Non-liquidating S corporation distributions.by Dilley, Steven C.
Shareholders in an S corporation must keep careful track of their tax basis. The amount of the tax basis determines the tax treatment of such items as flow-through losses and corporate distributions. Many S shareholders have two investments in the corporation - the investment in corporate stock and loans made to the corporation. These shareholder assets have tax bases which may change regularly as a result of corporate events. The beginning basis for stock is the amount the shareholder invested to obtain the stock. The beginning basis for debt is the amount the shareholder loaned to the corporation.
Stock Basis Rules
Under the proposed regulations, the basis of stock is adjusted in the following order:
a. Capital contributions by shareholders to the corporation; b. Separately stated income items (whether taxable or not); c. Non- separately computed income; and d. Excess of depletion deductions over basis of property subject to depletion.
a. Non-deductible expenses that are not properly chargeable to a capital account also reduce stock basis; b. The shareholder's oil and gas depletion deduction; c. Separately computed deduction items; d. Non- separately computed losses that pass through; and e. Nontaxable return of capital distributions.
Reducing stock basis for non-deductible items prevents a shareholder from converting a non-deductible expense at the corporate level into a deductible expense when stock is sold or a liquidating distribution is received. Distributions in excess of basis are treated as gains from the sale of stock.
The Timing of Basis Adjustments
All basis adjustments are deemed to occur on the last day of the corporation's tax year or on the date the shareholder sells his or her stock, if earlier. Income and loss items affect basis first, followed by distributions.
In essence, the ordering rule allows shareholders to "borrow" basis from anticipated net income at the end of the year while receiving distributions during the taxable year. Since adjustments to basis are made at the end of the year, the shareholder's basis at the time of the distribution is irrelevant. However, if losses occur subsequent to the distribution, and those losses result in a net loss for the taxable year, the distribution (which the shareholder anticipated to be tax- free) could be converted into a taxable distribution. The converse is also possible.
Comment. These rules limiting losses and allowing tax-free distributions up to the amount of the shareholder's adjusted basis are similar in certain respects to the rules governing the treatment of losses and cash distributions by partnerships. Under the partnership rules, however (unlike the S corporation rules), for any taxable year, a partner's basis is first increased by items of income, then decreased by distributions, and finally is decreased by losses for that year.
Example 1. Giant, Inc., an S Corporation, has only one shareholder, Linda Fath. Linda had a $637,000 stock basis at the beginning of 1992. During 1992, she received salary payments from Giant of $75,000 (including her portion of the health insurance premiums) and $48,000 of cash distributions. Results of operations for 1992 for tax purposes are presented in Table 1. What is the January 1, 1993, tax basis for her stock?
Even though the nondeductible items do not reduce Linda's current taxable income from the corporation, they do reduce her stock basis. Her current taxable income from the corporation would be $207,700. Linda probably participates materially in the corporation, but her adjusted gross income exceeds $150,000, so she does not benefit from the passive activity rental real estate loss exception. The items comprising her taxable income from the corporation would be:
The rental real estate loss reported on Form 8582 would be non- deductible (assuming Linda does not have offsetting passive income) and carryover. Basis Computations During a Loos Year
A net loss (not including distributions) first reduces the basis for stock, and then reduces the basis of debt owed to the shareholder by the corporation, if any. Under the proposed regulations, a shareholder's stock basis at the end of a current year that is available to absorb losses is increased by the amount of the shareholder's share of the corporation's separately and non-separately stated income items. The stock basis is reduced by the amount of any separately or non-separately stated loss items. Finally, the tax effect of any distributions the shareholder received during the year is determined.
As with C corporation stock acquisitions, an S corporution shareholder may have different bases in separately acquired shares of stock. As a result, the tax treatment of distributions will differ depending on the stock's basis (i.e., a distribution could generate a taxable gain for stock with a low basis, while at the same time be a tax-free retum of capital for stock with a high basis). Is it sufficient for S corporation shareholders to maintain basis by the various blocks of stock purchased? Although not answered directly, the proposed regulations are developed within a context that would require shareholders to separately maintain basis for each share of stock held.
