Under current tax law, an S corporation cannot produce earnings and profits (E&P). However, if the S corporation itself was previously a C corporation, it may have accumulated E&P from years when it was a C corporation. Similarly, if an S corporation was a party to a tax-free reorganization with another corporation that had accumulated E&P, the S corporation may have inherited the other corporation’s accumulated E&P. S corporations that have accumulated C corporation E&P have both problems and opportunities. This article examines both of these, explores solutions to the problems, and discusses the opportunities.
There are two possible problems that an S corporation with E&P may have: (1) the Sec. 1375 passive investment income tax (sometimes called the sting tax) and (2) the possible loss of S corporation status.
If the gross passive investment income (interest, dividends, certain types of rent, etc.) exceeds 25% of gross receipts, the corporation may be subject to the tax on its net passive investment income (gross passive investment income minus expenses of earning that income). This is not a problem if the S corporation has no accumulated E&P. However, if it does have both E&P and excess passive investment income, some of the excess net passive investment income may be subject to the sting tax at the highest corporate income tax rate. The tax will not apply to a year in which there is no taxable income. Furthermore, the IRS can waive this tax if the corporation mistakenly determined that it had no E&P and it distributes the E&P within a reasonable time after its discovery. 1 The request to waive the passive investment income tax is made to the IRS in the district where the Form 1120S, U.S. Income Tax Return for an S Corporation, was filed.
Even if there is no taxable income and the passive investment income tax does not apply, if the S corporation has both E&P and excess passive investment income for three consecutive tax years, the S corporation status will be lost on the first day of the fourth tax year. 2
However, the IRS may allow S corporation status to continue if convinced that the termination of S corporation status was inadvertent. 3 To obtain this relief, the corporation must submit a private letter ruling request to the IRS National Office in Washington, DC. The IRS has been reasonable in granting this type of relief. 4
Possible Solutions to Problems
These problems exist only if the S corporation has excess passive investment income. It may be possible to eliminate that income by increasing the amount of active income. The corporation might accomplish this by selling or distributing the assets that produce the passive investment income, or it might acquire a new active business, either directly or by investing in a partnership from which an allocable portion of the partnership’s active gross receipts will flow through to the corporation. Sec. 702(b) preserves the character of items constituting each partner’s distributive share of partnership items.
Example 1: J, an S corporation, has $100,000 of gross receipts, of which $30,000 are interest and dividends. J invests in a partnership from which its share of active gross receipts equals $60,000. Thus, the gross receipts are increased to $160,000, and the $30,000 of dividends and interest are less than 25% of the $160,000 gross receipts.
Another solution would be for J to pay out all of its accumulated E&P as dividends to its shareholders. As indicated above, an S corporation with no E&P can have unlimited amounts of passive investment income without either of those problems.
Example 2: J has accumulated E&P of $10,000 and an accumulated adjustments account (AAA) of $25,000. If the S corporation distributes $35,000 or more to its shareholders, it will have paid out all of its accumulated E&P.
The $10,000 E&P is taxable as a dividend to J’s shareholders, requiring J to issue Forms 1099-DIV, Dividends and Distributions. The $25,000 AAA is tax free to the shareholders if they have at least that amount of basis for their S corporation stock.
Sometimes an S corporation may not have sufficient cash to pay a dividend in an amount equal to its total AAA and E&P. In that case, there are several other alternatives. The corporation could issue notes to shareholders as a dividend. Alternatively, it could make the election to pay E&P prior to the AAA. 5 Shareholder consents to the election must be obtained. The S corporation makes the election on its tax return for the year in which the distribution is made. A description of how the corporation makes the election is included below.
Example 3: The facts are the same as in Example 2, except the election to distribute E&P first has been made, and the amount of the distribution is $12,000. All the $10,000 of E&P has thus been distributed and is taxable as a dividend to the shareholders, requiring the issuance of Forms 1099-DIV. The additional $2,000 is from the AAA and is tax free to the shareholders, provided they have sufficient basis in their S corporation stock. The distribution of all E&P eliminates any passive investment income problems.
