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Feb 1990

S corporation undistributed profits. (Federal Taxation)

by Stocker, William, III

    Abstract- The source of undistributed profits (UP), the equivalent of retained earnings, determines the tax treatment of distributions to an S corporation (S corp). The S corp must account for the separate components of UP and segregate them to a limited extent on the income tax return balance sheet. Classes of UP delineated by the Internal Revenue Code (IRC) include: accumulated adjustments account (AAA), previously taxed income (PTI), accumulated S corp earnings and profits (E&P), and the other adjustment account (OAA). Under the tax treatment of distributions, distributions are determined to be made from PTI, the positive balance of AAA, E & P, and the OAA. Under the IRC, an S corp without E&P does not need to classify its UP. Furthermore, its distributions would not be considered taxable shareholders' dividends and the components of UP would be considered reductions of the shareholders' basis.

The classes of UP are set forth by IRC Secs. 1368 and 1379. They include:

* Accumulated Adjustments Account (AAA). This generally consists of all income and loss items if the corporation for all years beginning after 1982 in which it was an S Corp., less distributions which were deemed to come from this account. Nontaxable income and related expenses are generally not included. Also not included are the recapture of investment tax credits originating in years in which the corporation was a C Corporation (C Corp.) and RARs and other tax adjustments relating to C Corp. years.

* Previously Taxed Income (PTI). This account, officially called "shareholders' undistributed taxable income previously taxed," consists of items of income and loss for all S Corp. years beginning in 1982 or earlier, less distributions deemed to have been made from this account. No amounts are included, however, from S Corp. years prior to any years in which the corporation was a C Corp. Any such amounts would he treated the same as C Corp. amounts. PTI is considered to belong to the individual shareholders. When a shareholder sells or otherwise disposes of his shares the applicable portion of PTI is transferred to paid-in capital for tax accounting purposes. Unless the corporation maintains its books solely on the income tax method, the books would, however, still reflect the amount in retained earnings. This would give rise to a reconciling item as discussed below.

* Accumulated C Corp. Earnings and Profits (C Corp. E & P). This account is generally the retained earnings (RE) of the corporation at the end of its last C Corp. tax year. There are, however, two important differences between RE and C Corp. E & P. First, C Corp. E & P starts with RE calculated according to the corporation's tax accounting methods. Thus, any tax versus book timing differences constitute a reconciling item between RE and C Corp. E & P. Second, C Corp. E & P differs from tax basis RE by the cumulative differences between accelerated and straight-line depreciation, income deferred under the installment method and certain LIFO inventory adjustments. Any investment tax credits obtained in a C Corp. which are recaptured during an S Corp. year, along with RARs relating to C Corp. years, are charged to C Corp. E & P.

* Accumulated S Corp. Earnings & Profits (S Corp. E & P). Any differences between taxable income and E & P for S Corp. years beginning prior to 1983 create S Corp E & P. Much of this will result from the reversal of Accumulated C Corp. E & P. For S Corp. tax years beginning after 1983 E & P does not change, except by distribution (or prior year tax adjustments as described above). E & P is in effect "frozen" at the end of the last C Corp. year or at the end of the tax year beginning in 1982, whichever is later.

* Other Adjustment Account. This is made up for all nontaxable income, less related expenses for all S Corp. years beginning after 1982, less distributions from this account. This account would not be used by a corporation that has always been an S Corp. and all of these items would be included in the AAA.

* Differences Between C Corp. Tax Basis RE and E & P. As discussed above, even if book versus tax timing differences are ignored, there may still be a difference between RE and E & P at the end of the last C Corp. year. This difference may start to reverse or become larger if the accumulated S Corp. E & P (less than, or in excess of, S Corp. taxable income ) is accumulated in years beginning prior to 1983.

Treatment of Distributions

Distributions during the year are deemed to be made from: 1) AAA to the extent it is positive; 2) PTI; 3) E & P; and 4) the other adjustments account. Distributions from E & P are considered to be dividends taxable to the shareholders. Additional distributions are deemed to be returns of capital for tax purposes even though tax and E & P timing differences may provide adequate book RE. The determination of the source of distributions is made at the end of the year. The various RE accounts are calculated as if no distributions were made. The distributions are then allocated according to these rules.

It is not clear how distributions of E & P are to be allocated between C Corp. E & P and S Corp. E & P. This can be important in that an S Corp. with C Corp. E & P is subject to a tax on excessive passive income and could have its S Corp. election terminated if passive income exceeds 25% of gross receipts for three consecutive years. A corporation can elect to distribute accumulated E & P before AAA. This should especially be considered when eliminated E & P could avoid the tax on passive income.

