Determining the Taxability of S Corporation Distributions: Part I
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An S corporation, unlike a C corporation, generally escapes income tax at the corporate level; instead, its items of income, deduction, credit, etc., flow through to its shareholders, who calculate and pay any tax due. Under Sec. 1368, an S corporation’s distribution of cash or property may give rise to three possible tax consequences to the recipient shareholder: a tax-free reduction of the shareholder’s basis in the corporation’s stock,1 a taxable dividend,2 or gain from the sale of the stock (generally resulting in capital gain).3 These options are not mutually exclusive; a single distribution may result in two or even all three of those consequences.
Integral to determining the taxability of an S corporation’s distributions are two shareholder-level attributes—stock basis and previously taxed income—and two corporate-level attributes—earnings and profits (E&P) and the accumulated adjustments account (AAA). Failure to fully grasp the role each plays in determining the taxability of a distribution adds needless complexity to the process and often results in an incorrect conclusion.
The purpose of this two-part article is to provide a comprehensive review of the rules for determining the taxability of an S corporation’s distributions to its recipient shareholders. Part I provides an overview of the intent of Sec. 1368 and the related regulations, the shareholder- and corporate-level attributes that drive a distribution’s taxability, and the rules for determining the tax consequences of distributions made from an S corporation without accumulated earnings and profits. Part II of the article, in the February issue, will examine the taxability of distributions made from an S corporation with accumulated earnings and profits, while also addressing ancillary considerations and planning opportunities.
Understanding the Intent of the S Corporation Distribution Rules
Before embarking on an in-depth discussion of the taxability of S corporation distributions, it is helpful to first understand precisely why distributions made by an S corporation are afforded different treatment than those made by C corporations.
The hallmark of subchapter C is the concept of “double taxation.” When a C corporation earns taxable income, the income is taxed at the corporate level. When the corporation subsequently distributes that income, the distribution is generally taxed to the shareholder as a dividend.4 Thus, the same dollars of income the corporation earned are taxed twice, once at the entity level and again at the shareholder level.
S corporations, however, are generally subject to a single level of taxation. When an S corporation generates income, that income is typically not taxed at the entity level;5 rather, the income is allocated among the shareholders, who report and pay tax on their share of the S corporation’s income on their individual income tax returns. When the S corporation subsequently distributes that income, under the single level of taxation specific to S corporations, the distribution is not taxed a second time.
The purpose of Sec. 1368 and the underlying regulations is to preserve this vital difference between C and S corporations: income—or more specifically, E&P—of a C corporation must be taxed a second time when distributed, while income of an S corporation should not be taxed a second time.
At first blush, the multiple attributes and distribution tiers that litter Sec. 1368 appear complicated and confusing; however, by focusing on the intent of the governing authority—to preserve the difference between distributions of C corporation income and S corporation income—the process of determining the taxation of S corporation distributions becomes much clearer.
Key Attributes
The interplay between two shareholder-level attributes—stock basis and previously taxed income (PTI)—and two corporate-level attributes—E&P and AAA—determines the taxability of an S corporation’s distributions. PTI has grown increasingly rare after being replaced by the AAA on Jan. 1, 1983, under the Subchapter S Revision Act of 1982.6 Discussion of PTI will be reserved for Part II of this article in the February issue.
Stock Basis
Under Sec. 1367, a shareholder in an S corporation is required to adjust his or her basis in the corporation’s stock annually to reflect the items of income, gain, loss, deduction, and distribution allocated to that shareholder. These annual adjustments are necessary to preserve the single level of taxation afforded to S corporations.
Example 1: A forms S Co., an S corporation, by contributing $500 to the corporation in exchange for 100% of S Co.’s stock. Under Sec. 358, A’s initial basis in his stock is $500. In year 1, S Co. generates $100 of taxable income, which is not taxed at the entity level, but is allocated to A, who reports the income on his individual income tax return.
Assume the $100 of taxable income increases the value of S Co. from $500 to $600. If A does not increase his stock basis to reflect the $100 of income recognized by S Co. and allocated to A, and A sells the S Co. stock for its current value of $600, A will recognize $100 of gain on the sale: $600 sales price less $500 stock basis. Thus, the $100 of income earned by S Co. will have been taxed twice: once when earned by S Co. and allocated to A, and a second time when A disposes of the stock. This is not the intent of subchapter S.
To prevent this result, under Sec. 1367(a)(1), A increases his basis in S Co. stock from $500 to $600 to reflect the $100 of S Co.’s taxable income allocated to A. As a result, when A subsequently disposes of the S Co. stock for its $600 value, he will not recognize any further gain or loss ($600 sales price less $600 stock basis). This preserves a single level of taxation on the $100 of S Co. income.
