). The AAA account, which is intended to distinguish previously earned but undistributed S corporation income from E&P of a prior C corporation which must be taxed as a dividend if distributed, is irrelevant. Although an S corporation without E&P is not required to maintain AAA, it may be beneficial to do so in case it acquires E&P as a result of reorganization or acquisition. Once a corporation distributes all its accumulated E&P, it is no longer required to track AAA, but again might continue to do so.
The taxation of distributions by S corporations with E&P can be complicated. There are shareholder level attributes and corporate level attributes to consider. The applicable rules are intended to preserve the difference between the treatment of distributions from S corporations and those from C corporations.
Kerri L.S. Mast, JD, is an attorney and wealth planner at Brown Brothers Harriman.