Chapter 4

Distributions

Learning Objectives

Upon completion of this chapter, you will

  • Be able to apply the rules for cash distributions.
  • Be aware of the rules for property distributions.
  • Understand the ordering of distributions.

Introduction

In this chapter, we will discuss the following:

  • Cash distributions
  • Property distributions
  • Accumulated Adjustment Account (AAA)
  • Distributions during the Post-termination Transition Period
  • Effect on Stock Basis of Distributions

Distributions are payments of cash or property to shareholder based on stock ownership. S corporation distributions are governed by IRC Section 1368. Distributions have no effect on the current share of income that is taxable to shareholders. Whether or not a distribution is taxable or not depends on whether the S corporation has any accumulated E & P from C years or as an S corporation in preSSRA years.

Earnings and Profits (E&P)

For taxable years beginning after 1982, an S corporation will not generate E&P. If a corporation is formed and immediately elects S corporation status, it cannot have E&P as long as it remains an S corporation and does not acquire a corporation carrying over E&P under Sec. 381. An S corporation may have accumulated E&P attributable to any taxable years for which an S election was not in effect, a taxable year from 1958-1982 for which an S election was in effect (e.g., tax-exempt income, accelerated depreciation), or from certain corporate acquisitions which resulted in a carryover of the acquired corporation’s E&P. If a corporation is an S corporation for its first tax year beginning after 1996, its accumulated E & P is reduced by any pre-1983 E & P accumulated while the corporation was an S corporation.

A C corporation generates E&P under Sec. 312. When the C corporation elects S status, the E&P balance carries into the S corporation. E&P is designed to track the C corporation's income in a way that reflects the corporation's economic (rather than taxable) income. For example, new assets can be depreciated for tax purposes by using the modified accelerated cost recovery system (MACRS), but for E&P purposes must be depreciated by using the alternative depreciation system (ADS).

When considering E&P, we should remember that a distribution of E&P is a taxable dividend to the recipient[EM1]. If the S corporation does not have E&P or has negative E&P it cannot distribute a taxable dividend.

Reduction of AE&P

When a C corporation with E&P becomes an S corporation, the amount of E&P is frozen[EM2]. Once S corporation status is effective, the E&P amount is reduced only by

  • Distributions of that E&P (taxable dividend distributions) [Section 1371(c)(3)],
  • Certain redemptions, reorganizations, liquidations, or corporate divisions [Section 1371(c)(2)], and
  • Tax paid at the corporate level because of business credit recapture [Section 1371(d)(3)].

Example 4-1

C Inc., elects S status on January 1, when it has $100,000 of E&P. The companypasses through a $70,000 loss for the year ended December 31 and distributes $20,000 to its sole shareholder during the year. The $70,000 pass-through loss does not affect E&P. Since the corporation has no undistributed S corporation earnings at the end of the year, the $20,000 distribution reduces E&P, and is dividend income to the shareholder. The balance in the corporation's E&P at December 31 is $80,000 ($100,000 – $20,000).

To discuss distributions made by S corporations we will first divide the discussion between distributions made by S corporations without E&P and S corporations with E&P.

Cash Distributions Made by S Corporations without E&P [Section 1368(b)]

If an S corporation has no AE&P at the end of its taxable year, the treatment of distributions made by the corporation during the year is relatively simple. In that event, distributions are first treated as a tax-free return of stock basis[EM3]. The shareholder reports the distribution when received. The shareholder’s basis in the stock, however, is computed at the close of the taxable year in which the distributions are made [Section 1368(d)]. Stock basis is first adjusted for income, but not losses, before the basis is reduced for distributions [Section 1368(d)(1)]. Basis for distributions does not include a shareholder’s debt basis. Excess of distributions over stock basis is gain from the sale of stock, thus capital gain.[EM4]

Example 4-2

D owns all of the stock of an S corporation for which he has a basis of $20. This year the corporation suffered on ordinary loss of $100 and distributed cash to D of $100. D will reduce his basis for the distribution first. Thus, the distribution will reduce D’s basis to zero. The additional $80 ($100 distribution – $20 basis) will be a capital gain for D. Because D has a zero basis in the stock, the loss will be limited by Section 1366.