A shareholder must increase the basis of S corporation stock for the following items:7
- Capital contributions;
- Separately stated items of income (including tax-exempt income) and nonseparately computed income; and
- The excess of the deductions for depletion over the basis of the property subject to depletion.
A shareholder must decrease basis for the following items:8
- Distributions, other than those taxed as dividends under Sec. 1368;
- Separately stated items of loss and deduction and any nonseparately computed loss;
- Nondeductible expenses that are not properly chargeable to a capital account;
- The amount of the depletion deduction for any oil and gas property held by the S corporation to the extent the deduction does not exceed the shareholder’s share of the adjusted basis of the property.
Of utmost importance to determining the taxability of an S corporation’s distributions is the order in which these adjustments are required to be made because, while distributions reduce basis, in many cases, it is the shareholder’s stock basis that will, in turn, determine the taxability of a distribution.
The regulations mandate that stock basis first be adjusted for the required increases to basis.9 Next, stock basis is reduced by nondividend distributions before any reduction for losses or nondeductible expenses.10 Under the general rule, basis is next reduced for nondeductible expenses and the oil and gas depletion deduction described in Sec. 1367(a)(2)(E), before finally being reduced for any separately stated items of loss and deduction and nonseparately stated losses.11
Basis cannot be reduced below zero; to the extent losses exceed the remaining stock basis after reductions for distributions and nondeductible expenses, the excess losses can be applied to reduce any basis the shareholder has in the S corporation’s indebtedness to the shareholder.12 If the losses exceed the shareholder’s basis in both stock and debt, the losses are suspended and may be carried forward indefinitely.13
Example 2: A owns 100% of S Co., an S corporation. A begins 2013 with a basis of $5,000 in his S Co. stock. During 2013, S Co. generates $2,000 of ordinary income and $7,000 of long-term capital loss and makes a $5,000 distribution to A.
For 2013, A begins by increasing his beginning stock basis of $5,000 for the $2,000 of ordinary income. This $7,000 basis is then decreased by the $5,000 distribution, reducing A’s stock basis to $2,000. A then reduces stock basis to zero for $2,000 of the $7,000 long-term capital loss. Assuming A has no basis in S Co.’s indebtedness, the remaining $5,000 of long-term capital loss must be carried forward, where it will be treated as a newly incurred loss in 2014.
As discussed later, when an S corporation has no accumulated E&P at the time of a distribution, a shareholder’s stock basis will be the only attribute relevant in determining the distribution’s taxability.
Earnings and Profits
Because of the amendments to the S corporation rules made by the Subchapter S Revision Act of 1982, after Jan. 1, 1983, an S corporation no longer generates current E&P. An S corporation can possess accumulated E&P, however, in two scenarios:
- The corporation had accumulated E&P from prior C corporation years on the date of the S election; or
- The S corporation acquired substantially all of the assets of a C corporation in a transaction qualifying under Sec. 381, requiring the S corporation to succeed to the E&P of the target.14
When an S corporation makes a distribution in a year in which it has E&P, the process of determining the distribution’s taxability becomes more involved. This increased complexity is necessary to preserve the second level of taxation that must occur when C corporation “income” is distributed. Under Secs. 316 and 301, any distribution made from a C corporation is first treated as having come from current or accumulated E&P, and to the extent the distribution comes from current or accumulated E&P, it is taxed as a dividend to the recipient shareholder.15 Thus, it is a corporation’s E&P balance that caps the amount of the distribution that is subject to double taxation.
It is important to note, however, that E&P is not synonymous with either taxable income or retained earnings; rather, E&P is an independent measure of a corporation’s economic income for the purpose of differentiating between those distributions that are made from earnings and that must be taxed a second time as a dividend and those that represent a return of shareholder capital that should not be taxed a second time. Each year, a C corporation is required to compute its E&P by adjusting taxable income to reflect the economic effect of items of income, gain, loss, and deduction.
A corporation cannot evade the double-taxation regime of subchapter C merely by electing S status; rather, on the date the S election is effective, any E&P accumulated through the election date will survive and be taxed as a dividend when distributed, even though the entity has become an S corporation.16
Example 3: C Co., a C corporation, has $1 million of accumulated E&P on Dec. 31, 2012. C Co. wishes to distribute $1 million to its shareholders but wants to avoid making a taxable dividend. Hoping to avoid the consequences of distributing E&P, C Co. makes an S election effective Jan. 1, 2013. Unfortunately for C Co., its $1 million of accumulated E&P survives the S election. Should C Co. distribute its $1 million of E&P while an S corporation, it will be taxed to the recipient shareholders as a dividend.
