If a Subchapter S corporation has no earnings and profits (E&P) from when it was a C corporation, all distributions are considered to be return of basis in the shareholder’s stock. Distributions up to the amount of basis are nontaxable. Distributions in excess of basis are capital gain.
Subchapter S corporations With Earnings And Profits (E&P)
A Subchapter S corporation can have E&P from one of the following sources:
• Liquidations, redemptions, and reorganizations governed by the rules of Subchapter C of the Internal Revenue Code.
• Tax years in which the subchapter S corporation was a C corporation.
• Corporate acquisition that results in carryover of E&P under IRC §381.
If a subchapter S corporation has E&P, it must maintain a retained earnings account consisting of three subsidiary accounts: (1) Accumulated Adjustments Account (AAA), (2) Earnings and Profits Account (E&P), and (3) Other Adjustments Account (OAA).
Ordering rules determine the taxation of distributions made by a Subchapter S corporation with E&P.
Accumulated Adjustments Account (AAA) ....... Not Taxable
Earnings and Profits (E&P) ............................. Taxable Dividend
Other Adjustments Account (OAA) .................. Not Taxable
Stock Basis/Return of Capital .......................... Not Taxable
In Excess of Stock Basis ................................ Capital Gain
Note: Some Subchapter S corporations have a retained earnings account called Previously Taxed Income (PTI). The PTI account represents undistributed earnings from pre-1983 Subchapter S corporation years. See the instructions for Schedule M-2, Form 1120S for information about treatment of PTI.
Election to Take E&P First: An election is available to take distributions first from E&P [IRC §1368(e)(3)]. The election is made on a year-by-year basis. See Regulation §1.1368-1(f) for information about how to make the election.
Accumulated Adjustments Account (AAA)
Distributions to shareholders from the AAA are not taxable. The AAA is a cumulative total of undistributed net income items generated by the Subchapter S corporation. This account is adjusted in the same fashion as a shareholder’s basis. However, unlike stock basis, the AAA can have a negative balance resulting from Subchapter S corporation losses (but not from distributions to shareholders). Income in a later year can make the account positive only after the negative balance has been restored. Any
decrease in stock basis has no impact on AAA when the AAA balance is negative.
Note: Tax exempt income, related expenses, and federal taxes attributable to a C corporation tax year are maintained in the Other Adjustments Account (OAA). See "Other Adjustments Account (OAA)" below. The AAA is a corporate account and does not belong to any particular shareholder. Therefore, a new shareholder that acquires stock from the Subchapter S corporation also acquires a share of AAA and can receive tax-free distributions from it.
Other Adjustments Account (OAA)
The OAA is used only by a Subchapter S corporation that has accumulated E&P. The OAA is increased by tax-exempt income and decreased by related expenses and distributions to shareholders from the account. The account is also
decreased by federal tax paid which is attributable to a C corporation tax year. The OAA can have a negative balance resulting from pass-through items, but a negative balance may not result from distributions to shareholders. Distributions from the OAA are not taxable to
Application Of Ordering Rules Distributions by a Subchapter S corporation with earnings and profits have the following effects on the shareholders:
1) Distributions come first from the AAA, and are tax free to shareholders. Distributions from the AAA reduce a Subchapter S corporation shareholder’s adjusted basis.
2) Distributions come second from the E&P account. Distributions from E&P are taxable to shareholders as dividends. Distributions from E&P do not reduce the Subchapter S corporation shareholder’s basis in stock. An election is available to take distributions first from E&P before AAA.
3) Distributions come third from the OAA, and are tax free to shareholders. Distributions from OAA reduce the Subchapter S corporation shareholder’s basis in stock.
4) Distributions in excess of the combined amounts in the AAA, E&P and OAA accounts are considered a return of capital, up to the Subchapter S corporation shareholder’s basis in the stock.
5) Distributions in excess of the Subchapter S corporation shareholder’s basis in stock are treated as capital gains from the sale of property.
Subchapter S corporation Post Termination Transition Period
When a Subchapter S corporation’s ‘S’ status terminates, a "Post Termination Transition Period (PTTP)" begins. During the PTTP, distributions from the AAA and OAA accounts retain their character as nontaxable distributions. The distributions reduce the Subchapter S corporation shareholder’s basis [IRC §1371(e)(1)]. If the Subchapter S corporation fails to distribute all of the AAA and OAA by the end of the PTTP, then any remaining AAA and OAA turns into E&P.
Election: With the consent of all Subchapter S corporation shareholders to whom distributions are made during the PTTP, the Subchapter S corporation can elect to treat distributions as dividends up to the E&P of the Subchapter S corporation. The election is made by attaching a statement to Form 1120 for the year the PTTP ends. The statement should contain a declaration that the Subchapter S corporation elects to have Section 1371(e)(1) not apply to any distribution during
the period, and should be signed by all Subchapter S corporation shareholders required to make the election.
The PTTP ends the later of:
1) One year after the PTTP begins, or
2) Due date for the last Subchapter S corporation return (including extensions), or
3) 120 days after a court decision, agreement with the IRS, or audit determination stating that the corporation did not qualify as a Subchapter S corporation.
If a Subchapter S corporation wants to make dividend distributions, but lacks sufficient capital, Reg. §1.1368-1(f)(3) allows the Subchapter S corporation to make a "deemed dividend." The dividend is considered to have been made, even though no money is distributed. The amount of the deemed dividend is treated as a capital contribution, and increases the basis of the Subchapter S corporation shareholder’s stock.
When property is distributed, the Subchapter S corporation shareholder uses the fair market value of the property to figure the tax effect and the adjustment to basis of his/her stock. If the property is appreciated property, the Subchapter S corporation is considered to have sold the property to the shareholder at FMV.