The tax return for an S Corp. (Form 1120S) includes a balance sheet (Schedule L) which requires the presentation of the beginning and ending balances of AAA, PTI and Other Adjustments Account. Also to he shown is "Other Retained Earnings" which would include E & P as well as the difference between that amount and C Corp. tax basis RE. There is also a box to be checked if there are any C Corp. E & P included in other RE. Schedule M of Form 1120S is an analysis of the changes in AAA, PTI and other adjustments account for the year. The instructions for Form 1120S require that Schedule M show the actual tax basis amounts, while Schedule L is to agree with the corporations' books. Any book to tax timing differences will cause the Schedule L book amounts to differ from the Schedule M tax basis amounts. A schedule reconciling these differences should be attached to the return. it should be noted that, unlike the Schedule M-1 reconciliation on a C Corp. return, the reconciliation between Schedules L and M of the S Corp. return is a reconciliation of balance sheet amounts, not a reconciliation of income or loss.

Under the IRC, an S Corp. that has no E & P is not subject to the need for classification of its UP. No distributions would be considered dividends taxable to the shareholders, and all would be considered reductions of the shareholders' basis (or capital gains to the extent they exceeded basis). included in this category would be all Corps. incorporated after December 31, 1982, which never had any C Corp. activity. Corporations in this situation are required by the Form 1120S to report their RE on Schedules L and M as though it was all AAA. Included in this requirement is the reconciliation between the Schedule L book amount and Schedule M tax basis amount.

For simplicity this article has avoided any discussion of acquisitions, liquidations, redemptions or reorganizations, all of which can have a significant effect on an S Corp. retained earnings account. For financial reporting purposes, the composition of S Corp. RE is not a required disclosure, however, it is often useful to financial statement users to provide a schedule showing the various accounts. This is particularly true when the statements are to be used by stockholders who may want to know how much is distributable and what the tax effect would be. if a schedule is presented in the financial statements it would probably be more helpful to show the tax basis amounts, rather than hook amounts, along with the differences shown in a separate category with a descriptive title such as "Tax Timing Differences." If the portion of such differences relating to PTI or Other Adjustments Account (e.g., accrued municipal bond interest income on a cash basis taxpayer) is material, these should be disclosed separately from timing differences related to AAA.

William Stocker, III

Business Master File Offsets

All tax practitioners should be well aware that the IRS has recently re-instated the previously suspended Business Master File (BMF) Offset Program. This program, which will take taxpayer overpayments and offset these against deficiencies arising from other periods or types of taxes, was originally suspended in 1985 after many taxpayers faced enormous headaches. The IFS believes that various improvements in procedures and computer programs will now make the program workable.

When a deficiency is the result of a discrepancy between federal tax deposits claimed and the amount shown on the IRS master file, a 10-week freeze will go into effect. During that time the taxpayer must respond with proof of payment, using a special IRS supplied bar coded" envelope.

When IRS records show an unexplained overpayment, a notice will be generated together with a similar "bar coded" envelope. The taxpayer will then have 15 weeks within which to respond before the IRS either offsets the overpayment against any open balance due account or refunds the overpayment.

All practitioners must take note that if IRS records show a balance due to the IRS as a result of a penalty or interest, there exists no time lag in the program before offset. Due to the frequency of IRS tax deposit penalties, it appears quite possible that numerous offsets will occur where erroneous payroll tax deposit penalties have been assessed, but the response to the IRS has not vet been processed. As a result of this program, the tax practitioner must now put greater emphasis on his clients' immediate response to all IRS correspondence, utilizing the bar coded" envelope supplied by the IRS.

John P. Orr, Jr.

Form 720 and Required Payments

Partnerships and S Corporations electing fiscal tax years under IRC Sec. 444 must use federal Form 720 to report IRC Sec. 7519 required payments. There has been considerable misunderstanding among practitioners surrounding the proper use of Form 720. To complicate matters, the IRS has been slow in reacting to the increased volume of Form 720 filings.

In May, 1988, the IRS published temporary regulations advising partnerships and S Corporations subject to Sec. 75 9 t file Form 720 for the second quarter of 1988. Many taxpayers who followed the regulations were soon besieged by IRS requests for subsequent quarterly Forms 720 and, in some instances, assessments for failure to file. Fortunately, the IRS realized their error quickly and corrected it.

