Final regs. clarify basis and distribution issues, but leave unanswered questions.

• Author: Jamison, Robert W.
• Position: Part 2

EXECUTIVE SUMMARY

The first part of this two-part article, in the May issue, examined the final regulations under Sec. 1367, the election of an S corporation split tax year, stock and debt basis issues and adjustments, and accumulated adjustments accounts. In Part II, below, the many examples presented elucidate the workings of the Sec. 1368 final regulations and analyze the effects of distributions to shareholders on the corporation's accumulated adjustments account, accumulated earnings and profits and previously taxed income. Various bypass elections and planning opportunities are also discussed.

Distributions

Sec. 1368 provides two sets of rules for distributions to shareholders; which set applies depends on whether the S corporation has accumulated earnings and profits (AE&P). In addition, Regs. Sec. 1.1368-1 provides fairly complex rules regarding certain elections, noncash property distributions and the split-tax-year election.

S Corporations Without AE&P

Under Sec. 1368(b) (1), a shareholder who receives a distribution from an S corporation with no AE&P treats it as a tax-free return of capital to the extent it does not exceed his adjusted stock basis; any excess over basis is treated as gain from the sale or exchange of property. As was discussed in Part I, a shareholder adds to basis positive adjustments for income items and reduces it by negative adjustments for expenses and losses; a spillover rule applies when distributions allocated to a given share exceed basis, but the shareholder owns other shares with sufficient basis to absorb the distribution. Apparently, the Code's treatment of distributions in the absence of AE&P is sufficiently straightforward that the IRS saw no need for elaboration in the regulations(24); however, as is discussed below, additional guidance on proper (1) corporate accounting for distributions of depreciated property and (2) treatment of distributions of previously taxed income (PTI) accounts to shareholders would have been welcome.

S Corporations With AE&P

Sec. 1368(c) prescribes the following treatment for distributions from an S corporation having AE&P:

[] The portion of the distribution that does not exceed the corporation's accumulated adjustments account (AAA) is treated as provided in Sec. 1368(b) (nontaxable to the extent of basis, and the excess is capital gain).

[] If the corporation has both AE&P and PTI, according to Regs. Sec. 1.1368-1 (d) (2), the portion of the distribution remaining after the AAA is treated as a distribution of AAA under Sec. 1368(b) to the extent it is a distribution of money and does not exceed the shareholder's net share immediately before the distribution of the PTI. (PTI is defined in pre-Subchapter S Revision Act of 1982 (SSRA) Sec.1375(d) (2).)

[] Any remaining portion of the distribution is treated as a dividend to the extent it does not exceed the corporation's AE&P.

[] Any remaining portion of the distribution is treated under Sec. 1368 (b).

The Code and regulations are silent as to the corporate accounting for distributions that exceed E&P.(25)

The AAA is the central focus for any distribution from an S corporation with AE&P, because it provides a cushion from dividend treatment. The AAA may also be important for distributions in the post-termination transition period should the S corporation later terminate its S election.

Passive investment income: S corporations with AE&P from C corporation years are subject to tax under Sec. 1375(a) when passive investment income (PII) exceeds 25% of gross receipts.(26) In general, an S corporation cannot accumulate E&P after its S election takes effect, with two exceptions:

[] A corporation with an S election in effect before its 1983 tax year could accumulate E&P under the S corporation rules as they existed prior to the SSRA.

[] An S corporation that acquires a target corporation in a tax-free reorganization or liquidation obtains any E&P accumulated by the target.

Pre-SSRA Sec. 1377 required S corporations to calculate current E&P. Although most of an S corporation's current E&P were usually distributed as actual or deemed dividends, some items might not have been (e.g., depreciation in excess of straight line and tax-exempt income); E&P accumulated at the end of the 1982 tax year under pre-SSRA law remained intact until distributed as dividends. The SSRA removed the need for S corporations to compute current E&P.

The enactment of Secs. 1375 (to tax PII) and 1362 (to terminate the S election for PII) only affected S corporations that had AE&P as C corporations; AE&P generated under pre-SSRA law were disregarded. Although both types of AE&P are treated as dividends when they are actually distributed, the SSRA offered no guidance to distinguishing between the two types of accumulations if a corporation had been both a C and an S corporation under pre-SSRA law.