Accumulated Adjustments Account
As evidenced by the previous example, any accumulated E&P at the time of an S election survives the election and will be taxed as a dividend to the recipient shareholders when distributed. The statute is structured, however, so as to permit an S corporation to distribute the S corporation’s income before being treated as having made a distribution from E&P, deferring the consequence of a taxable dividend. This reprieve is limited, however, to the positive balance of an S corporation’s AAA.
Effective Jan. 1, 1983, the AAA was created to track the cumulative taxable income earned by an S corporation but not yet distributed to its shareholders;17 thus, a newly electing S corporation will always start with a zero balance in its AAA,18 regardless of whether the corporation has E&P or retained earnings from prior C corporation years.
The maintenance of AAA is critical when an S corporation possesses accumulated E&P because it is the AAA balance that will serve as the line of demarcation between those distributions made from S corporation income, which should not be taxed a second time, from those made from C corporation E&P, which must be taxed as a dividend to the recipient shareholders. The larger the AAA balance, the more likely a distribution will not be taxed as a dividend.
Each year, an S corporation must adjust its AAA in a manner similar to a shareholder’s required adjustments to stock basis. Unlike stock basis, however, AAA is a corporate-level attribute and is generally unaffected by shareholder-level transactions such as sales or exchanges.
Specifically, an S corporation increases its AAA for the same items that increase basis, except AAA is not increased for capital contributions or tax-exempt income.19 Similarly, AAA is decreased for the same items that decrease basis, except for nondeductible expenses related to tax-exempt income and federal taxes attributable to any tax year in which the corporation was a C corporation.20
Unlike stock basis, AAA may be reduced below zero, but only by losses, not by a distribution.21
Similar to the required adjustments to stock basis, the most important element to maintaining AAA is the order in which the annual adjustments must be made. The regulations require a multistep process.
First, the S corporation must determine if it has a “net negative” adjustment for the tax year. A “net negative” adjustment is defined as the excess of reductions to the AAA balance—other than for distributions—over the increases for the year.22 While not denominated in the regulations as such, it is helpful to think of the opposite situation—when increases to AAA exceed reductions other than distributions—as a “net positive” adjustment.
If an S corporation has a net positive adjustment for the year, AAA is adjusted for the net positive adjustment before reducing AAA for any distributions made for the year.23 This is a shareholder-friendly rule, as it makes it more likely that a distribution will be treated as having been made from AAA, and not from dividend-producing E&P.
Conversely, if an S corporation has a net negative adjustment for the year, AAA is decreased by the distribution, but not below zero, before the reduction for the net negative adjustment.24 Again, this rule favors the shareholder as it ensures a higher AAA balance when the distribution is accounted for, making it less likely that the distribution will be a taxable dividend made from E&P.
A word of caution is necessary for AAA: When a corporation is wholly owned, AAA is not necessarily synonymous with the sole shareholder’s stock basis. While these amounts may be equal in certain circumstances, that is the exception rather than the rule, as there are several fundamental differences between the two attributes.
Because AAA is a corporate-level attribute, an S corporation’s beginning AAA on its election date will always be zero. A shareholder in a corporation converting from C to S status, however, will begin his or her first S corporation year with a basis in stock equal to his or her basis in the C corporation’s stock on the election date. In addition, if a shareholder acquires stock in an S corporation via purchase, he or she will take a cost basis in the acquired shares under Sec. 1012. Because AAA is a corporate-level attribute, however, the AAA balance will remain unchanged as a result of the purchase.
As previously indicated, AAA, unlike a shareholder’s basis in S corporation stock, is not increased for tax-exempt income, nor is it decreased for nondeductible expenses attributable to tax-exempt income. As will be discussed in Part II, in the February issue, this makes tax-exempt investments unattractive to many S corporations.
Lastly, while AAA can be driven negative by losses, a shareholder’s basis in the S corporation’s stock cannot be below zero.
Treating AAA and stock basis as one and the same can only add unnecessary complexity to the process of determining the taxability of an S corporation’s distributions, and in most cases, will lead to incorrect results.
General Rules for Taxation of S Corp. Distributions
The regulations differentiate between distributions made from an S corporation without accumulated E&P and those made from an S corporation with accumulated E&P. Thus, the first step in determining the taxability of an S corporation’s distributions is to identify whether the S corporation possesses accumulated E&P in the year of distribution.
