[Ed note: As part of our continuing goal to address some of the oft-misunderstood tax issues we encounter during busy season, (see prior lessons here, here, and here), WS+B staff member and budding star Melissa Crowe stops by to discuss how to determine the taxability of an S corporation’s distributions to its recipient shareholders. In my experience, CPAs tend to make the concepts of I.R.C. § 1368 more complicated than they really are, and Melissa does a wonderful job simplifying the steps necessary to reach the correct result. Now on to Melissa:]
The first question that needs to be addressed when determining the taxability of distributions made by an S corporation to its shareholders is, was the S corporation ever a C corporation? If the answer is no, then a shareholder’s basis in the corporation’s stock is all that matters;[i] the corporation’s accumulated adjustments account (AAA) — discussed later in this post — is irrelevant.
A distribution out of an S corporation that was never previously a C corporation is a nontaxable return of the shareholder’s basis in the corporation’s stock. If the distribution exceeds shareholder basis, the remaining distribution is taxed as a capital gain.[ii]
When an S corporation was previously a C corporation, however, the taxability of the S corporation’s distributions are another matter entirely. This is because when a C corporation makes the election to become an S corporation, any accumulated earnings and profit (E&P) from C corporation years carries over to the S corporation and is held until it is distributed as a taxable dividend to shareholders. As a result, any E&P from previous C corporation years must be taken into consideration when the S corporation makes a distribution.
As mentioned previously, only when E&P is present does an S corporation’s AAA account become relevant in determining the taxability of the corporation’s distributions. In brief, AAA is a corporate attribute that tracks the balance of the corporation’s taxable income which has passed through to shareholders but has not yet been distributed in cash. In its most basic form, the account is increased by an S corporation’s profit and decreased by its losses and distributions. Although losses can decrease an AAA account below zero, distributions cannot; an important thing to remember when adjusting AAA to account for a distribution.
There are three steps to consider when a distribution is made from an S corporation with E&P:
Step 1 – To the extent of a corporation’s positive balance in its AAA, any distributions are treated exactly the same as if the corporation did not have E&P. Thus, this portion of the distribution is tax free to shareholders to the extent of their basis in the corporation’s stock, with any amount in excess of such basis taxed as capital gain.[iii]
Step 2 – When the distribution exceeds the balance of the AAA and reduces it to zero, the S corporation’s E&P balance will then be reduced, and this portion of the distribution will be treated as a taxable dividend to shareholders. The shareholder’s basis will not be affected by a distribution from the E&P account.[iv]
Step 3 – Once an S corporation has fully distributed its E&P, the corporation is treated as if it had never been a C corporation, and a shareholder’s stock basis is again all that is relevant in determining the taxability of distributions. The remaining distribution is treated the same as it was in Step 1–first a nontaxable reduction of a shareholder’s basis to zero, with any remaining distribution treated as a capital gain to the shareholder.[v]
To illustrate, assume that a C corporation has made the election to become an S corporation, has a balance in its AAA account of $200, and has E&P from previous C corporation years of $100. In addition, the sole shareholder’s basis in the corporate stock is $300. The S corporation makes a distribution of $500 in the current year. The steps necessary to determine the taxability of this distribution would be as follows:
Step 1 – Reduce the balance in the AAA to zero with the first $200 of distribution. This also reduces the shareholder’s basis in the corporation’s stock. The AAA balance is reduced from $200 to zero, and stock basis is reduced from $300 to $100. This portion of the distribution is tax free to the shareholder. There now remains $300 to be distributed.
Step 2 – Reduce the corporation’s E&P account by the next $100 of distribution. The E&P account is now reduced from $100 to zero. Remember, the shareholder’s basis is not affected by distributions from E&P. This portion of the distribution is treated as a taxable dividend to the shareholder. There now remains $200 to be distributed.
Step 3 – Reduce the shareholder’s stock basis by the remaining $200 of distribution. The basis is now reduced from $100 to zero, and this $100 is treated as a tax free distribution. The remaining $100 is treated as a capital gain to the shareholder.
These three steps provide an easy guide to managing S corporation distributions and ensuring their proper tax treatment.
[Ed note: for more on this topic, including how and when to adjust the AAA for purposes of determining the taxability of an S corporation’s distributions, see this PDF — Taxability of S Corporation Distributions — which contains a decision tree and illustrative examples.]