Example 8: P was a C corporation from its date of incorporation until its tax year ending Dec. 31, 1978, when it had $50,000 of AE&P. Between 1979 and 1982 (i.e., pre-SSRA), it accumulated $150,000 more E&R In 1996, P expects to generate PII in excess of 25% of its gross receipts. As of Jan. 1, 1996, P's AE&P remained at $200,000. P's shareholders are willing to report dividend income to avoid the PII tax, but would like to limit the dividend income to $50,000. Absent regulatory guidance, P would need to distribute its entire $200,000 AE&P balance to ensure that it had distributed all of its C AE&P.

Regs. Sec. 1.1368-1 (f) (2) (iii) provides that when a corporation has both C and pre-SRA AE&P, any dividend distribution is deemed to come first from C E&P. Thus, a corporation that manages its distributions carefully can limit its dividend distributions to its C E&P.

Example 9: The facts are the same as in Example 8. P has no PTI and a zero-balance AAA. If P distributes $50,000 in 1996, it will have no C AE&P as of the end of that year and will permanently avoid the PII tax and potential termination of its S election.

Distributions of PTI: Under pre-SSRA law, S corporations did not pass through specific classes of income to shareholders. As under current law, the corporation was exempt from income tax, and shareholders included actual distributions of current income as dividends when received. If the corporation's distributions to its shareholders were less than its taxable income, pre-SSRA Sec. 1373(b) treated the difference as a dividend paid on the last day of the corporation's tax year, in proportion to each shareholder's percentage ownership of stock on that day; the deemed dividend was called "undistributed taxable income" (UTI).

Pre-SSRA Sec. 1371(f) allowed each shareholder a 2 1/2-month grace period after the close of the corporation's tax year to withdraw UTI. Pre-SSRA Sec. 1375(d) provided that if a shareholder did not withdraw his portion of UTI within that period, it was transferred to an account called "undistributed taxable income previously taxed to shareholders" (more commonly known as PTI). Each UTI and PTI account was personal to the shareholder who had reported the deemed dividend. Only cash distributions reduced PTI. A distribution came from PTI only if total S corporation distributions in any tax year exceeded that year's current E&P. Because a corporation would not normally determine its current E&P until after a year had closed, it was almost impossible to accurately predict whether a distribution was from current E&P or the recipient's PTI account. These awkward distribution rules were changed by the SSRA, which adopted the concept of the AAA. However, the SSRA recognized the existence of PTI accounts that had accumulated through the end of 1982 tax years, and Section 2 enacted Sec. 1379(c) to provide that PTI accounts could be withdrawn in post-1982 tax years. However, the SSRA offered no operating rules to determine the ordering of PTI, as opposed to the AAA, AE&P, and other corporate equity accounts.

Under pre-SSRA Sec. 1377(a), a distribution of PTI was treated as a reduction of shareholder basis. If a shareholder's basis was less than his PTI balance (a rare situation), the distribution was treated as a gain from the sale of stock. Thus, a distribution from PTI had the same effect on a shareholder as a distribution from AAA. However, there are two important distinctions between PTI and AAA:

[] The AAA, a corporate-level account, is transferable to new shareholders. By contrast, the PTI account may be distributed only to the shareholder who reported the deemed dividend in pre-1983 years.

[] The AAA account survives during the post-termination transition period (generally, one year after termination of the S election); a PTI account is extinguished immediately on S termination.

Given these distinctions, S corporations should make distributions from PTI accounts, not from the AAA, if a choice exists. In several issues of Publication 589, Tax Information on S Corporations, the IRS had (arbitrarily) stated that distributions come from a shareholder's PTI after the AAA has been exhausted. Regs. Sec. 1.1368-l(d)(2) adopts this same ordering rule, but it applies only to corporations with AE&P.

[] Observation: The Regs. Sec. 1.1368-1 (d) (2) ordering rule contains two apparent flaws:

1. Only distributions of money that exceed the corporation's AAA reduce PTI. This was the rule under pre-SSRA law, because noncash property distributions could escape corporate taxation under Sec. 311 (a), the General Utilities rule. After the Tax Reform Act of 1986's enactment of Sec. 311 (b), all corporations, including S corporations, have to recognize gain on nonliquidating distributions of noncash property. Thus, there is no longer a reason to distinguish between...