Tax professionals working in the S corporation environment regularly track earnings and profits (E&P) and the accumulated adjustments account (AAA) for their clients. Most of the time, these accounts are tracked to determine the tax effect of distributions made by an S corporation that was formerly a C corporation. However, tracking these accounts can be equally important if an S corporation, regardless of whether it was formerly a C corporation, enters into certain types of transactions such as redemptions, liquidations, reorganizations, or corporate separations.
AAA is a unique S corporation concept that "is an account of the S corporation and is not apportioned among shareholders" (Regs. Sec. 1.1368-2(a)(1)). AAA begins at zero on the first day the corporation elects to be taxed as an S corporation (id.). The items that increase and decrease AAA are provided in Regs. Secs. 1.1368-2(a)(2) and (a)(3). The account is increased by the sum of items described in Regs. Sec. 1.1368-2(a)(2), which are (1) the items of income described in Sec. 1366(a)(1)(A) other than income that is exempt from tax; (2) any nonseparately computed income determined under Sec. 1366(a)(1)(B); and (3) the excess of the deductions for depletion over the basis of property subject to depletion. AAA is decreased under Regs. Sec. 1.1368-2(a)(3)(i) by:
- The items of loss or deduction described in [Sec.] 1366(a)(1)(A);
- Any nonseparately computed loss determined under [Sec.] 1366(a)(1)(B);
- Any expense of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account, other than—
(1) Federal taxes attributable to any taxable year in which the corporation was a C corporation; and
(2) Expenses related to income that is exempt from tax; and
- The sum of the shareholders' deductions for depletion for any oil or gas property held by the corporation described in [Sec.] 1367(a)(2)(E).
Regs. Sec. 1.1368-2(a)(3)(iii) also provides that AAA is decreased by distributions. However, unlike the decreases provided for in Regs. Sec. 1.1368-2(a)(3)(i), distributions cannot reduce AAA below zero.
When adjusting AAA, taxpayers make the increases and decreases in the following order, which is provided in Regs. Sec. 1.1368-2(a)(5): (1) increased under Regs. Sec. 1.1368-2(a)(2); (2) decreased under Regs. Sec. 1.1368-2(a)(3)(i) without taking into account any net negative adjustment; (3) decreased by any portion of an ordinary distribution to which Sec. 1368(b) or (c)(1) applies; (4) decreased by any net negative adjustment; and (5) adjusted for redemption distributions.
While AAA is an S corporation concept, E&P is a C corporation concept that in its most fundamental application applies to an S corporation that was formerly a C corporation, in determining the taxability of distributions made by the S corporation. The calculation of E&P is found in Sec. 312 and the regulations thereunder, which falls within Subchapter C of Chapter 1 of the Code. In the C corporation context, E&P is used to determine the amount of a distribution taxable as a dividend. Sec. 301 covers the treatment of distributions of property by a C corporation. The "portion of the distribution which is a dividend (as defined in [Sec.] 316) shall be included in gross income" (Sec. 301(c)(1)). Sec. 316(a) provides that "the term 'dividend' means any distribution of property made by a corporation to its shareholders (1) out of its earnings and profits accumulated after February 28, 1913, or (2) out of its earnings and profits of the taxable year."
Therefore, to the extent a C corporation has either accumulated or current E&P, any distribution of property will be taxed as a dividend to its shareholders. "Among the items entering into the computation of corporate earnings and profits for a particular period are all income exempted by statute, income not taxable by the Federal Government under the Constitution, as well as all items includible in gross income under [Sec.] 61 or corresponding provisions of prior revenue acts" (Regs. Sec. 1.312-6(b)).
In general, the C corporation rules apply to S corporations unless otherwise provided or to the extent that the C corporation rules are inconsistent with the S corporation rules (Sec. 1371(a)). S corporations only make adjustments to E&P for transactions involving the application of Subchapter C (such as redemptions, liquidations, reorganizations, divisive reorganizations, etc.), distributions treated as a dividend under Sec. 1368(c)(2), and increases in tax under Sec. 49(b) or 50(a) for which the S corporation is liable (Secs. 1371(c) and (d)).
