In the throes of economic uncertainty, most business owners are so focused on staying afloat that tax planning becomes an afterthought. It seems less practical to plan for the future when the present is so bleak. However, it is times like these when informed tax planning can be even more critical. Looming tax changes could deliver another blow to unprepared business owners, but an awareness of these changes may enable owners to identify opportunities that may not have existed in better economic times.
One such change with major implications for S corporations with prior C corporation earnings is the sunset of the 15% tax rate on qualified dividends. This favorable rate is due to expire on December 31, 2010, as provided in the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). 1 Barring new legislation, in 2011 dividends will again be taxed at ordinary income tax rates. Further, those ordinary rates are scheduled to revert to their amount prior to the Economic Growth and Tax Relief Reconciliation Act of 2001. 2 This means the top ordinary income tax rate of 39.6% will again be in effect. In the case of S corporations with prior C corporation earnings (accumulated earnings and profits), this will be particularly difficult for their shareholders. Distributions after 2010 may be taxed at a rate more than double what they are taxed at currently.
The scheduled rate increases, trapped earnings and profits, and losses being sustained in the poor economy may combine to create a perfect storm for some S corporation owners. But with an appropriate strategy, S corporations and their owners can leverage poor financial performance to reduce or eliminate future tax on accumulated earnings and profits (AE&P). This article discusses how S corporations with AE&P can use current distributions and dividends to create tax savings for their shareholders in future years.
Typical Order of Distributions
When an S corporation makes a distribution to its shareholders, it typically is considered to have come from the following sources in this order: 3
- Accumulated adjustments account (AAA): nontaxable to the extent of shareholder basis;
- For pre-1983 S corporations only, previously taxed income (PTI): non-taxable; 4
- AE&P: taxed as a qualified dividend at 15% through 2010;
- Return of capital: nontaxable to the extent of remaining stock basis; and
- Capital gain from the deemed disposition of stock: taxed as long-term capital gain if held for one year or more.
The above order applies to distributions of cash as well as noncash property, with the exception of PTI; distributions of PTI must be in the form of cash. 5 Based on the typical order of distributions, AE&P will not be reduced, in the form of dividends, until all the company’s AAA has been distributed. For companies with prior C corporation earnings, the AAA balance can act as a shield, preventing the recognition of dividend income by its shareholders upon receipt of distributions. Management can defer this income indefinitely by limiting annual distributions to the amount of the AAA at each year’s end.
However, the AAA is reduced not only by distributions but also by any loss and deductions recognized by the company during the year. 6 These losses or deductions can eliminate or greatly reduce any AAA, causing current or future distributions to be taxed as dividends. As companies struggle in the down economy, many are incurring large losses and depleting their AAA balances. If they eventually distribute cash or property next year and the 15% qualified dividend rate has expired as scheduled, they will be taxed on the AE&P distributions at ordinary income rates, which may be as high as 39.6%.
Future-looking taxpayers may prefer to recognize dividend income in 2010 when it is still guaranteed to be taxed at a maximum of 15%. This will eliminate the possibility of paying 39.6% on any future distributions. Furthermore, if the shareholders have experienced losses in 2010 or carried forward an NOL from a prior year, they can offset the dividend income, which could eliminate the AE&P at no tax cost to the shareholders. The issue, however, is whether the company has enough cash or liquid property available in 2010 to make distributions that exceed the AAA and AE&P balances.
Distribute Earnings and Profits First
Fortunately, the IRS allows S corporations to modify the order in which distributions are applied. Sec. 1368(e)(3) provides that an S corporation with AE&P can elect to treat its distributions for the year as AE&P-source funds, and therefore taxable as dividends, to the extent of AE&P. Any distributions exceeding AE&P will then be applied to AAA, and any further remaining amount will follow the sequence provided by Sec. 1368(b) (steps 4 and 5 above). 7 The election to modify the order of distribution sources requires the consent of all shareholders that received a distribution from the S corporation during the tax year (affected shareholders). 8 The reordering applies to all distributions for the year, so the company cannot choose to divide them between AAA and AE&P, but the election applies only for the tax year in which it is made. If the company wants to distribute AE&P before AAA in a subsequent year, a separate election for that year will be required.
To make this election, the company must attach a statement to its timely filed (including extensions) original or amended return. The statement should indicate that the company is electing under Regs. Sec. 1.1368-1(f)(2) to distribute earnings and profits first and must state that all affected shareholders consent to the election. The statement does not need to be signed.
This irrevocable election makes it possible for an S corporation with AE&P and limited cash to treat all distributions made in 2010 as coming from AE&P even if it still has AAA remaining. Shareholders may prefer to make this election to get AE&P out of the company while dividend rates are still 15%.
But what about companies with no cash available to make distributions before December 31, 2010? Many businesses are having trouble acquiring financing, collecting on receivables, and maintaining positive cashflow. However, there are a few ways for such businesses to take advantage of the 15% dividend rate. They may be able to liquidate some assets and then make cash distributions. This is possible, of course, only if the company has nonessential business assets or is willing to sell investment assets at a likely loss. Another option for the company is to make distributions of property other than cash. But if distributed property has a fair market value that exceeds its basis, the S corporation must recognize the difference as taxable gain. If fair market value is less than basis, the corporation does not recognize a loss. A much better option exists for these companies, and that is the election to make a deemed dividend.