The next problem arose when the second annual Form 720 was scheduled to be filed by May 15, 1989, Many taxpayers were unsure as to which quarterly 1989 Form 720 to file. The IRS, in Notice 89-41, issued in March 1989, had stated that a first quarter 1989 Form 720 should be filed if requesting a refund of a prior year required payment. Furthermore, since first quarter Forms 720 were due April 30 or May 30, many taxpayers used first quarter Form 720 for MaN, 15 required payments.

Taxpayers who filed first quarter forms using sound judgment in the absence of definite guidance were rewarded with IRS notices for late filing penalties. Apparently IRS had not programmed their computers to process a first quarter 720 filed on May 15, 1989. Fortunately, once again the IRS moved quickly to correct their error.

The IRS has been taking measures to prevent future problems relating to Form 720 processing. it is imperative that practitioners and taxpayers follow the Form 720 instructions and complete the proper lines on the form. IRS representatives have given unofficial advice that a first quarter Form 720 should be filed for the required payment reporting due May 15, 1990. Official IRS notification should follow in early 1990.

Michael Alderman

Eugene Winston

Update on the Alternative Minimum Tax Credit

One of the new concepts introduced by TRA 86 is the Alternative Minimum Tax Credit (AMTC). The need for the credit resulted from Congress' intention to revise the minimum tax calculation to more closely measure economic income. To do this, Congress instituted a new corporate tax and revised the individual Alternative Minimum Tax (AMT) systems that were meant to be completely separate from the regular tax methods. The AMT has its own distinct rules that not only create income items, but also establish different bases for assets and different carryforwards for NOLs, passive losses, investment interest expense, etc. This attempt to measure income under a totally different set of rules can result in double inclusion or deduction of certain items when taxpayers switch from the AMT system to the regular tax system. To provide relief from this potential adverse result, Congress provided the AMTC.

The theory behind the AMTC is to allow taxpayers to offset their regular tax by the AMT paid in prior years (but not below the AMT in the current year). However, only the amount of prior year Alternative Minimum Tax attributable to deferral adjustments is available for the credit. Deferral adjustments are those items which are theoretically taxed under the AMT in one year and the regular tax in another. A prime example of this type of adjustment is depreciation on post 1986 assets.

An adjustment that is not a deferral item must be an exclusion item. An exclusion item is one which is only taxed under one method. A credit is not allowed for these items because a double inclusion is theoretically not possible.

The statute does not provide a definition of deferral items but does use the term exclusion items. Sec. 53(d)(1)(B) provides that the credit equals the excess of the AMT for any year over the AMT that would have been imposed if only the exclusion adjustments such as the following were taken into account:

For Individuals Only

1. Taxes;

2. Personal interest;

3. Medical expenses;

4. Miscellaneous itemized deductions; and

5. Personal exemptions. For Corporations and Individuals

1. Excess depletion;

2. Interest income on private activity bonds; and

3. Appreciation on capital gain property gifted to charity. After taking the AMT attributable to the above items into account, the remaining AMT represents the amount attributable to deferral items and, thus, is the amount available for credit in subsequent years. This credit may be carried forward indefinitely.

Note that under current law, the credit is determined by a residual method. Taxpayers are required to compute their AMT on only exclusion items, and the residual of the AMT paid over this amount is the amount attributable to deferral items. A drastically different answer could result if a one step calculation was imposed; that is, if the credit just equaled the AMT calculated with only deferral items.

For example, assume an individual has taxable income of $1,000,000 with exclusion items of $350,000 and deferral items of $200,000. The taxpayer would have a regular tax of $280,000 and the AMT would be $45,500 (tentative minimum tax of $325,500-$280,000 regular tax). The credit computed under Sec. 53 would be as follows:













Note however that if the AMT attributable to deferral items was computed by taking taxable income plus deferral items, the AMTC would be $0.

As indicated above, most individuals will not have the full amount of AMT paid available as a credit in subsequent years. This is because most individuals will usually have some amount of exclusion items (for example taxes, interest, etc.). This may not in itself result in a decrease of th@ potential credit if the exclusion items alone do not generate an AMT. If in the above example the exclusion items were only $250,000, the individual would have the full AMT paid available as a credit. However, a normal operating corporation will not usually have significant exclusion items. The Book Unreported Profits Adjustment is not an exclusion item even if the reason for the difference between book and tax is exclusion items. Without any exclusion items, corporations should get a full credit for any AMT paid.

However, a corporation (as well as an individual, but it is not as obvious) can have no exclusion items and yet not get any credit for the AMT it pays. This can happen due to the differences in the amounts and utilization of the NOLs between the two separate tax systems. Generally, the NOL for AMT purposes must be adjusted to exclude any preference or adjustment item and it may not offset more than 90% of the AMT taxable income. With this general understanding of the AMT NOL.

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