Determining the tax treatment of S corporation distributions requires us to do much the same thing. However, we need to keep track of S corporation earnings so that these can be distributed to shareholders tax free – as long, of course, as the shareholders have sufficient basis in their stock to receive it tax free. This process, however, can be complicated somewhat if the S corporation used to operate as a C corporation and – when electing S corporation status – still had retained E&P that had not been paid out as a dividend. Under these circumstances, we have to keep track of both S corporation earnings and the C corporation E&P and make sure that the latter is taxed as a dividend if it is ever distributed to the shareholders. Failing to do so would allow C corporation shareholders to avoid taxation on dividends by allowing a C corporation, with lots of the earnings and profits, to elect S corporations status before paying it out.
Accordingly, in the S corporation context, we have to keep track of three different types of income that could be earned or retained by an S corporation. The first is the accumulated adjustment account, or the AAA account. This account is nothing more than a running total of all of the undistributed S corporation income and deduction items, including both separately and non-separately stated items. Because it is a running total, we have to increase this account each year by any income items earned by the corporation, and then decrease it by any distributions of S corporation earnings made, and then by any S corporation loss or deduction items, in that order.
The next account is the accumulated earnings and profits account, or the AEP account. This is nothing more than a running total of any C corporation earnings and profits that were not paid out prior to the corporations of S corporation status. Not every S corporation will have an AEP account. If the S corporation never operated as a C corporation, or if it paid out all of its AEP, it may not have any AEP remaining to track.
The third and last account is the other adjustments account, or OAA. This is a running account of items that affect basis but not the AAA account. In essence, these are tax-exempt income items and other non-deductible expenses earned by the S corporation, but not otherwise included in the S corporation’s earnings.
We then follow precisely the same type of process we did with C corporations to determine how any distribution that an S corporation makes during the year to a shareholder is treated for tax purposes. We apply these three accounts to distributions occurring during the year – just as E&P was in the C corporation context – in the following order.
First, we allocate AAA to distributions during the year until that account is completely depleted. These are treated as tax-free distributions to the extent of its shareholders’ basis because they are S corporation earnings. Amounts distributed in excess of the shareholders’ basis are treated as capital gain upon the sale or disposition of the stock to that shareholder.
Once AAA is depleted, we apply AEP until this account is depleted. As these are payments of C corporation E&P, they are taxed as dividends to the receiving shareholders. It is important to note that because these are dividends, distributions out of AEP do not reduce the shareholder’s basis in his S corporation stock.
Once the AEP is depleted, OAA is allocated to distributions during the year until this account is depleted. These distributions are tax-free to the receiving shareholder.
Finally, once all three accounts have been depleted, any remaining property distributions are treated as a return of basis to the extent of the shareholder’s basis in his stock and then as capital gain upon the sale or disposition of the stock. Of course – just as with E&P – payments from these accounts reduce the balance in each of the accounts until they are completely depleted.
It is important to note that S corporations may elect to change the order and pay out AE&P first. This could be significant if the S corporation is trying to avoid involuntary termination of the S election due to excess net passive income during the year in question.
Let’s review an example. Short, a calendar year S corporation, distributes $1,300 of cash to its only shareholder, Otis, on December 31st . Otis’ basis in his stock is $1,400, AAA is $500, and the corporation has $750 of AEP before the distribution.
In determining how these different payments will be treated, it’s worth noting that if the entire amount of the distribution were treated as AAA, Otis has sufficient basis in his stock to receive the amount of that payment tax free. Accordingly, none of this payment is going to generate capital gain on disposition of the sale of the stock. To determine the precise way in which this distribution will be treated, we walk through the required steps in order.
First, we allocate AAA until the account is depleted. Here, we have $500 worth of AAA, so the first $500 of the $1,300 distribution comes out of AAA. This amount is nontaxable S corporation earnings, and it reduces his stock basis by $500 – the amount of the AAA distribution – and reduces the balance in the AAA account to zero.
The rules require us to next distribute out of the AEP account. $800 of the original $1,300 distribution remains to be allocated among the accounts. Accordingly, as we only have $750 in AEP, the next $750 of the remaining $800 comes out of AEP. It does not reduce Otis’ basis, but it is treated as a taxable dividend to Otis. The payout reduces the corporation’s AEP to zero as well.
At this point, $1,250 of the $1,300 distribution has now been covered by allocations from the corporation’s AAA and AEP accounts. That leaves $50 to be addressed by the third step in our process, which is the allocation from the OAA account.
The corporation doesn’t have anything in the OAA account, so we proceed to the fourth step, which is to treat it as a return of basis to the extent of the shareholder’s basis in his stock. Otis has more than enough basis remaining to cover it, so the last $50 is a nontaxable return of basis. Otis’ basis, however, is reduced by this last $50, leaving him with an S corporation stock basis of $850.
One other similarity between the tracking of S corporation income and C corporation income exists. For the purpose of recognizing gain at the S corporation level, distributions of property to an S corporation shareholder – just as with C corporations – are treated as if the property had been sold to the shareholder for its fair market value. If the property is appreciated property or if it has gain built into the property, it will increase the corporation’s AAA account, and the gain recognized will be allocated among the S corporation’s shareholders for recognition on their individual income tax returns.
Accordingly, the effect of distributions to both AAA and the S corporation shareholders’ respective bases in their stock must be determined before the effect of distributions to receiving shareholders can be determined. You have to adjust both of these taxable attributes by any gain recognized before determining the final treatment of these distributions to the shareholders receiving them.
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