Debt Qualifying as Basis
If an S corporation shareholder desires to take immediate deductions rather than wait until the S corporation is profitable, it is important to be aware of how to create S corporation basis. Additional cash contributions or the acquisition of corpo- rate stock will increase a shareholder's stock basis. Since losses flow through on the basis of the percentage of stock ownership, acquisition of additional stock will also increase the shareholder's proportionate amount of losses. In addition, a loan from a shareholder to the corporation gives basis to the lending shareholder. However, an increased debt will not proportionately increase the amount of losses allocated to the shareholder.
A shareholder guarantee of corporate borrowing does not establish basis until the shareholder actually repays the loan on behalf of the corporation. Repayment of a loan may be accomplished by substituting a personal note for a corporate note.
In order for the debt basis to absorb the loss in excess of stock basis, the debt must be outstanding at year end (or at the date the shareholder terminates his/her interest in the corporation). If there are multiple debts, the loss is applied pro rata based on the relative bases of the debt. A net increase in a subsequent year is applied first to restore the basis of debt owed to the shareholder, then to stock basis. This restoration applies only to debt owed to the shareholder on the first day of the corporation's tax year. If there are multiple debts, the net increase first restores the basis of debt paid so that gain from payment of the debt is avoided. Any remaining net increase then restores the basis of debt in the same proportion that the basis of the debt was reduced. A "net increase" in basis is defined as all the basis adjustment items, except a contribution to capital. Thus, distributions may convert a net income year into a net decrease year.
Example 2 The facts are the same as for Example 1, except the beginning stock basis is zero and the corporation owes Linda $600,000. This debt has a $380,000 basis. The net basis increase resulting from the cuffent year's income and deduction items is $156,000 as shown in Table 2. However, the "net increase" is $108,000 ($156,000 less the $48,000 distribution) which increases the debt basis to $488,000. Linda's stock basis is increased by $48,000 to $48,000. Linda would not have to recognize $48,000 of gain from a distribution exceeding her stock basis. Her end of year stock basis is zero ($0 + 48,000 - $48,000).
Comment Distributions to shareholders should generally not be made when stock basis is zero because a taxable gain may result. The various basis adjustments (not including distributions) may be insufficient to absorb the distribution. Instead, it might be preferable to consider a debt payment.
Corporate Level Consequences of
Cash Distributions. If the distribution is in the form of cash (rather than property or debt forgiveness, for instance), the distribution could be from the Accumulated Adjustments Account (AAA), the Other Adjustments Account (OAA), or from Accumulated Earnings and Profits (AEP). In each case the distribution reduces the account from wfiich it is made. The financial accounting retained earnings account is a combination of all three of these tax accounts. Of course, there would be significant book/tax differences in the computation of various income items.
Property Distributions. The C corporation distribution of appreciated propetty rules apply to S corporations. Thus, the corporation recognizes the gain from distribution of the property. However, the loss from distribution of corporate property is not recognized because IRC Sec. 311(a) disallows losses in transactions involving corporations and their shareholders. Also, a distribution of appreciated property may be subject to the IRC Sec. 1374 built-in gains tax.
Example 3. Reo, an S corporation, distributes property worth $35,000 to its sole shareholder. If the basis of the property is $20,000, Reo recognizes a $15,000 gain. If the basis is $40,000, Reo has a non- recognized $5,000 loss because of IRC Sec. 311(a).
The recognized gain is added to the S corporation's current operating results. Thus, the gain flows through and is taxed to the shareholders. If a loss results, it flows through as a nondeductible loss to the shareholders. Because of the general rule against loss recognition, an S corporation will generally not want to distribute property that has a value lower than its basis. Such a distribution will cause the basis of the property to "step down" to the fair market value.
Distribution Consequences to
Corporations Without Accumulated Earnings and Profits. The distribution consequences when the S corporation has no former C corporation AEP are quite straight-forward. When a shareholder receives a non-liquidating cash or property distribution, the distribution is measured by the cash received or the property's fair market value. The distribution will be- * First, a non-taxable return of capital to the extent of the shareholder's stock basis, and * Second, a gain from the sale of the stock to the extent that the cash or the property's fair market value exceeds the stock's basis.
The character of the gain the shareholder recognizes when the distribution exceeds stock basis is determined by the character of the shareholder's stock. Usually, the stock is a capital asset.
