It is relatively easy for an S corporation to inadvertently lose its tax status. For example, a disgruntled shareholder may transfer all or a portion of his or her shares to a person that is not qualified to hold S corporation shares, such as a C corporation or a nonresident alien. Upon the occurrence of such an event and the subsequent automatic termination of its S election, the corporation becomes a taxable C corporation. Well-advised shareholders may prevent an inadvertent termination of a corporation’s S election by means of a shareholders’ agreement that restricts the transfer of stock.
However, there are times where the shareholders of an S corporation may decide to deliberately revoke the corporation’s S election; for example, where the individual income tax rate is greater than the corporate tax rate, and the circumstances are otherwise “right” (as where a sale of the business is not reasonably foreseeable), a particular corporation and its shareholders may determine that it makes economic sense to give up the S election.
Shareholder Considerations in Giving up “S”
Aside from the change in flow-through treatment and the application of certain other rules (for example, the application of the surtax on net investment income ), the loss of “S” status should not impact the corporation’s shareholders. They retain the same adjusted basis and holding period for their shares.
Before revoking the S election, however, there are still a number of factors that shareholders should consider. Most important, perhaps, is the fact that the former S corporation may not again file an S election until the fifth taxable year after the year in which the revocation was effective. In addition, when a new S election is eventually made, the corporation’s assets become subject to the built-in gains tax.
Another factor to consider, and one that is often overlooked, is the treatment of any S corporation income that had previously been taxed to the shareholders (under the S corporation flow-through rules ) but had not been distributed to them. This income will be reflected in the corporation’s accumulated adjustment account (“AAA”) and in the adjusted basis of the stock held by the shareholders.
In a recent advisory ruling, the IRS considered the case of an S corporation that sought to distribute or, more accurately, to preserve its AAA.
Taxpayer was incorporated as a C corporation, and it operated as such until it made its first election to be treated as an S corporation. At that time, Taxpayer had accumulated earnings and profits (E&P) from its operations as a C corporation. After making its S election, Taxpayer continued to generate profits. Taxpayer had a positive AAA balance when its majority shareholders later revoked its S election. It also carried forward its E&P from the C corporation period preceding its first S election.
During the Taxpayer’s post-termination transition period (“PTTP”), Taxpayer distributed some, but not all, of its AAA to its shareholders, leaving some undistributed AAA related to its initial S period.
In general, the PTTP is the one-year period that follows the end of the corporation’s S period. During the PTTP, a former S corporation may distribute cash (and only cash) to its shareholders on a tax-free basis. Taxpayer represented that it did not distribute all of the AAA during the PTTP; it did not have available cash equal to its AAA to distribute because it needed to retain cash to capitalize new market growth opportunities.
Taxpayer subsequently made a second S election. Taxpayer represented that it had converted from C to S to C and back to S to take advantage of individual and corporation tax rates available at the time of each conversion. Taxpayer requested a ruling regarding whether its AAA balance from its first S period survived the period between the end of the PTTP for the first S period and the effective date of its second S election.
The IRS Responds
An S corporation’s AAA is an account of the S corporation. It is not apportioned among the shareholders. (Contrast this to the individual capital account of a partner in a partnership.)
All S corporations start with a AAA balance of zero on the first day of their S status. For S corporations with E&P from a prior period as a C corporation or a merger with a C corporation, the AAA tracks the corporation’s ability to make tax free distributions (of S corporation earnings) to its shareholders. To the extent that a corporation has a positive AAA, and the distribution does not exceed a shareholder’s basis in his or her stock, the S corporation can make tax-free distributions to that shareholder.
That portion of a distribution that remains after the AAA has been eliminated is treated as a C corporation dividend to the extent it does not exceed the E&P of the S corporation.
When a corporation’s S status terminates, the IRS explained, the corporation goes through a PTTP. During this period, the former S corporation can continue to take advantage of some of the benefits associated with its S status. Specifically, the shareholders will be able to receive tax-free distributions from the former S corporation to the extent the corporation has a positive AAA balance.
Any distribution of money by a corporation with respect to its stock during a PTTP is applied against and reduces the adjusted basis of the stock, to the extent that the amount of the distribution does not exceed the AAA.
The question addressed by the advisory was whether the corporation’s remaining positive AAA disappears forever after the PTTP, or if it reappears upon a subsequent S election.
After reviewing the statute and the legislative history, the IRS concluded that an S corporation’s AAA is reset to zero after the PTTP and remains zero going into any subsequent S period for the corporation.
The IRS also noted that a shareholder’s adjusted basis in his or her S corporation stock generally will reflect taxable income of the corporation while it is an S corporation, and that basis will not disappear when the S corporation status changes. Even though, at first blush, it might appear that a corporation that fails to distribute its AAA during the PTTP will lose the ability to make tax-free distributions of previously taxed income when it re-elects S corporation status in a subsequent period, the IRS pointed out that the corporation retains the ability to make tax-free distributions from the shareholder’s basis, though it must first distribute its C corporation E&P. (Similarly, the gain on a subsequent sale, liquidation or redemption of the stock would be reduced by this stock basis.) Thus, the IRS reasoned, the question becomes one of a timing difference, not a permanent difference in the taxability of corporate distributions.
According to the IRS, the PTTP is the only time during which a corporation may draw down its AAA on a tax-free basis by making distributions after the revocation of its S corporation status.
In most cases, the “timing difference” to which the IRS referred in the advisory will be of small comfort to shareholders, notwithstanding its technical accuracy. Rather, shareholders will likely wonder why they are being taxed on the distribution by the C corporation of monies on which they have already been taxed during the corporation’s S period.
If the corporation does not fit within the special AAA distribution rule during the PTTP, the regular C corporation distribution rules will apply: the distribution is treated as a dividend to the extent of the corporation’s E&P, then as a return of basis in the stock, then as capital gain. Under current rules, both the dividend and the capital gain would be subject to the 20% federal tax rate for capital gains and to the 3.8% surtax on net investment income (without regard to the shareholder’s level of participation in the business).
Of course, Taxpayer could have distributed its entire AAA, tax-free (but with a reduction in stock basis) while it was still an S corporation, without regard to the “PTTP cash distribution” rule. This may have been accomplished by a distribution of available cash plus other, in-kind (preferably non-appreciated) property.
If the corporation ended its S period with insufficient cash, it may have been able to accelerate the generation and collection of cash receipts during its C period, which cash would then be available for effecting a PTTP distribution of AAA.
Alternatively, Taxpayer may have been able to borrow the necessary funds from which to distribute the AAA, either before the revocation of the S election or during the PTTP.
If an S corporation and its shareholders are aware of the AAA and PTTP distribution rules, they should be able to plan accordingly and will, thereby, avoid the loss of the AAA on the revocation of the corporation’s S election.