Cash Distributions Made by S Corporations with E&P [Sec. 1368(c)]

If an S corporation has E&P, the rules governing distributions become more complex. For tax purposes an S corporation’s “retained earnings” account consists of the four tiers shown below. Any distributions come out of the following accounts in the order shown:

  1. Accumulation Adjustments Account (AAA)
  2. Previously Taxed income (PTI; on Schedule L referred to as shareholders’ undistributed taxable income previously taxed)
  3. Accumulated E&P
  4. Other Adjustments Account (OAA)

[EM5]

Distributions are deemed to come first from the AAA account. These distributions are considered a nontaxable return of basis. Any distribution that comes out of AAA that exceeds a shareholder’s basis in its stock is a capital gain. AAA is an account that is adjusted in a manner similar to basis adjustments with the following exceptions [Section 1368(e)(1)]. AAA is

  • Not increased by tax-exempt income (e.g., tax-exempt interest, life insurance proceeds – such items become part of the OAA). Thus a distribution of such income could be treated as a distribution of accumulated E&P if the AAA is insufficient.
  • Not decreased by deductions related to tax-exempt income (these reduce OAA).
  • This account may be negative.

AAA is a corporate-level account and is not affected by transfers of stock; shareholders who obtain shares automatically obtain an interest in this account. In contrast, previously taxed income (PTI) is not transferable, and nontaxable distributions of PTI cannot be made to a new shareholder. Although rare, a shareholder’s share of the AAA may exceed the basis in his stock (e.g., inherited low value stock, purchase at low value). Except as provided by regulations, AAA is allocated pro rata among all distributions made during the year. Redemptions under Sections 302 and 303 reduce AAA proportionately as of the date of the redemption, whether AAA is positive or negative [proposed regulation section 1.1368-2(d)(2)]. If an S corporation acquires the assets of another S corporation in a tax-free reorganization where Section 381(a)(2) applies, the AAA and AE&P accounts of the two S corporations are combined. Note that a negative AAA of one S corporation can offset a positive AAA of another S corporation. [Proposed regulation Section 1.1368-2(d)(2).]

Accumulated Adjustments Account (AAA)

The AAA starts at zero on the first day of an S corporation's first taxable year beginning after 1982. Thereafter, it is increased and decreased each year by, with certain exceptions, the same items that adjust basis, but not in the same order as basis is adjusted. If the total decreases exceed the total increases, the excess is a “net negative adjustment” and the AAA itself is adjusted in a different order. The AAA is adjusted by using the following steps:

The balance of AAA at the beginning of the taxable year is increased by

  • Nonseparately stated income;
  • Separately stated items of income and gain (except for tax-exempt income);
  • Excess of the shareholder's deductions for depletion (other than oil and gas) over the shareholder's proportionate share of basis of the property subject to depletion; and
  • Certain business tax credit recapture.

AAA is decreased by

  • Nonseparately stated loss;
  • [EM6]Separately stated items of loss or deduction (except for expenses related to tax-exempt income);
  • Any expense of the corporation that is neither deductible in computing its taxable income nor capitalizable (except AAA is not reduced by federal taxes attributable to a C corporation year);
  • The amount of the shareholder's deduction for depletion of oil and gas property held by the S corporation to the extent the deduction does not exceed the property's adjusted basis allocated to the shareholder under Section 613A(c)(11)(B); and
  • Certain business tax credit recapture.

AAA Is Reduced by the Full Amount of Loss or Deduction

The AAA, like basis, is reduced by the entire amount of a loss or deduction, even though the shareholder cannot use the deduction because of another provision such as the passive activity loss rules or the at-risk rules [Reg. Sec. 1.1368-2(a)(3)(ii)]. Unlike basis, the AAA can be negative. A negative AAA balance can be caused by S corporation losses and deductions, but not by distributions [Sec. 1368(e)(1)(A); Reg. Sec.1.1368-2(a)(3)].

It should be noted that some tax commentators have suggested that the insurance premium should reduce AAA.Rev. Rul. 2008-42 was issued to clarify the treatment of key-person life insurance proceeds and premiums on the accumulated adjustment account (AAA). Essentially the ruling held that neither tax-exempt income (here, the death benefits paid on a life insurance policy) nor the expense related to a tax-exempt income item (the insurance premiums paid) will affect the AAA under Sec. 1368(e)(1)(A). Rather, these items should be reported in the Other Adjustments Account (OAA).

