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GENERAL RULES ON S CORP TAXATION
General Rules for Taxation of S Corp. Distributions
The regulations differentiate between distributions made from an S corporation without accumulated E&P and those made from an S corporation with accumulated E&P. Thus, the first step in determining the taxability of an S corporation’s distributions is to identify whether the S corporation possesses accumulated E&P in the year of distribution.
As previously discussed, an S corporation can possess accumulated E&P only if it was previously a C corporation or it acquired the assets of a C corporation in a Sec. 381 transaction. So, an S corporation cannot possess E&P if it has never been a C corporation (i.e., it has been an S corporation since formation) and has never acquired the assets of a Ccorporation in a Sec. 381 transaction.
Determining whether the S corporation has accumulated E&P is critical. If an S corporation does not have accumulated E&P, determining a distribution’s taxability is a straightforward process. If an S corporation does have accumulated E&P at the time of a distribution, however, determining the taxability of that distribution becomes more complicated.
Taxability of Distributions From S Corps. With No Accumulated E&P
Regs. Sec. 1.1368-1(c) provides that a distribution by an S corporation that has no accumulated E&P is taxed under a two-tier approach:
First, the distribution is a tax-free reduction of the shareholder’s basis in the corporation’s stock; 25 then
Any distribution in excess of the shareholder’s stock basis is treated as gain from the sale or exchange of the underlying stock. 26
Noticeably absent from these rules is any reference to the S corporation’s AAA balance. This is because the AAA balance serves to provide a dividing line between those distributions made from previously earned but undistributed S corporation income, which should not be taxed a second time, and those made from prior C corporation E&P, which must be taxed as a dividend. If no accumulated E&P is present, this dividing line is unnecessary, as it is not possible for a distribution to be a taxable dividend made from E&P.
Thus, in determining the taxability of distributions from an S corporation with no accumulated E&P, the AAA balance is completely irrelevant; rather, the only attribute of consequence is the shareholder’s basis in the corporation’s stock. The AAA balance must continue to be maintained, however, because, as will be discussed in Part II, in the February issue, it will become relevant if the corporation terminates or revokes its S election.
Example 4: A owns 100% of the stock of S Co., an S corporation. On Jan. 1, 2013, A has a basis in his S Co. stock of $30,000, and S Co. has an AAA balance of $10,000. S Co. has been an S corporation since formation and has no accumulated E&P. During 2013, S Co. allocates to A $50,000 of ordinary income and $30,000 of long-term capital loss and distributes $40,000 to A .
Because S Co. does not have any accumulated E&P, its AAA balance of $10,000 is irrelevant in determining the taxability of the $40,000 distribution. Instead, the distribution is first treated as a tax-free reduction of A ’s basis in his S Co. stock, with any excess distribution generating capital gain.
To determine the distribution’s taxability, A must adjust his stock basis. Under the regulations, A first increases his beginning basis of $30,000 for the $50,000 of income allocated to A during 2013. A ’s adjusted basis of $80,000 is then reduced by the distribution of $40,000 before it is reduced for any losses or nondeductible expenses.
The $40,000 distribution reduces A ’s basis in his S Co. stock from $80,000 to $40,000, and the entire distribution is tax free under Sec. 1368(b).
Lastly, A reduces his remaining stock basis of $40,000 by the $30,000 of long-term capital losses allocated to him during 2013, leaving A an ending stock basis of $10,000.
If the distribution exceeds the shareholder’s basis in the corporation’s stock, the excess generally generates capital gain.
Example 5: Assume the same facts in Example 4, except S Co. generates only $20,000 of income, and the distribution is increased to $60,000. A determines the taxability of the $60,000 distribution as shown in Exhibit 1.Because the $60,000 distribution to A exceeds A ’s predistribution basis in his Scorporation stock of $50,000, only $50,000 of the distribution is a tax-free return of basis. The $10,000 distributed in excess of A ’s basis in the S Co. stock is treated as amounts realized on the sale of the stock, resulting in capital gain. Because A has no remaining stock basis, A may not use any of the $30,000 long-term capital loss allocated to him unless he has basis in indebtedness of S Co. 27
Because the ordering rules require basis to be reduced for distributions before losses, an S corporation will always be permitted to distribute the income allocated to a shareholder in year 1 during year 2, regardless of whether the S corporation has a loss in year 2. This rule allows an S corporation to distribute the cash necessary for shareholders to pay their tax liability arising from the prior year’s income without fear that an operating loss in the year the cash is distributed will render the distributions taxable.
