Modifying the Order of Distribution Rules for an S Corporation with AE&P

Editor: Joel E. Ackerman, CPA, MST

A distribution from an S corporation is generally treated as made from the corporation’s accumulated adjustments account (AAA) tax free to the extent of a shareholder’s basis. It is then treated as taken from any remaining balance of AAA and is taxed at capital gain rates. Next, it is treated as a tax-free reduction of previously taxed income (PTI), which consists of S corporation earnings from tax years beginning 1982 and earlier, and then as a taxable dividend to the extent of accumulated earnings and profits (AE&P). After AE&P is exhausted, any remaining distribution amount is treated as tax free to the extent of the shareholder’s basis, and the balance is treated as a capital gain.

Because of these ordering rules, any AE&P are essentially “trapped” in this group of undistributed earnings until AAA and PTI are fully depleted. There may be some cases in which it would be advantageous to distribute AE&P before AAA and/or PTI. Fortunately, the Code allows a taxpayer to elect to change these ordering rules and treat S corporation distributions as made out of AE&P first.

Elections

Three elections allow S corporations to distribute AE&P before AAA and/or PTI:

1. An election to distribute AE&P before AAA;
2. An election to make a deemed dividend; and
3. An election to forgo distributions of PTI. (See exhibit)

An S corporation can elect to modify the distribution order of AAA and AE&P. Specifically, the S corporation can elect under Sec. 1368(e)(3)(A) to treat distributions as being made from AE&P before reducing AAA.

In addition, an S corporation that lacks liquid assets to distribute AE&P can also elect to make a deemed dividend under Regs. Sec. 1.1368-1(f)(3), effectively bypassing AAA and reducing AE&P first by creating a hypothetical distribution. If this election is made, the first election described above will be considered to have been made.

Generally, an S corporation will want to distribute PTI as quickly as possible, because the ability to distribute PTI tax free is limited to those who were shareholders at the time it was earned. PTI cannot be distributed tax free to subsequent shareholders or after an S corporation election terminates. However, if the S corporation has PTI and wishes to bypass it in addition to AAA, the S corporation will have to make an election under Regs. Sec. 1.1368-1(f)(4). If it does not make this election but makes the first two, distri-butions will first reduce PTI tax free, then AE&P, and finally AAA.

Purpose

There are a few potential tax advantages associated with strategically accelerating AE&P distributions. For instance, if a shareholder has an NOL carryforward that is going to expire, these elections can essentially get AE&P out of the S corporation tax free to the extent of the NOL.

S corporations with AE&P and passive investment income (PII) (as defined in Sec. 1362(d)(3)) that exceed 25% of gross receipts are subject to a tax on excess net passive income of 35%. Similar to the built-in gains tax, this tax is paid by the S corporation and reported on the company’s income tax return. By making the preceding elections and distributing AE&P as a dividend (taxable at 15%), the S corporation and its shareholders will no longer be subject to this tax. Further, a corporation that has no AE&P cannot have its S election terminated due to excess PII.

Currently, qualified dividends are taxed at a preferential rate of 15% under Sec. 1(h); this rate is set to expire in 2010. Although these rates were originally set to expire after 2008 and were extended by the Tax Increase Prevention and Reconciliation Act of 2005, P. L. 109-222, there is a real possibility that this provision will not be renewed. Therefore, making these elections and distributing any AE&P before then will effectively eliminate the possibility of this income being taxed at ordinary rates.

Timing and Manner of Elections

For an S corporation to make these elections, it must attach a statement to the timely filed original or amended corporate return that identifies the elections and states that each shareholder consents to the elections. The elections need not be signed, because they will be considered to be verified by the taxpayer’s signature on Form 1120S. The elections, if made, are irrevocable and apply only to the year of the election. (See Regs. Sec. 1.1368-1(f)(5).)

EditorsNotes

Joel E. Ackerman, CPA, MST is with Holtz Rubenstein Reminick LLP, DFK International/USA Melville, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

If you would like additional information about these items, contact Mr. Ackerman at (631) 752-7400 x262 or jackerman@hrrllp.com.