Differences between Basis and AAA Adjustments

The AAA increases and decreases by the same items as basis does each year, except

  • Tax-exempt income increases basis, but does not increase the AAA.
  • Expenses relating to tax-exempt income reduce basis, but do not decrease the AAA.
  • Federal taxes relating to a C corporation year reduce basis, but do not decrease the AAA[EM7].
  • The order that increases and decreases are applied to basis and AAA differ.
  • Losses and deductions (but not distributions) can reduce the AAA below zero. [EM8]Basis can never have a negative balance.

[EM9]

Calculation of AAA, AE&P, and Basis Illustrated

The calculation of AAA, AE&P, and basis and the resulting tax effect on distributions is illustrated in the following examples.

Example 4-3
A corporation that became an S corporation on January 1, of the current year, when it had $15,000 of AE&P. The sole shareholder, had basis in his stock of $10,000 on that date. For the taxable year ended December 31, the company showed the following items:
Nonseparately stated income / $45,000
Tax-exempt interest / 1,000
Long-term capital gain / 2,000
Charitable contributions / 1,200
Disallowed portion of M&E / 500
Expenses relating to tax-exempt income / 100
Distributions / 12,000
To determine the taxability of the distribution, you must first compute the AAA and AE&P balances at December 31.
AAA / AE&P
Balances, beginning of year / $0 / $12,500
Nonseparately stated income / 45,000
Long-term capital gain / 2,000
Balances, before reductions / 47,000 / 12,500
Charitable contributions / (1,200)
Disallowed 50% of M&E / (500)
Balances, before distributions / 45,300 / 12,500
Distributions nontaxable / (12,000)
Balances, end of year / $33,300 / $12,500
Next, stock basis is calculated as follows:
Basis
Basis, beginning of year / $10,000
Nonseparately stated income / 45,000
Tax-exempt interest / 1,000
Long-term capital gain / 2,000
Basis, before distributions and other reductions / 58,000
Distributions / (12,000)
Basis, before other reductions / 46,000
Charitable contributions / (1,200)
Disallowed 50% of M&E / 500
Expenses relating to tax-exempt income / (100)
Basis, end of year / $45,200
The $12,000 distribution reduces both the AAA and stock basis, and is consequently a nontaxable return of capital. Because the distribution does not exceed the amount in AAA, the AE&P does not change.
Example 4-4
Walt has been the sole stockholder of an S corporation for five years. At the beginning of the current calendar taxable year, Walt's basis in his stock is $52,000, and the corporation shows an AAA balance of $38,000, and an AE&P balance of $22,000. During the year, he receives a $55,000 distribution. At the end of the current year, the corporation passes through nonseparately stated income of $7,000 and a capital loss of $2,000.
The AAA and AE&P balances at December 31 are calculated as follows:
AAA / AE&P
Balances, beginning of year / $38,000 / $22,000
Nonseparately stated income / 7,000
Balances, before reductions / 45,000 / 22,000
Long-term capital loss / (2,000)
Balances, before distributions / 43,000 / 22,000
Distributions to extent of AAA / (43,000)
Distributions to extent of AE&P / (12,000)
Balances, end of year / $0 / 10,000
Next, stock basis is calculated, as follows:
Basis
Basis, beginning of year / $52,000
Nonseparately stated income / 7,000
Basis, before distributions and other reductions / 59,000
Distributions to extent of AAA / (43,000)
Basis, before other reductions / 16,000
Long-term capital loss to extent of basis / (2,000)
Basis, end of year / $14,000

Distributions from Previously Taxed Income (PTI)

Distributions are deemed to come secondly from previously taxed income (PTI) during S years prior to 1983. These distributions are nontaxable to the extent of the shareholder’s basis. Before 1983, the S corporation income upon which the shareholder had paid tax, but which had not been distributed, was called Previously Taxed Income, or PTI. For tax years beginning after 1982, S corporations do not generate PTI, but the AAA represents a variation on the same theme; income that has been previously taxed to the shareholder can be distributed free of further tax. But what if the S corporation carried PTI into a post-1982 year? It could – and in many cases did – happen. Unfortunately, the Code is something less than enlightening when it addresses the problem of how to distribute these items, because it seems to ignore the fact that there can be a distribution tier composed of PTI. If the corporation has no AE&P, there is no problem. PTI has already increased the basis of the stock. Distributions from an S corporation with no AE&P apply first as a nontaxable return of capital, to the extent of stock basis, so PTI will automatically be a tax-free reduction in basis when distributed. Distributions in excess of stock basis create a capital gain.

