Both a C corporation and an S corporation can distribute taxable dividends to the extent that the corporation has accumulated earnings and profits (AE&P). An S corporation cannot generate earnings and profits (E&P) but, as discussed in the following paragraphs, a C corporation’s AE&P transfers to the S corporation when the S election is made (Sec. 1371(c)).
Dividends are distributions of current E&P or AE&P of a C corporation (Sec. 316(a)). An S corporation can pay a dividend only when AE&P that arose when the corporation was in C status is distributed (Sec. 1371(c)). Therefore, a corporation that has been an S corporation since inception and has not acquired another corporation with AE&P cannot issue a dividend.
For federal income tax purposes, a “distribution” is a payment in cash or property from a corporation to a shareholder based on stock ownership. A “dividend” is a distribution from AE&P (Sec. 316). Therefore, a distribution may or may not include a dividend. State law and corporate minutes often refer to distributions to shareholders as dividends without regard to whether AE&P is actually distributed.
Calculating C Corporation E&P
C corporations generate positive or negative E&P each year, calculated by making annual adjustments to taxable income. Depreciation, for example, can cause one such adjustment. For purposes of calculating taxable income, assets generally can be depreciated under the modified accelerated cost recovery system (MACRS), but they must be depreciated under the alternative depreciation system (ADS) when computing E&P (Sec. 312(k)(3) (A)). In addition, the Sec. 179 expense is deducted for regular tax purposes in the year the asset is placed in service but is deducted pro rata over five years when determining E&P (Sec. 312(k)(3)(B)). Furthermore, the Sec. 179 expense may be handled entirely differently for book purposes in arriving at retained earnings.
The term “retained earnings” refers to a corporation’s undistributed earnings; its computation is normally governed and determined by generally accepted accounting principles (GAAP). AE&P is also a measure of the undistributed earnings of a corporation, but from a tax point of view. In other words, accounting rules govern the determination of retained earnings, while AE&P is calculated under tax law. Because of these differences, AE&P seldom matches retained earnings.
Some S Corporations Will Not Have AE&P
AE&P is significant because its distribution results in a taxable dividend. An S corporation does not generate E&P, but many S corporations have AE&P because of previous operation as a C corporation. An S corporation can also have AE&P when it acquires certain other corporations that have AE&P. Accordingly, an S corporation will not have AE&P if it was never a C corporation and has not acquired another corporation.
When a C corporation becomes an S corporation, the AE&P retains its character (i.e., distributions of AE&P continue to be taxable dividends). However, S corporation income that already has been taxed can be distributed first, generally with no current tax effect on the shareholder.
Reducing AE&P by Distributions and Other Items
C corporation AE&P is frozen on the date the corporation converts to S status. The AE&P generally will not increase (except when the corporation acquires another corporation with AE&P) and will be reduced only by the following transactions:
- Distributions treated as dividends (Sec. 1371(c)(3));
- Payment of tax at the corporate level because of general business credit recapture (Sec. 1371(d)(3));
- Certain redemptions, reorganizations, liquidations, or corporate divisions (Sec. 1371(c)(2)); and
- Payment by the S corporation of LIFO recapture (Sec. 1363(d)(5)).
S corporation transactions do not increase an S corporation’s frozen AE&P balance, and it is reduced only by the items listed in the previous paragraph. By comparison, certain other negative adjustments to E&P are allowable to a C corporation. Depreciation, for example, will cause positive adjustments to a C corporation’s E&P at first and negative adjustments after the depreciation methods begin to equalize.
Example 1: Z is a C corporation that, for tax purposes, breaks even every year. Z elects S status at the beginning of the current year when it has $75,000 of AE&P caused by the difference between depreciation under MACRS and ADS. In the first year of S status, depreciation per the tax return under MACRS is $90,000 while depreciation under ADS would be $100,000. If Z had remained a C corporation, the $10,000 difference would be a negative adjustment, and Z would reduce its AE&P by that amount. Because the corporation is in S status, however, no AE&P adjustment for the depreciation difference is allowable.
Business credit recapture is paid at the corporate level if the credit was originally claimed while the corporation was a C corporation (Sec. 1371(d)). Business credit recapture paid at the corporate level reduces the corporation’s AE&P (Sec. 1371(d)(3)). In addition, the recapture tax paid by the S corporation is a nondeductible, noncapitalizable expense that reduces basis. However, the business credit recapture tax paid by the S corporation does not reduce an accumulated adjustments account (AAA) because the recapture is a federal tax attributable to a C corporation year, and an AAA is not reduced by such items (Sec. 1368(e)(1)(A)).
As illustrated below, an S corporation’s AE&P is not adjusted if the adjustment was based on an estimate under the completed contract method and the estimate turns out to be wrong (Cameron, 105 T.C. 380 (1995)). The Eighth Circuit reached the same conclusion in Broadaway, 111 F.3d 593 (8th Cir. 1997).
Example 2: C is a C corporation that uses the completed contract method of accounting for long-term contracts. C is not required to use the percentage of completion method for regular tax purposes, but it calculates its E&P using that method (Sec. 312(n)(6)). For simplicity, assume that C has one contract and no AE&P at the beginning of 2008. The contract is not completed during that year, so C shows no income or loss on its Form 1120, U.S. Corporation Income Tax Return. C estimates that under the percentage of completion method it would have $50,000 of income, so that amount is the AE&P balance on January 1, 2009, when C elects S status. On January 15, 2009, C distributes $45,000 to Q, its sole shareholder. Q’s basis in stock is $60,000. C’s net operating income shown on its 2009 Form 1120S, U.S. Income Tax Return for an S Corporation, is $1,000. Under these facts, C’s AAA before considering the distribution is $1,000, so the distribution would be a $1,000 nontaxable distribution of AAA and a $44,000 dividend. The dividend would reduce the AE&P balance from $50,000 to $6,000. Q, however, discovers that the $50,000 income estimate under the percentage of completion method should have been only $7,000. If the AE&P balance on January 1, 2009, was $7,000, the $45,000 distribution would be (1) a $1,000 nontaxable distribution of AAA, (2) a $7,000 dividend, and (3) a $37,000 nontaxable return of basis.
According to the Tax Court’s ruling in Cameron, the beginning AE&P balance cannot be changed from $50,000 to $7,000, even though the incorrect estimate would have corrected itself if C had remained a C corporation. The Tax Court ruled that, under Regs. Sec. 1.451-1(a), if income is properly accrued based on a reasonable estimate and the exact amount is found to be different, the difference is taken into account in the tax year in which the exact amount is determined. Electing S status is a voluntary act, and one of its consequences is the freezing of the AE&P.
This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 23d Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, James A. Keller, and Brooke Pascall, published by Practitioners Publishing Company, Ft. Worth, TX, 2009 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.