Transactions affecting AAA and E&P
Besides the adjustments to AAA and E&P resulting from the normal operations and distributions of an S corporation, certain transactions also result in adjustments to these accounts. Some of the transactions that affect AAA will also cause an adjustment to the S corporation's E&P. This discussion looks at transactions as well as some examples that will cause an adjustment to one or both of these accounts.
Regs. Sec. 1.1368-2(d)(1)(i) provides:
In the case of a redemption distribution by an S corporation that is treated as an exchange under [Sec.] 302(a) or [Sec.] 303(a) (a redemption distribution), the AAA of the corporation is adjusted in an amount equal to the ratable share of the corporation's AAA (whether negative or positive) attributable to the redeemed stock as of the date of the redemption. [emphasis in original]
Regs. Sec. 1.1368-2(d)(1)(iii) goes on to add that the accumulated E&P is adjusted under Sec. 312 independently of the adjustment made to AAA. A distribution under Sec. 302(a) is treated as an exchange if one of the requirements under Sec. 302(b) is satisfied. Sec. 303(a) covers distributions in redemptions of stock to pay death taxes. If the requirements of Sec. 303(a) are met, the distribution will be treated as an exchange for the stock redeemed.
Example 1: S is an S corporation with two shareholders, G and H, each owning 50 shares of S's stock. On Dec. 31, 2016, S redeems for $13 all of shareholder G's stock in a redemption that is treated as a sale or exchange under Sec. 302(a). Further assume that on Dec. 31, S had AAA of $6 and E&P of $20. The result of the redemption is that S will adjust AAA by the ratable share of AAA attributable to the redeemed shares, or $3 (50% × $6). Likewise, E&P is adjusted by the ratable share of E&P attributable to the redeemed shares, or $10 (50% × $20) (see Regs. Sec. 1.1368-3, Example (9)).
Regs. Sec. 1.1368-2(d)(2) provides:
An S corporation acquiring the assets of another S corporation in a transaction to which [Sec.] 381(a) applies will succeed to and merge its AAA (whether positive or negative) with the AAA (whether positive or negative) of the distributor or transferor S corporation as of the close of the date of distribution or transfer. Thus, the AAA of the acquiring corporation after the transaction is the sum of the AAAs of the corporations prior to the transaction.
The E&P of a corporation is also adjusted for transfers described in Sec. 381(a). Regs. Sec. 1.312-11(a) provides:
In a transfer described in [Sec.] 381(a), the acquiring corporation, as defined in [Regs. Sec.] 1.381(a)-1(b)(2), and only that corporation, succeeds to the earnings and profits of the distributor or transferor corporation (within the meaning of [Regs. Sec.] 1.381(a)-1(a)). Except as provided in [Regs. Sec.] 1.312-10, in all other cases in which property is transferred from one corporation to another, no allocation of the earnings and profits of the transferor is made to the transferee.
Regs. Sec. 1.381(a)-1(a) provides:
[Sec.] 381 provides that a corporation which acquires the assets of another corporation in certain liquidations and reorganizations shall succeed to, and take into account, as of the close of the date of distribution or transfer, the items described in [Sec.] 381(c) of the distributor or transferor corporation.
One of the attributes included in Sec. 381(c) is E&P (see Sec. 381(c)(2)). Sec. 381(a) applies to the acquisition of assets by one corporation of another corporation in a distribution to which Sec. 332 (relating to liquidations of subsidiaries) applies or in a transfer to which Sec. 361 (relating to nonrecognition of gain or loss to corporations) applies, but only if the transfer is in connection with a reorganization described in Sec. 368(a)(1)(A), (C), (D), (F), or (G).
The regulations are clear that the AAA of the acquiring corporation following a transaction that qualifies under Sec. 381(a) is the sum of the AAAs of both corporations prior to the transaction. The rules for combining E&P under Sec. 381(c)(2) are more complex in the C corporation context. However, with transactions involving S corporations, the complexities should not come into play since the S corporations would not have E&P deficits to deal with.
Example 2: Shareholders of T1 and T2 will incorporate Newco. Newco will elect S corporation status. Immediately after the incorporation of Newco, the shareholders of T1 and T2 will contribute their stock in T1 and T2 to Newco in exchange for stock of Newco. Newco will elect to treat T1 and T2 as qualified Subchapter S subsidiaries (QSubs). The taxpayer represented that the transfer to Newco by T1 and T2 shareholders qualifies under Sec. 351. Under these facts, it was determined that Newco will succeed to the E&P and AAA of T1 and T2. It was held that Newco acquired the assets of T1 and T2 in a transaction to which Sec. 381(a) applied, since the QSub elections were treated as a Sec. 332 liquidation of a subsidiary (Letter Ruling 200105034).