Example 4: Journal, Inc., an S corporation, distributes $80,000 cash to its sole shareholder, Jim Bonina. Jim has a $167,000 tax basis for his stock. The $80,000 distribution reduces Jim's basis to $87,000 and is nontaxable.
Example 5. Assume the same facts as Example 4 except Jim's basis is $67,000. Jim has a $13,000 long-term capital gain if he has held the stock more than 12 months. His stock basis is now zero.
The distribution's effect is not determined until the current year impact of the S corporation's operations flow through to the shareholder.
Corporations With Accumulated Earnings and Profits. The simple treatment of non-liquidating distributions by S corporations when no former C corporation earnings and profits exist is offset by the complexity and confusion surrounding the rules when the corporation does have accumulated earnings and profits. The priority of non-liquidating distributions from an S corporation that has accumulated earnings and profits is as follows: * First, the distribution is tax-free up to the corporation's AAA; * Second, the distribution is a taxable dividend from the AEP account to the extent the distfibution exceeds the AAA; * Third, the distribution exceeding the S corporation's AEP is tax-free to the extent of any remaining stock basis; and * Fourth, the distribution exceeding stock basis is received in return for the sale of the stock, and is, therefore, taxable gain.
These statutory steps in analyzing S corporation distributions when accumulated earnings and profits are present are expanded somewhat when the "Other Adjustments Account" (OAA) is present.
Example 6: Housa, Inc., an S corporation which formerly was a C corporation and has AEP, distributes $144,000 to its sole shareholder when Housa has the following account balances:
The $144,000 distribution reduces AAA to zero, reduces AEP to $10,000 and results in a $7,000 dividend to the shareholder. The shareholder's stock basis becomes $38,000 ($175,000 - $137,000 distril)ution out of AAA).
The AAA can be negative - a result caused by net negative adjustments (e.g., a loss year) from operating the S corporation. Negative AAA can only be restored by later year net positive adjustments. A distribution cannot be made from negative AAA.
The Accumulated Adjustments
The AAA is a corporate-level account and not a shareholder-level account. Therefore, it is not personal to any particular shareholder. When stock is transferred from one shareholder to another, the transferee becomes entitled to a proportionate share of the AAA based on stock ownership.
Items of non-taxable income and deductions related to non-taxable income are placed in the "Other Adjustments Account" (OAA). The OAA is a creation of the IRS; it is not mentioned in the S corporation distribution section, IRC Sec. 1368. This section defines the AAA and says that the AAA shall include "no adjustment... for income (and related expenses) which is exempt from tax." This definition would seem to require that items such as key person life insurance proceeds and premiums could not be included in the AAA. However, Form 1120S instructions mention only taxexempt bond interest and interest expense on funds borrowed to purchase tax-exempt bonds as examples of items placed in the OAA. In effect, OAA is a secondary account to "hold" cumulative tax-exempt interest income and related expense items.
Example 7: Liquiway, Inc., an S corporation with AEP, has $5,000 of taxexempt interest and $16,000 (20% of $80,000) disallowed meals and entertainment expense. The tax-exempt interest would be in the OAA, but the disallowed expense would not. The $16,000 expense is not an expense related to taxexempt income. Thus the $16,000 would be included in the AAA.
The AAA account is computed in a fashion similar to the shareholder's stock basis computation. The proposed regulations do provide guidance related to several questions. What happens if some (or all) losses passed through to shareholders are nondeductible because of insufficient basis? The proposed regulations indicate the AAA is decreased "by the entire amount of any loss or deduction even though a portion of the loss or deduction is not taken into account by a shareholder under IRC Sec. 1366(d)(1) or is otherwise not currently deductible under the Code." What about nondividend distributions in excess of a shareholder's basis? The proposed regulations indicate that the AAA is reduced (but not below zero) by any portion of a distribution (regardless of whether it exceeds the shareholder's stock basis). Property distributions reduce AAA and OAA by the fair market value of the property.
Income Account (PTI)
If a current S corporation was an S corporation for its last taxable year prior to the October 10, 1982, effective date of the SSRA of 1982 and it had a PTI account, there is a method of distributing that account tax-free. The former PTI account is personal to the shareholders and is not a corporate-level account like the AAA and therefore cannot be transferred to any new shareholders. Any distribution out of the PTI account is taxfree and reduces the shareholders' stock basis. Property distributions cannot carry out any of the PTI account, and, therefore, PTI distributions can only come from cash. In the priority of distributions, the PTI account comes after distributions out of the AAA account.
