Determining the taxability of S corporation distributions.

• Author: Nitti, Tony
• Position: Part 2

Part I of this article, in the January issue, examined the role a shareholder's basis in S corporation stock, earnings and profits (E&P), and the accumulated adjustments account (AAA) play in determining the taxability of an S corporation's distributions and the rules for determining the taxability of distributions from an S corporation with no accumulated E&P. In Part II, this article covers the taxability of distributions from an S corporation with accumulated E&P and ancillary issues and planning opportunities. Before reading Part II, readers should review Part I on the proper adjustments to be made to stock basis, E& and and AAA before determining how a distribution is taxed.

Taxability of Distributions From S Corporations With Accumulated E&P

When a distribution is made from an S corporation with accumulated E&P, it must be analyzed to determine its source to preserve the different treatment of distributions of S corporation income, which should not be taxed a second time, from distributions of C corporation E&P, which must be taxed as a dividend to the recipient shareholder.

Sec. 1368(c) accomplishes this task by dividing a distribution made from an S corporation with accumulated E&P into three tiers, determining the taxability to the recipient shareholders as follows:

Tier 1: To the extent the AAA balance is positive, the distribution is treated as if made by an S corporation with no accumulated E80.

Tier 2: Distributions in excess of AAA are treated as dividends to the extent of the accumulated E&P balance.

Tier 3: Distributions in excess of accumulated E&P are treated as made by an S corporation with no accumulated E&P.

While these tiers often appear confusing, a closer examination reveals the logic--the goal of preserving the difference between distributions of S corporation income and C corporation E&P.

By providing that the first dollars of distribution are treated as having been made from an S corporation with no HO to the extent of the AAA balance, the regulations permit a corporation to distribute its remaining previously taxed but undistributed income before the corporation will be deemed to have distributed its accumulated E&P. This does not mean, however, that the distribution is tax free; it simply means that the distribution will not be a taxable dividend. To determine the distribution's taxability, the shareholder must adjust his or her basis in the corporation's stock. As discussed in Part I, the distribution will first be treated as a tax-free reduction of the shareholder's stock basis, with any distribution in excess of basis generating capital gain.

Once a distribution has reduced a corporation's AAA to zero, the regulations rationalize that because all previously earned S corporation income has been distributed, the next dollars of distribution are made from the corporation's accumulated E&P and must be taxed as a dividend until the E&P balance has been reduced to zero.

After the corporation's accumulated E&P has been fully distributed, the corporation can no longer make a taxable dividend, and, as a result, the only attribute that becomes relevant to determining the distribution's taxability is the shareholder's basis in the corporation's stock. Thus, the distribution will again be treated as a tax-free reduction of the shareholder's stock basis, with any distribution in excess of basis generating capital gain.

When a distribution is made from an S corporation with accumulated E&P, three separate attributes--AAA, E&P, and shareholder's stock basis--must be adjusted to determine the distribution's taxability. As the following example illustrates, the attributes must be adjusted in a specific order.

Example 1:A owns 100% of S Co., an S corporation. On Jan. 1, 2013, S Co. has AAA of $2,500 and prior accumulated E&P of $7,500. Also on Jan. 1, 2013, A has an adjusted basis in S Co. stock of $10,000. During 2013, S Co. allocates to A $9,000 of ordinary income and $2,000 of long-term capital loss. S Co. also distributes $11,000 to A.

To determine the taxability of the $11,000 distribution, the distribution must be divided into three tiers:

Tier 1: The $11,000 distribution will be treated as having come from an S corporation without accumulated E&P to the extent of the positive AAA balance. This requires the AAA balance to be computed first.

To adjust S Co.'s beginning AAA balance of $2,500, it must first be determined whether S Co. has a net positive adjustment or a net negative adjustment for 2013. Because S Co.'s $9,000 of income exceeds its $2,000 of losses by $7,000, S Co. has a $7,000 net positive adjustment. S Co. must therefore increase its AAA by the $7,000 net positive adjustment before accounting for the $11,000 distribution.

AAA is increased from $2,500 to $9,500 by the $7,000 net positive adjustment, leaving S Co. with a positive AAA balance of $9,500. Thus, the first $9,500 of the $11,000 distribution is treated as having come from an S corporation with no accumulated E&P and is not taxed as a dividend. However, this result does not mean the distribution is tax free to A; rather, A must determine the $9,500 distribution's taxability by reference to his basis in the S Co. stock.

Tier 2: Tier 1 accounted for only $9,500 of the $11,000 distribution. The remaining $1,500 distribution is treated as having come from S Co.'s accumulated E&P balance of $7,500, reducing the E&P balance to $6,000. The entire $1,500 distribution made under Tier 2 is taxed as a dividend, and the resulting dividend income does not increase A's basis in his S Co. stock, nor does this portion of the distribution by S Co. reduce S Co.'s AAA or A's stock basis.

Tier 3: The distribution does not exceed the E&P balance, so no portion of the distribution is allocated to Tier 3.

Because of the potential confusion caused by tracking multiple attributes, a distribution should be accounted for in table form, separating the distribution between the portion that is not from E&P and is included in Tiers 1 and 3 (column S) from the portion that is made from E&P and included in Tier 2 (column C), as shown in Exhibit 1 on p. 126.

Exhibit 1: Adjustments in Example 1 AAA E&P S C Beginning balance $2,500 $7,500 Increase: Net positive adjustment 7,000 AAA before distribution 9,500 Reduce for distributions 9,500 $9,500 Ending AAA 0 Distribution from E&P (1,500) $1,500 Ending E&P 6,000 Next, A must adjust his stock basis to determine the taxability of the $9,500 distribution that is included under Tiers 1 and 3 and not taxed as a dividend (column S), as shown in Exhibit 2.

Exhibit 2: As basis adjustment in Example 1 Beginning basis $10,000 Increase for income 9,000 Basis before distribution 19,000 Reduce for distribution (9,500) Basis before losses 9,500...