Other Distributions

Distributions in excess of AAA and PTI are considered to come from accumulated E&P and are taxable as dividends.

The last level of distributions comes from the Other Adjustments Account (OAA). The Code adopts no express rules for the treatment of those items which do not affect the AAA; tax-exempt income and related expenses. The IRS in its instructions requires that taxpayers maintain a special Other Adjustments Account presumably to account for these items. The S corporation tax return, Form 1120S, states that tax-exempt income should increase the Other Adjustments Account (OAA), and expenses directly related to tax-exempt income should reduce OAA[EM10]. The OAA is not in the Code and is used to record pass-through items that do not adjust AAA. According to the IRS instructions, distributions are out the OAA after accumulated E&P are exhausted and are nontaxable. As with distributions from AAA and PTI, distributions in excess of stock basis will create a capital gain.

Any further distributions are a nontaxable return of basis. Amounts in excess of basis are treated as gains from the sale of stock and are taxed as capital gain.

Section 1368(e) Election

An S corporation may make an annual election (i.e., for one year only) with the consent of all affected shareholders to bypass the PTI and/or AAA in determining the taxation of all distributions made during the taxable year [Sec. 1368(e)(3)].

Distribution Order / No. Election / Sec. 1368(e)(3) Bypass Election / PTTP Election
1 / AAA / AE&P / AAA
2 / PTI / AAA / AE&P
3 / AE&P / PTI / PTI
4 / OAA / OAA / OAA

Note.The bypass election is not sufficient if PTI is present. Sec. 1379(c) preserves the old distribution order where there is PTI present. Thus, an election under Sec. 1368(e)(3) placed PTI first in the order of distribution. (Proposed Regulations Sec. 1.1368-1(f)(2)(ii).) An additional election under old Sec. 1375 will permit distribution of AE&P first where both AAA and PTI are present. See Regulations Sec. 1-1375-4(c) and Proposed Regulations Sec. 1.1368-1(f)(4).

A corporation that elects to bypass AAA may also elect to make a deemed dividend of all of its AE&P (proposed regulation section 1.1368-1(f)(3)).

An S corporation with AE&P has more problems to cope with than one without AE&P. Accumulated earnings and profits can cause difficulties for S corporations with excess net passive income. In this case the corporation may be subject to a tax on the excess net passive income and more importantly, the S election will terminate if the corporation has excess net passive income for three consecutive years. Also, distributions are more complicated and can include dividend income if there is AE&P.

The bypass election is typically used to purge the corporation of its AE&P in order to avoid the passive investment income or the termination of its S election for having excess passive investment income.

Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, dividends received by an individual shareholder from domestic and qualified foreign corporations generally are taxed at the same rates that apply to long-term capital gains [Sec. 1(h)(11)]. This treatment applies for both regular and alternative minimum tax purposes. The Tax Increase Prevention and Reconciliation Act of 2005 extended this treatment for another two years. The dividend rate is effective for tax years beginning after 2002 and before 2011.

Now that the maximum tax rate on dividend income is 15%, some existing S corporations may want to make the election under Section 1368(d)(3) and distribute their AE&P to shareholders as soon as possible. Also, under some circumstances, because of losses or other considerations, receipt of the taxable dividend may not cause a tax burden on the shareholders, making it an opportune time to distribute AE&P to them.

Example 4-5
Alvin owns all of the shares of Alco, an S corporation. Alco has the following account balances:
Accumulated Adjustments Account / $30,000
Previously Taxed Income / $20,000
Accumulated Earnings and Profits / $20,000
Alco has had excess passive income for the past two years and anticipates excess net passive income in again this year. Alvin plans to withdraw $30,000 from the corporation this year.
Without the election allowed by Section 1368(d)(3), the distribution will be a nontaxable distribution that comes from the AAA account. However, because of the problem with excess net passive income, the corporation should consider making the elections under Section 1368(d)(3) and Section 1375 to make the distribution out of AE&P first. In that case the first $20,000 would come from AE&P with the remaining $10,000 coming from AAA. If these elections were made it would cost Alvin $3,000 ($20,000 × 15%) because the $20,000 from AE&P would be a taxable dividend. However, the benefits of eliminating the AE&P (i.e., eliminating the excess net passive income tax and being allowed to retain its S status) should outweigh the cost.

Property Distributions