If the corporation does not have sufficient cash to pay out the E&P if it makes the election to distribute E&P first, there is another possible solution to the problem. Regs. Sec. 1.1368-1(f)(3) provides that a deemed dividend election may be made with shareholder consents. If the corporation makes this election, no property needs to be distributed. It is treated as though the E&P had actually been distributed to the shareholders and they had contributed the deemed distribution amounts back to the corporation, all on the last day of the tax year for which the election is made. The corporation can elect to treat all or any part of its E&P as having been distributed. To eliminate the passive investment income problems, the corporation should elect as to all its accumulated E&P.
The deemed dividend election is made on the tax return for the year to which it applies. The S corporation must attach a statement to its tax return, as described below.
Example 4 : The facts are the same as in Example 2, except that no distribution is made, but the deemed dividend election is made for all the E&P. In that case, the $10,000 of E&P is treated as having been distributed on the last day of the tax year, and the shareholders are treated as having recontributed that amount back to J. Thus, J will no longer have any E&P. The $10,000 E&P is taxed as a dividend to the shareholders, and J will need to file Forms 1099-DIV.
How to Make These Elections
An S corporation makes one of the above elections (to distribute E&P before AAA or to make a deemed dividend) for a tax year by attaching a statement to a timely filed original or amended Form 1120S for that tax year. In the statement, the corporation must identify which election it is making under Regs. Sec. 1.1368-1(f) and must state that each shareholder consents to the election. The statement is verified by signing the return to which it is attached. 6 A statement of the election to make a deemed dividend under Regs. Sec. 1.1368-1(f)(3) must also include the amount of the deemed dividend that is treated as being distributed to each shareholder. These elections are irrevocable and are effective only for the tax year for which they are made. 7
As indicated above, the making of a deemed dividend distribution of the E&P under Regs Sec. 1.1368-1(f)(3) is also treated as a contribution of capital to the corporation, thus increasing the stock basis of the shareholders. This can be used to a taxpayer’s advantage in a situation in which the taxpayer has insufficient basis to deduct losses of the S corporation. Furthermore, a deemed dividend distribution for the year 2010 would be taxable at the 15% dividend tax rate.
Example 5: The facts are the same as in the previous example. In addition, the sole shareholder had a zero basis for his stock as of January 1, 2010. The corporation has an ordinary operating loss of $15,000 for its 2010 tax year. If the deemed dividend election is made for all the E&P on the 2010 Form 1120S, which is due to be filed in 2011, the shareholder will have a basis of $10,000 and so will be able to currently deduct $10,000 of the $15,000 loss. The remaining $5,000 loss will be carried over for that shareholder to the year 2011. Thus, on his 2010 Form 1040, he will be able to deduct the $10,000 as an ordinary loss and will be taxed on the $10,000 as a dividend distribution subject to only a 15% tax rate.
The interplay of the ordinary income tax rates and the 15% dividend tax rate for 2010 is an opportunity that will probably disappear with increases in tax rates and the elimination of the special 15% dividend tax rate. Thus, it should be taken advantage of in 2010, either by actual distributions or by using the deemed dividend election.
Practitioners need to be aware of the E&P rules so they can avoid problems, solve problems once they occur, and take advantage of opportunities. With careful planning an S corporation with E&P can avoid the Sec. 1375 passive investment income tax and the possible loss of S corporation status. By acting quickly, some taxpayers can also take advantage of the 15% dividend tax rate.
1 Sec. 1375(d).
2 Sec. 1362(d)(3).
3 Sec. 1362(f).
4 See IRS Letter Rulings 200930027 (7/24/09), 201031030 (8/6/10), and 201025033 (6/25/10) for examples of these situations.
5 Regs. Sec. 1.1368-1(f)(2).
6 Regs. Sec. 1.1368-1(f)(5)(iii).
7 Regs. Sec. 1.1368-1(f)(5)(iv).
Sydney S. Traum practices law through his professional corporation, Sydney S. Traum, P.A., in Miami-Dade County, FL, and is a member of the AICPA’s S Corporation Technical Resource Panel. He is author of Aspen Publishers’ quarterly supplemented looseleaf tax service, The S Corporation: Planning & Operation, and Aspen’s The S Corporation Answer Book. He is a member of the FICPA Federal Tax Committee and the American Bar Association Tax Section S Corporation Committee and is chair of the Florida Bar Tax Section S Corporation Committee. He is a past president of the American Association of Attorney-Certified Public Accountants and of the Dade County Chapter of the Florida Institute of CPAs (FICPA). For more information about this article, please contact Mr. Traum at firstname.lastname@example.org.