Example 6: A owns 100% of S Co., which has no accumulated E&P. In 2012, S Co. generates $20,000 of income, increasing A ’s basis in the S Co. stock from $0 to $20,000. In March 2013, S Co. distributes the $20,000 of 2012 earnings to A . In 2013, S Co. allocates to A $40,000 of ordinary loss. To determine the taxability of the $20,000 distribution, A must adjust his basis in S Co.’s stock as shown in Exhibit 2.
The entire $20,000 distribution represents a tax-free reduction of A ’s basis in S Co. stock. Because the distribution reduces A ’s basis in the S Co. stock to zero, A may not use the $40,000 ordinary loss allocated to him in 2013. 28 A must carry forward the loss to 2014, when it will be treated as a newly incurred loss of the same character.
Part II of this article, in the February issue, will cover the taxability of distributions made from an S corporation with accumulated E&P, while also addressing ancillary considerations and planning opportunities.
1 Sec. 1368(b)(1).
2 Sec. 1368(c)(2).
3 Sec. 1368(b)(2).
4 Sec. 301(c)(1).
5 Note, however, that an S corporation may pay corporate-level tax on its “built-in gains” under Sec. 1374 or its “excess net passive income” under Sec. 1375.
6 Subchapter S Revision Act of 1982, P.L. 97-354.
7 Sec. 1367(a)(1).
8 Sec. 1367(a)(2).
9 Regs. Sec. 1.1367-1(f).
11 Regs. Sec. 1.1367-1(g) provides that a shareholder may elect to reduce basis by losses prior to reduction for nondeductible expenses. This election is generally irrevocable, and any nondeductible expenses or oil and gas depletion deductions limited by basis are carried forward to reduce basis in later years (under the default ordering rule, any nondeductible expenses or oil and gas depletion deductions limited by basis are not carried forward but, rather, disappear).
12 Sec. 1366(d)(1).
13 Sec. 1366(d)(2).
14 Sec. 381(c)(2). See also S. Rep’t No. 97-640, 97th Cong., 2d Sess. (1982).
15 Note, however, that a corporate shareholder may be permitted to reduce the dividend income by the dividends-received deduction of Sec. 243.
16 The accumulated E&P at the close of the S corporation’s tax year should be reported on Form 1120S, Schedule B, Line 9. If the corporation had a negative E&P balance when the S election was made, the corporation has no accumulated E&P, and no balance should be reported on Schedule B. Accumulated E&P at the time of an S election is generally not increased or decreased for any items of S corporation income, gain, loss, or deduction. Under Sec. 1371, E&P may be adjusted during S corporation years only for distributions of E&P, payment of corporate-level tax due to investment credit recapture, and certain redemptions, reorganizations, liquidations, and corporate divisions. In addition, Sec. 1363(d)(5) provides that E&P is reduced for the S corporation’s payment of tax for LIFO recapture.
17 Regs. Sec. 1.1368-2(a)(1).
19 Regs. Sec. 1.1368-2(a)(2).
20 Regs. Sec. 1.1368-2(a)(3)(i).
21 Regs. Sec. 1.1368-2(a)(3)(ii). Note, AAA is reduced by the full amount of losses or deductions the S corporation incurred during the year, even if the losses or deductions are limited at the shareholder level because of the lack of basis under Sec. 1366, passive activity limitations under Sec. 469, or at-risk limitations under Sec. 465.
22 Sec. 1368(e)(1)(C).
23 Regs. Sec. 1.1368-2(a)(5).
25 A shareholder may not apply a distribution against any basis in debt the S corporation owes the shareholder. Basis in debt is reduced only by losses, not by distributions.
26 Sec. 1368(b). If the S corporation stock is held as a capital asset, the resulting income is long-term or short-term capital gain depending on the shareholder’s holding period. If the shareholder holds the stock as a dealer, the distribution in excess of basis will result in ordinary income. Note, further, that if the S corporation uses a fiscal year and the shareholders use a calendar year, the shareholders may not be certain of the tax status of a particular distribution until after the close of the corporation’s tax year, which may be after the due date of the shareholders’ tax returns. For example, if an S corporation with a Sept. 30 year end makes a distribution to its sole shareholder on Dec. 31, 2012, the shareholder will be unable to determine if the distribution exceeds basis until the corporation’s tax year is complete on Sept. 30, 2013, and basis can be adjusted. However, any gain recognized for a distribution in excess of basis would be required to be recognized by the shareholder on his or her 2012 tax return. This problem can typically be solved by extending the shareholder’s tax return or filing an amended return once basis can be computed.
27 Note, however, that even if A has basis in S Co.’s indebtedness, $10,000 of the $60,000 distribution to A will continue to generate capital gain, because the taxability of a distribution is determined only by reference to a shareholder’s basis in the corporation’s stock.
28 A may use the $40,000 loss to the extent A has basis in S Co.’s indebtedness.