As previously discussed, an S corporation can possess accumulated E&P only if it was previously a C corporation or it acquired the assets of a C corporation in a Sec. 381 transaction. So, an S corporation cannot possess E&P if it has never been a C corporation (i.e., it has been an S corporation since formation) and has never acquired the assets of a C corporation in a Sec. 381 transaction.
Determining whether the S corporation has accumulated E&P is critical. If an S corporation does not have accumulated E&P, determining a distribution’s taxability is a straightforward process. If an S corporation does have accumulated E&P at the time of a distribution, however, determining the taxability of that distribution becomes more complicated.
Taxability of Distributions From S Corps. With No Accumulated E&P
Regs. Sec. 1.1368-1(c) provides that a distribution by an S corporation that has no accumulated E&P is taxed under a two-tier approach:
- First, the distribution is a tax-free reduction of the shareholder’s basis in the corporation’s stock;25 then
- Any distribution in excess of the shareholder’s stock basis is treated as gain from the sale or exchange of the underlying stock.26
Noticeably absent from these rules is any reference to the S corporation’s AAA balance. This is because the AAA balance serves to provide a dividing line between those distributions made from previously earned but undistributed S corporation income, which should not be taxed a second time, and those made from prior C corporation E&P, which must be taxed as a dividend. If no accumulated E&P is present, this dividing line is unnecessary, as it is not possible for a distribution to be a taxable dividend made from E&P.
Thus, in determining the taxability of distributions from an S corporation with no accumulated E&P, the AAA balance is completely irrelevant; rather, the only attribute of consequence is the shareholder’s basis in the corporation’s stock. The AAA balance must continue to be maintained, however, because, as will be discussed in Part II, in the February issue, it will become relevant if the corporation terminates or revokes its S election.
Example 4: A owns 100% of the stock of S Co., an S corporation. On Jan. 1, 2013, A has a basis in his S Co. stock of $30,000, and S Co. has an AAA balance of $10,000. S Co. has been an S corporation since formation and has no accumulated E&P. During 2013, S Co. allocates to A $50,000 of ordinary income and $30,000 of long-term capital loss and distributes $40,000 to A.
Because S Co. does not have any accumulated E&P, its AAA balance of $10,000 is irrelevant in determining the taxability of the $40,000 distribution. Instead, the distribution is first treated as a tax-free reduction of A’s basis in his S Co. stock, with any excess distribution generating capital gain.
To determine the distribution’s taxability, A must adjust his stock basis. Under the regulations, A first increases his beginning basis of $30,000 for the $50,000 of income allocated to A during 2013. A’s adjusted basis of $80,000 is then reduced by the distribution of $40,000 before it is reduced for any losses or nondeductible expenses.
The $40,000 distribution reduces A’s basis in his S Co. stock from $80,000 to $40,000, and the entire distribution is tax free under Sec. 1368(b).
Lastly, A reduces his remaining stock basis of $40,000 by the $30,000 of long-term capital losses allocated to him during 2013, leaving A an ending stock basis of $10,000.
If the distribution exceeds the shareholder’s basis in the corporation’s stock, the excess generally generates capital gain.
Example 5: Assume the same facts in Example 4, except S Co. generates only $20,000 of income, and the distribution is increased to $60,000. A determines the taxability of the $60,000 distribution as shown in Exhibit 1.
Because the $60,000 distribution to A exceeds A’s predistribution basis in his S corporation stock of $50,000, only $50,000 of the distribution is a tax-free return of basis. The $10,000 distributed in excess of A’s basis in the S Co. stock is treated as amounts realized on the sale of the stock, resulting in capital gain. Because A has no remaining stock basis, A may not use any of the $30,000 long-term capital loss allocated to him unless he has basis in indebtedness of S Co.27
Because the ordering rules require basis to be reduced for distributions before losses, an S corporation will always be permitted to distribute the income allocated to a shareholder in year 1 during year 2, regardless of whether the S corporation has a loss in year 2. This rule allows an S corporation to distribute the cash necessary for shareholders to pay their tax liability arising from the prior year’s income without fear that an operating loss in the year the cash is distributed will render the distributions taxable.
Example 6: A owns 100% of S Co., which has no accumulated E&P. In 2012, S Co. generates $20,000 of income, increasing A’s basis in the S Co. stock from $0 to $20,000. In March 2013, S Co. distributes the $20,000 of 2012 earnings to A. In 2013, S Co. allocates to A $40,000 of ordinary loss. To determine the taxability of the $20,000 distribution, A must adjust his basis in S Co.’s stock as shown in Exhibit 2.
