Hey you! Yeah, you.
As the end of 2011 approaches, are you tired of having no basis in your S corporation stock,[1] leaving you unable to utilize yet another tax loss?
Does your S corporation have E&P from previous C corporation years that, when distributed, will be taxed as a dividend?
Has the brutal economy left both you and your S corporation so devoid of excess cash that taking a distribution or contributing additional cash to the corporation is an impossibility?
Have “traditional” sit-ups left you with an aching neck and a still-flabby midsection?
It the answer to all of these questions is a resounding “yes!” we’ve got the solution to all of your problems (well, all except that last thing. For ripped abs that glisten in the summer sun, you’ll need this.)
Here’s how it works:
At the moment, the tax rate on qualified dividends is only 15%. Only the most optimistic among us expect things to stay that way, with many anticipating a return to the old days where dividends were taxed at ordinary income rates as high as 35%. As a result, now is the ideal time to “purge” your S corporation’s E&P and pay tax on the resulting dividend at the current preferential rate.
But with cash at a premium, taking a distribution of E&P out of an S corporation would appear foolish for two reasons: 1) the S corporation may not have the cash necessary to make the distribution, particularly since in order for an S corporation distribution to be one made from E&P, the total distributions during the year must generally exceed the corporation’s AAA balance; and 2) even with the preferential tax rates on dividends potentially soon to expire, who would want to accelerate taxable income that could otherwise remain deferred in the S corporation?
Well, what if I told you that you could purge the corporation’s E&P, pay tax on the dividend at only 15%, and create enough stock basis to free up the S corporation’s otherwise unusable 2011 loss — thereby potentially fully offsetting the dividend income — all without spending a penny of anyone’s hard-earned cash?
Look no further than the “deemed dividend” rule of Treas. Reg. § 1.1368-1(f)(3).
A deemed dividend is an election available to an S corporation and its shareholders to make a hypothetical distribution of the corporation’s E&P from previous C corporation years to all shareholders as of the last day of the corporation’s tax year. Importantly, NO cash is required to make the election; hence the term “deemed dividend.”
Under the fiction created by the regulations, the amount elected is treated as a cash distribution from E&P that is received by the shareholders and then is immediately contributed to the capital of the corporation. This deemed contribution has the effect of increasing stock basis to the extent of the deemed dividend, making it highly advisable to shareholders with reduced or nonexistent stock basis that are facing a 2011 tax loss[2]; especially now in light of the preferential rate afforded dividends.
Example: On Dec. 31, 2011, X, the sole shareholder of S Co., has no basis in his S stock. S Co. anticipates a tax loss of $100,000 for 2011, none of which can be utilized by X on his 2011 Form 1040 due to X’s lack of stock basis. S Co. also has accumulated E&P of $100,000 and AAA of $200,000.
S Co. may make a deemed dividend election with its 2011 tax return to distribute $100,000 of E&P, reversing the normal rules whereby a distribution first comes from an S corporation’s AAA. As a result of making the election, X will be treated as having received a $100,000 dividend, which will be taxed at 15%. However, X is also treated as having contributed the $100,000 back to S Co., increasing X’s stock basis by $100,000 and allowing X to utilize the $100,000 loss generated by S Co. in 2011. Assuming this loss is not subject to limitation under Sections 465 or 469, X has effectively traded $15,000 of tax liability for a $35,000 tax benefit (assuming a 35% ordinary tax rate), a net benefit of $20,000.
There are a couple of additional considerations:
- As mentioned, the election reverses the typical order of S corporation distributions by providing that all distributions made throughout the year first come from E&P, rather than the corporation’s AAA balance. Thus, any previous cash distribution made during the year that was originally planned to not come from E&P will now be deemed to have done so; a fact that warrants consideration prior to making the election. Of course, since in my example, you’ve got no basis in your S corporation stock, it doesn’t really matter if a distribution is treated as a distribution from AAA — in which case it will be treated as capital gain[3] — or a dividend, since either way the applicable tax rate is 15%.
- The election to make a deemed dividend is made by attaching a statement to the S corporation’s timely filed original or amended income tax return (Form 1120S) for the year in which the distributions are made. This means that you’ve got not only until the end of 2011, but until the date you timely file your 2011 tax return to make the election and have the deemed dividend/recontribution apply.
- The statement must declare that the corporation is electing to make a deemed dividend under Reg. 1.1368-1(f) and that each affected shareholder consents. Each shareholder who receives a distribution during the tax year (including a deemed dividend) must consent to the election. Furthermore, the statement must include the amount of the deemed dividend that is distributed to each shareholder
- The election is irrevocable and is effective only for the tax year for which it is made. No specific IRS form is necessary to make the election.
