S corporations: facing the 15% sunset.

• Author: Rowe, Daniel

In the throes of economic uncertainty, most business owners are so focused on staying afloat that tax planning becomes an afterthought. It seems less practical to plan for the future when the present is so bleak. However, it is times like these when informed tax planning can be even more critical. Looming tax changes could deliver another blow to unprepared business owners, but an awareness of these changes may enable owners to identify opportunities that may not have existed in better economic times.

One such change with major implications for S corporations with prior C corporation earnings is the sunset of the 15% tax rate on qualified dividends. This favorable rate is due to expire on December 31, 2010, as provided in the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). (1) Barring new legislation, in 2011 dividends will again be taxed at ordinary income tax rates. Further, those ordinary rates are scheduled to revert to their amount prior to the Economic Growth and Tax Relief Reconciliation Act of 2001. (2) This means the top ordinary income tax rate of 39.6% will again be in effect. In the case of S corporations with prior C corporation earnings (accumulated earnings and profits), this will be particularly difficult for their shareholders. Distributions after 2010 may be taxed at a rate more than double what they are taxed at currently.

The scheduled rate increases, trapped earnings and profits, and losses being sustained in the poor economy may combine to create a perfect storm for some S corporation owners. But with an appropriate strategy, S corporations and their owners can leverage poor financial performance to reduce or eliminate future tax on accumulated earnings and profits (AE&P). This article discusses how S corporations with AE&P can use current distributions and dividends to create tax savings for their shareholders in future years.

Typical Order of Distributions

When an S corporation makes a distribution to its shareholders, it typically is considered to have come from the following sources in this order: (3)

1. Accumulated adjustments account (AAA): nontaxable to the extent of shareholder basis;

2. For pre-1983 S corporations only, previously taxed income (PTI): nontaxable; (4)

3. AE&P: taxed as a qualified dividend at 15% through 2010;

4. Return of capital: nontaxable to the extent of remaining stock basis; and

5. Capital gain from the deemed disposition of stock: taxed as long-term capital gain if held for one year or more.

The above order applies to distributions of cash as well as noncash property, with the exception of PTI; distributions of PTI must be in the form of cash. (5) Based on the typical order of distributions, AE&P will not be reduced, in the form of dividends, until all the company's AAA has been distributed. For companies with prior C corporation earnings, the AAA balance can act as a shield, preventing the recognition of dividend income by its shareholders upon receipt of distributions. Management...