In the case of corporation separations, Regs. Sec. 1.1368-2(d)(3) provides:
If an S corporation with accumulated earnings and profits transfers a part of its assets constituting an active trade or business to another corporation in a transaction to which [Sec.] 368(a)(1)(D) applies, and immediately thereafter the stock and securities of the controlled corporation are distributed in a distribution or exchange to which [Sec.] 355 (or so much of [Sec]. 356 as relates to [Sec.] 355) applies, the AAA of the distributing corporation immediately before the transaction is allocated between the distributing corporation and the controlled corporation in a manner similar to the manner in which the earnings and profits of the distributing corporation are allocated under [Sec.] 312(h).
As indicated in Regs. Sec. 1.1368-2(d)(3), there is also an adjustment under Sec. 312 to E&P for a transaction that meets the requirements of that subsection of the regulations (see Regs. Sec. 1.312-10(a)). In the case of a transaction that meets the requirements of these sections, AAA and E&P are allocated between the distributing and controlled corporation under Regs. Sec. 1.312-10(a) as follows:
In the case of a newly created controlled corporation, such allocation generally shall be made in proportion to the fair market value of the business or businesses (and interests in any other properties) retained by the distributing corporation and the business or businesses (and interests in any other properties) of the controlled corporation immediately after the transaction. In a proper case, allocation shall be made between the distributing corporation and the controlled corporation in proportion to the net basis of the assets transferred and of the assets retained or by such other method as may be appropriate under the facts and circumstances of the case. The term "net basis" means the basis of the assets less liabilities assumed or liabilities to which such assets are subject.
In addition, E&P of a corporation is adjusted for distributions or exchanges to which Sec. 355 applies, even if the requirements of Sec. 368(a)(1)(D) are not met. The E&P of the distributing corporation is decreased by the lesser of (1) the amount by which the distributing corporation's E&P would have decreased if Sec. 368(a)(1)(D) had applied; or (2) the net worth of the controlled corporation. The effect on the controlled corporation's E&P depends on whether immediately before the transaction its E&P was greater or less than the decrease in the distributing corporation's E&P. If the decrease to the distributing corporation is more than the E&P of the controlled corporation immediately before the transaction, then the controlled corporation's E&P will equal the decrease on the distributing corporation (Regs. Sec. 1.312-10(b)). However, if the decrease is less than the controlled corporation's E&P immediately before the transaction, the E&P of the controlled corporation will be unchanged (id.).
Example 3: Distributing will transfer Old Business assets to Controlled in exchange for all the stock in Controlled. Distributing will distribute all the Controlled stock to the Distributing shareholders, constituting a reorganization within the meaning of Secs. 368(a)(1)(D) and 355. It was held that under Sec. 312(h), proper allocation of E&P between Distributing and Controlled will be made under Regs. Sec. 1.312-10(a) and that AAA of Distributing immediately prior to the spinoff will be allocated between Distributing and Controlled in a manner similar to the manner in which the E&P of Distributing is allocated (Letter Ruling 199923011).
Accurate tracking is key
Taxpayers and their advisers should be aware of situations that cause a transfer or adjustment to AAA and E&P. The proper tax treatment of distributions by an S corporation could change significantly if these accounts are not tracked and accounted for properly following a transaction. The preamble of T.D. 8508 may provide the most accurate summary of the importance of tracking AAA and E&P, when applicable, regardless of whether the S corporation has E&P:
Under the final regulations, only S corporations with earnings and profits must maintain an accumulated adjustments account (AAA) to determine the tax effect of distributions during S years and the post-termination transition period as defined in [Sec.] 1377(b)(1). An S corporation without earnings and profits does not need to maintain the AAA in order to determine the tax effect of distributions. Nevertheless, if an S corporation without earnings and profits engages in certain transactions to which [Sec.] 381(a) applies, such as a merger into an S corporation with C corporation earnings and profits, the S corporation must be able to calculate its AAA at the time of the merger for purposes of determining the tax effect of post-merger distributions.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.