You may not realize this, but there’s far more at stake in next month’s presidential election than the fate of national security, gay marriage and America’s continued independence from China. There’s also the distinct possibility that if President Obama wins reelection, S corporation shareholders will find themselves in the counterintuitive position of trying to accelerate taxable income into the waning days of 2012. Allow me to explain.
First, let’s make three key assumptions:
- You own an S corporation that was previously taxed as a C corporation.
- As of the start of your 2012 tax year, your S corporation has accumulated earnings and profits (E&P) from your previous days as a C corporation.
- Lastly, your S corporation has a positive balance in its Accumulated Adjustments Account (AAA), but you expect to make some large distributions in future years that may well exceed this positive balance.
Next, some foundations of tax principles:
C Corporation Distributions, In General
During the time a business is operated as a C corporation, any distributions are governed by Section 301(c), which provides that to the extent the distribution is made from the corporation’s current or accumulated E&P, the distributions are taxed as a dividend to the shareholder.
E&P, in its simplest form, is the measurement of a corporation’s economic — as opposed to taxable — income that is available for distribution to its shareholders. The purpose of determining E&P is to differentiate those distributions that are made from a corporation’s income and thus should be taxed as dividends to the recipient shareholders from those that represent a nontaxable return of a shareholder’s capital.
This treatment of E&P distributions as taxable dividends gives rise to the dreaded “double taxation” that largely defines the Subchapter C regime, as a shareholder’s dividend income will have been taxed twice: once when the income was earned by the corporation, and a second time when the shareholder receives the dividend.
S Corporation Distributions and the Accumulated Adjustments Account
Unlike C corporations, S corporation income is generally subject to only a single level of tax. The statute ensures this beneficial treatment from a mechanical perspective by providing that income earned by an S corporation increases the shareholders’ basis in the corporation’s stock (IRC Section 1367(a)(1)), while a distribution of those same earnings is treated as a tax-free reduction of the shareholders’ previously increased stock basis (IRC Section 1368).
S Corporations with Prior C Corporation E&P
Because of the advantageous treatment afforded S corporation distributions, there is tremendous motivation for a C corporation with substantial E&P to convert to an S corporation prior to making a distribution, so that the distribution will be treated as a tax-free return of shareholder stock basis rather than a taxable dividend.
Recognizing this potential loophole, the statute provides that a C corporation’s accumulated E&P survives the S election and remains with the S corporation. Should this E&P be subsequently distributed — even during an S corporation year — the distribution will be taxed as a dividend to the recipient shareholders as if it had been made while the business was a C corporation.
S Corporation Distribution Ordering Rules and the Importance of the Accumulated Adjustments Account
Because an S corporation’s prior E&P continues to lurk, waiting to be taxed as a dividend when distributed, the statute provides an ordering rule to determine which S corporation distributions are deemed to have been made from S corporation income – and will be subject to the favorable rules discussed above — versus when the corporation is deemed to be distributing prior C corporation E&P, which will be taxed as a dividend to the shareholders with no offset for the shareholders’ stock basis.
This line of demarcation comes in the form of an S corporation’s Accumulated Adjustments Account (AAA). This corporate level attribute is intended to measure the income earned by the S corporation that has previously been taxed to the shareholders as flow-through income, but has not yet been distributed, similar — but not identical to — a C corporation’s E&P.
To the extent an S corporation’s distribution does not exceed the positive balance in its AAA, the distribution will be taxed according to the general S corporation rules. Once the distribution exceeds the AAA balance, however, the next dollars of distribution are deemed to have come from E&P and will be taxed as a dividend to the recipient shareholders until all of the E&P has been distributed.
These ordering rules are intended to be taxpayer-friendly, as S corporation shareholders would generally prefer to have a distribution treated as a tax-free return of basis than a taxable dividend. But in 2012, that may not be the case, particularly if the S corporation is planning to make large distributions in future years that may well exceed the corporation’s AAA balance at the time of the distribution and as a result, be taxed as a dividend when made. Here’s why:
The maximum tax rate on qualified dividends is currently 15%. Should no new legislation be passed between now and December 31st, however, this top rate is slated to return to 39.6%, with an additional 3.8% tacked on for taxpayers with unearned income in excess of $250,000, for a total rate of 43.4%.
If reelected, President Obama would allow the preferential rates afforded dividends to expire in exactly this manner, meaning dividend rates may well triple in 2013. And if this were happen, well…S corporation owners would be remiss not to consider getting rid of their corporation’s E&P now, at the favorable 15% rates, even if it means accelerating dividend income into 2012 that otherwise would not have been recognized.
To that end, there are three ways you can purge your S corporation’s E&P between now and the end of 2012:
- If your S corporation has plenty of cash lying around — and few do in today’s economy — the corporation could simply make a large enough distribution in 2012 to wipe out its AAA as well as its complete E&P balance in accordance with the normal ordering rules.
- Alternatively, if cash is precious, the corporation can elect under Treasury Regulation 1.1368-f(2) to reverse the traditional distribution ordering rules, and have the S corporation’s 2012 distribution be treated as having come first from E&P, and then from AAA. This allows the corporation to purge its E&P balance at preferential rates with whatever cash is available
- Lastly, if you simply don’t have any cash available to distribute, the regulations still provide a mechanism for purging all of the S corporation’s E&P during 2012. Treas. Reg. 1.1368-(1)(f)(3) provides that an S corporation can elect to make a deemed dividend of all or part of the corporation’s E&P balance. In the fictional transaction, cash equal to the elected amount is deemed distributed by the corporation to its shareholders and then immediately contributed by the shareholders back to the corporation. Obviously, if this election is made, the S corporation is also deemed to have made the election discussed in #2 above to reverse the normal ordering rules. This election has the added effect of providing the shareholders with a basis increase for the amount of the deemed dividend, which may free up current or suspended losses.
The elections discussed at #2 and #3 above are irrevocable, and both must be made by attaching a statement to an originally filed (including extensions) original or amended return. This means that for shareholders electing to make a deemed dividend under Treas. Reg. Section 1.1368-1(f)(3), because no cash is actually distributed, the timing of the election provides a rare post-year-end planning opportunity. These shareholders can sit back and watch the election — and any legislation emerging from the subsequent lame-duck session of Congress — unfold before deciding which step to take with the added benefit of hindsight.