A deemed dividend does not require the actual distribution of cash. The S corporation makes an irrevocable election under Regs. Sec. 1.1368-1(f)(3) in the same manner as it would make the election to distribute earnings and profits first. 9 The election allows the company to distribute all or part of its AE&P without transferring any cash to its shareholders. This is because the amount of the dividend is considered to have been distributed in cash and then immediately contributed back to the S corporation. The transaction is treated as having occurred on the last day of the corporation’s year and requires all shareholders on that date to include dividend income on their individual returns. As a result, all such shareholders must consent to the election to make the deemed dividend.
The amount of the dividend is determined by the S corporation, with the only restriction being that it cannot exceed the amount of AE&P at year end (reduced by actual distributions of AE&P made during the year). Shareholders are considered to have received their proportionate share of the total deemed dividend based on their ownership percentage at the company’s year end. The specific shareholders should be listed on the election statement, with their Social Security numbers and amount of their share of the deemed dividend.
The ability to specify the amount of the deemed dividend is advantageous, particularly in S corporations with one or two shareholders. With basic knowledge of their individual tax situations, the amount of the deemed dividend can be set to take advantage of other factors on the individuals’ returns, such as NOL carryovers, current-year losses, or large itemized deductions. In addition, the shareholder’s stock basis in the S corporation is increased by the amount of the deemed dividend to reflect the simultaneous contribution to capital.
Example: S corporation Y has one shareholder, Z. Y had ordinary business loss of $100,000 for the year ended December 31, 2010, and made no distributions during the year. Y has $50,000 in AAA and $150,000 in AE&P on December 31, 2010, after adjusting for the current-year activity. Z’s stock basis in Y on December 31, 2010, is $150,000 ($100,000 in capital stock plus $50,000 in undistributed S corporation earnings), again after adjusting for current-year activity.
Aware of the sunset provisions in JGTRRA, Z elects to make a deemed dividend of $150,000 to eliminate all of Y’s AE&P in 2010. Y will make the following entry on its books to reflect the simultaneous dividend distribution to Z and contribution of capital from Z:
Paid-in capital $150,000
The $150,000 deemed dividend will be reported on Y’s Form 1120S, U.S. Income Tax Return for an S Corporation, Schedule K, line 17c, as well as on a Form 1099-DIV that Y will furnish to Z. Z will report $150,000 of dividend income on his Form 1040, along with the $100,000 of ordinary loss passed through to him by Y. Z’s stock basis is increased by his $150,000 capital contribution.
This article focuses on the strategy of distributing AE&P in 2010 in preparation for the scheduled expiration of the 15% qualified dividend rate. However, there are other situations in which an S corporation and its shareholders may benefit from the discussed elections. If the S corporation is subject to the tax on excess net passive income, 10 eliminating AE&P will also eliminate the tax. An S corporation with AE&P that has excess passive investment income for three consecutive tax years will face involuntary termination of its S election. 11 If AE&P is removed, so is the threat of termination.
Ultimately, the decision to make one or all of these elections should be considered in light of the impact on the individual shareholders’ taxes. If a shareholder generates a large operating loss in 2010, it may be beneficial to forgo creating dividend income in 2010 and instead carry back the loss up to five years for an immediate refund. In addition, a shareholder’s investment interest expense carryover alone may not be reason enough to create dividend income in 2010 because any dividends included in investment income lose their favorable tax rates. Conversely, the limitation on itemized deductions is completely phased out for 2010, so the additional dividend income would not negatively affect the deduction amount for this year only.
Clearly, there are many factors for shareholders to consider prior to making the elections, and all affected shareholders must consent to them. Fortunately, the shareholders do not have to make these elections until the due date of the S corporation’s return, including extensions. This should give shareholders and their tax advisers an opportunity to assess their 2010 individual tax situations before deciding to make the election to distribute earnings and profits or the election to make a deemed dividend.
The economic recession has obviously created severe hardship for businesses and their owners. Despite a myriad of current legislation aimed at providing tax relief, there are sunset provisions in prior law that, if fulfilled, will increase tax rates and increase the troubles of S corporation owners that must take taxable distributions. For that reason, informed tax planning remains as important as ever in 2010. There are specific elections available to S corporations that enable them to distribute earnings and profits before AAA or to make a deemed dividend. These elections may allow proactive owners to take advantage of recent business losses and the expiring favorable dividend rates to reduce or eliminate tax on future distributions.
1 Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27.
2 Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.
3 Sec. 1368(c).
4 Regs. Sec. 1.1368-1(d)(2).
6 Regs. Sec. 1.1368-2(a)(3)(i)(A).
7 If the company has PTI in addition to AE&P and wishes to forgo distribution of PTI, a separate election under Regs. Sec. 1.1368-1(f)(4) is needed. Absent this election, but with the election to distribute earning and profits first, the distribution order will be PTI, then AE&P, and finally AAA.
8 Sec. 1368(e)(3)(A).
9 Upon making this election, the company is considered to have made the election under Regs. Sec. 1.1368-1(f)(2) to distribute AE&P first. The company therefore does not have to make a specific election for that. But if it has PTI, the election to forgo distribution of PTI must still be made separately.
10 Sec. 1375(a)(1).
11 Sec. 1362(d)(3)(A).
Daniel Rowe is a tax manager with Deemer, Dana & Froehle LLP in Savannah, GA. For more information about this article, contact Mr. Rowe at email@example.com.