The entire $20,000 distribution represents a tax-free reduction of A’s basis in S Co. stock. Because the distribution reduces A’s basis in the S Co. stock to zero, A may not use the $40,000 ordinary loss allocated to him in 2013.28 A must carry forward the loss to 2014, when it will be treated as a newly incurred loss of the same character.
Part II of this article, in the February issue, will cover the taxability of distributions made from an S corporation with accumulated E&P, while also addressing ancillary considerations and planning opportunities.
Footnotes
1 Sec. 1368(b)(1).
2 Sec. 1368(c)(2).
3 Sec. 1368(b)(2).
4 Sec. 301(c)(1).
5 Note, however, that an S corporation may pay corporate-level tax on its “built-in gains” under Sec. 1374 or its “excess net passive income” under Sec. 1375.
6 Subchapter S Revision Act of 1982, P.L. 97-354.
7 Sec. 1367(a)(1).
8 Sec. 1367(a)(2).
9 Regs. Sec. 1.1367-1(f).
10 Id.
11 Regs. Sec. 1.1367-1(g) provides that a shareholder may elect to reduce basis by losses prior to reduction for nondeductible expenses. This election is generally irrevocable, and any nondeductible expenses or oil and gas depletion deductions limited by basis are carried forward to reduce basis in later years (under the default ordering rule, any nondeductible expenses or oil and gas depletion deductions limited by basis are not carried forward but, rather, disappear).
12 Sec. 1366(d)(1).
13 Sec. 1366(d)(2).
14 Sec. 381(c)(2). See also S. Rep’t No. 97-640, 97th Cong., 2d Sess. (1982).
15 Note, however, that a corporate shareholder may be permitted to reduce the dividend income by the dividends-received deduction of Sec. 243.
16 The accumulated E&P at the close of the S corporation’s tax year should be reported on Form 1120S, Schedule B, Line 9. If the corporation had a negative E&P balance when the S election was made, the corporation has no accumulated E&P, and no balance should be reported on Schedule B. Accumulated E&P at the time of an S election is generally not increased or decreased for any items of S corporation income, gain, loss, or deduction. Under Sec. 1371, E&P may be adjusted during S corporation years only for distributions of E&P, payment of corporate-level tax due to investment credit recapture, and certain redemptions, reorganizations, liquidations, and corporate divisions. In addition, Sec. 1363(d)(5) provides that E&P is reduced for the S corporation’s payment of tax for LIFO recapture.
17 Regs. Sec. 1.1368-2(a)(1).
18 Id.
19 Regs. Sec. 1.1368-2(a)(2).
20 Regs. Sec. 1.1368-2(a)(3)(i).
21 Regs. Sec. 1.1368-2(a)(3)(ii). Note, AAA is reduced by the full amount of losses or deductions the S corporation incurred during the year, even if the losses or deductions are limited at the shareholder level because of the lack of basis under Sec. 1366, passive activity limitations under Sec. 469, or at-risk limitations under Sec. 465.
22 Sec. 1368(e)(1)(C).
23 Regs. Sec. 1.1368-2(a)(5).
24 Id.
25 A shareholder may not apply a distribution against any basis in debt the S corporation owes the shareholder. Basis in debt is reduced only by losses, not by distributions.
26 Sec. 1368(b). If the S corporation stock is held as a capital asset, the resulting income is long-term or short-term capital gain depending on the shareholder’s holding period. If the shareholder holds the stock as a dealer, the distribution in excess of basis will result in ordinary income. Note, further, that if the S corporation uses a fiscal year and the shareholders use a calendar year, the shareholders may not be certain of the tax status of a particular distribution until after the close of the corporation’s tax year, which may be after the due date of the shareholders’ tax returns. For example, if an S corporation with a Sept. 30 year end makes a distribution to its sole shareholder on Dec. 31, 2012, the shareholder will be unable to determine if the distribution exceeds basis until the corporation’s tax year is complete on Sept. 30, 2013, and basis can be adjusted. However, any gain recognized for a distribution in excess of basis would be required to be recognized by the shareholder on his or her 2012 tax return. This problem can typically be solved by extending the shareholder’s tax return or filing an amended return once basis can be computed.
27 Note, however, that even if A has basis in S Co.’s indebtedness, $10,000 of the $60,000 distribution to A will continue to generate capital gain, because the taxability of a distribution is determined only by reference to a shareholder’s basis in the corporation’s stock.
28 A may use the $40,000 loss to the extent A has basis in S Co.’s indebtedness.
| EditorNotes | |
| Tony Nitti is a partner with WithumSmith+Brown, PC, in Aspen, Colo. For more information about this article, contact Mr. Nitti at anitti@withum.com. |
