Modifying the order of distribution rules for an S corporation with AE&P.

• Author: Burke, Daniel J.
• Position: Accumulated earnings and profits

A distribution from an S corporation is generally treated as made from the corporation's accumulated adjustments account (AAA) tax flee to the extent of a shareholder's basis. It is then treated as taken from any remaining balance of AAA and is taxed at capital gain rates. Next, it is treated as a tax-free reduction of previously taxed income (PTI), which consists of S corporation earnings from tax years beginning 1982 and earlier, and then as a taxable dividend to the extent of accumulated earnings and profits (AE&P). After AE&P is exhausted, any remaining distribution amount is treated as tax flee to the extent of the shareholder's basis, and the balance is treated as a capital gain.

Because of these ordering rules, any AE&P are essentially "trapped" in this group of undistributed earnings until AAA and PTI are fully depleted. There may be some cases in which it would be advantageous to distribute AE&P before AAA and/or PTI. Fortunately, the Code allows a taxpayer to elect to change these ordering rules and treat S corporation distributions as made out of AE&P first.

Elections

Three elections allow S corporations to distribute AE&P before AAA and/or PTI:

1. An election to distribute AE&P before AAA;

2. An election to make a deemed dividend; and

3. An election to forgo distributions of PTI. (See exhibit, below.)

An S corporation can elect to modify the distribution order of AAA and AE&P. Specifically, the S corporation can elect under Sec. 1368(e)(3)(A) to treat distributions as being made from AE&P before reducing AAA.

In addition, an S corporation that lacks liquid assets to distribute AE&P can also elect to make a deemed dividend under Regs. Sec. 1.1368-l(f) (3), effectively bypassing AAA and reducing AE&P first by creating a hypothetical distribution. If this election is made, the first election described above will be considered to have been made.

Generally, an S corporation will want to distribute PTI as quickly as possible, because the ability to distribute PTI tax free is limited to those who were shareholders at the time it was earned. PTI cannot be distributed tax free to subsequent shareholders or after an S corporation election terminates. However, if the S corporation has PTI and wishes to bypass it in addition to AAA, the S corporation will have to make an election under Regs. Sec. 1.1368-1(f)(4). If it does not make this election but makes the first two, distributions will first reduce PTI tax free, then AE&P, and finally...