Distribution Out of Accumulated
Earnings and Profits
Distributions that are in excess of the AAA are out of AEP. The distribution amount is equal to cash distributed plus the adjusted basis of the property distributed. An S corporation which is distributing appreciated property, reduces the AEP account by the distributed property's adjusted basis and the recognized gain generated by the distribution (i.e., the property's fair market value).
The complicated set of accounts an S corporation with AEP must maintain is summarized in Exhibit 1. Exhibit 2 compares the AAA computation to the computation of a shareholder's tax basis for the S shares.
Election on Distributions
Subchapter S and the proposed regulations provide various elections that can alter the normal distribution ruies. Each of these elections is discussed below.
Election to Distribute Accumulated Earnings and Profits Before tbe Accumulated Adjustments Account. An S corporation is permitted to elect to distribute AEP before the AAA. To be effective, the election must be made by all the shareholders and indicated in an attachment to the election year corporate return. If this AEP election is made, and PTI exists, distributions are treated as made first from PTI, then from AEP, and finally from AAA. This AEP election may be well advised under the following circumstances: 1. The shareholder is temporarily in a low tax bracket (especially with rate increases anticipated in the near future). 2. The shareholder is temporarily subject to the alternative minimum tax, and all income for the year is subject to the 24/o individual alternative minimum tax rate. 3. The shareholder has investment interest and/or alternative minimum tax interest deduction limitations. In either case, dividend income may be tax-free. 4. The shareholder has a net operating loss limitation which will expire soon. 5. The corporation has passive income in excess of 25% of gross receipts.
The AEP election, however, may have its pitfalls since it is in effect for all distributions made within the taxable year. A relatively small amount of AEP makes the dividend inexpensive. Consider, however, the effect of a large accumulation of eamings and profits.
In a letter ruling (PLR 8935013), the IRS stated that an S corporation cannot treat some of its cash distributions as dividends and some as coming from the AAA. An S corporation had AEP of $1 million and distributions of $240,000. The shareholders elected to treat distfibutions as coming first from the available AEP. The corporation wanted to treat $40,000 of the distribution as a dividend out of AEP and the balance of $200,000 as a distribution from the AAA. The IRS concluded that the election applies to all distributions made during the election year, and an S corporation cannot choose to have the election apply to only a portion of its distributions.
Election to Forego PTI. If the corporation has PTI and makes the election to distribute AEP before AAA, PTI is stIll distributed before the AEP. However, under the proposed regulations, the corporation may also elect to forego distribution of the PTI before AEP. An S corporation making an election to by-pass AAA and PTI will treat distributions first from AEP, foflowed by AAA, and then PTI. An S corporation making ah election to bypass only PTI will treat distributions first from AAA, followed by AEP, and then PTI.
Deemed Dividend Election. An S corporation electing to distribute AEP before AAA may also elect to distribute all or part of its AEP through a deemed dividend. Factors to consider are as fonows: * The deemed dividend amount may not exceed AEP on the last day of the tax year, reduced by any actual AEP distributions during the year. * The deemed dividend is considered as 1) distributed in proportion to stock ownership, 2) received by shareholders, and 3) contributed by the shareholders to the corporation. All three events are deemed to occur on the last day of the tax year. * The deemed dividend must be consented to in writing by all the shareholders.
Making the Various Elections. The election to distribute AEP before AAA is made by attaching a statement to a timely filed original or amended return. The statement must state that the corporation is making an election under Reg. Sec. 1.1368-1(f). The statement must also identify the election, be signed by a corporate officer, and be signed by each shareholder who receives a distribution (actual or deemed) during the year. The deemed dividend election and the "foregoing Pll distribution election" (if they are being made) must meet the same requirements. The election(s) are effective only for the tax year for which they are made.
Keeping track of the consequences of distributions from S corporations has evolved into a complex matter. Both the corporation and its shareholders must meticulously maintain records of where the distribution is coming from and what affect it has on each shareholder's basis.
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