S Corporation shareholders: A potential bright side to a gloomy "sunset"?

By Kurt Ohliger, Jr. CPA (Aug, 2010)

As the days of 2010 dwindle, school buses will soon be on the road, leaves will be changing colors and sunsets will come earlier. Whenever I think of sunsets, it conjures up visions of my time in Hawaii watching a fire-red ball disappearing beneath the horizon across the Pacific Ocean. One "sunset" that surely will not be as pleasing occurs on December 31, 2010. On this date, the favorable tax rates applicable to qualified dividends will "sunset", that is, expire along with many other oft-referred to "Bush tax cuts". Absent any legislation, effective January 1, 2011 qualified dividends currently taxed at a preferential rate of 15 percent, will once again be taxed at ordinary tax rates. To further add to the gloom, the ordinary tax rates are scheduled to revert to their levels prior to the Economic Growth and Tax Relief Reconciliation Act of 2001, with the top marginal rate being 39.6 percent!

For those S corporations that were previously C corporations and still have undistributed C corporation retained earnings, 2010 might be the time to pay out those earnings to shareholders in the form of dividends. However, in order to distribute these "accumulated earnings and profits", special planning and tax return elections might be required to achieve the desired dividend treatment of the distributions.

When an S corporation makes distributions to its shareholders, the Internal Revenue Code (IRC) specifies the order and tax treatment of those distributions. IRC Section 1368(c) provides that distributions to shareholders are considered to come from the following sources, in the order listed:

  • Accumulated Adjustments Account (AAA): distributions are nontaxable to the extent of shareholder basis;
  • Previously taxed income (PTI): applies to pre-1983 S corporations only and all distributions of PTI are nontaxable;
  • Accumulated Earnings & Profits (AE&P): distributions are taxed as dividends;
  • Return of capital: distributions are nontaxable to the extent of shareholder's stock basis; and
  • Capital gain: distributions in excess of basis result in the deemed disposition of shareholder stock and are taxed as long-term capital gains if the stock was held for one year or more.

Typically, S corporations with prior C corporation retained earnings try to avoid distributions in excess of its AAA account so as to not generate dividend income for the shareholders. In addition to distributions, current year net losses also reduce the AAA balance.

In these tough economic times, S corporations that are struggling to maintain sufficient profit levels may have to reduce the level of shareholder distributions in 2011 and beyond in order to avoid "dipping into" prior AE&P and thereby triggering dividends to the shareholder, potentially taxed at a rate as high as 39.6 percent. If that is a likely scenario for your S corporation, a distribution of prior AE&P may be a desired 2010 tax planning strategy.

IRC Section 1368(e)(3) allows S Corporations to make an election to change the ordering rules for distributions. The election provides that S Corporations with AE&P can treat all distributions as first coming from AE&P rather than the typical AAA. The distributions would be taxable dividends to the shareholders to the extent of AE&P. Any distributions in excess of AE&P would then be applied against AAA. The election, which the S corporation attaches to its timely filed (including extensions) original return, requires the consent of all the shareholders that received distributions during the year, applies to all distributions made during the year and is only applicable for the tax year in which it is made (i.e. 2010 in this case). The irrevocable election allows shareholders to distribute AE&P while dividend rates are still 15 percent.

One obvious requirement to making the distributions is the availability of cash. The inability to obtain financing, restrictions and covenants on accessing available financing to make distributions to shareholders and other economic factors may inhibit a corporation from distributing the AE&P to take advantage of the preferential dividend rates. However, distributions out of AE&P can be made in cash or in property other than cash. If property other than cash is distributed, certain adverse tax consequences may apply if the fair market value of the property distributed exceeds its tax basis.

So how can an S corporation distribute AE&P if it does not have the available cash or any nonessential business assets to liquidate or distribute? Regulation Section 1.1368-1(f)(3) provides another election which allows S corporations to make a "deemed dividend" to its shareholders. A deemed dividend does not require the actual distribution of cash or property. Instead, the amount of the dividend is considered to be first distributed in cash and then immediately contributed back to the corporation by the shareholders. The deemed dividend and subsequent capital contribution are treated as having occurred on the last day of the tax year. The shareholders will be required to report the dividend income on their individual tax returns. The capital contribution increases the shareholder's stock basis. Similar to the election to reorder the source of distributions, all shareholders must provide their consent and the election is attached to the corporation's timely filed (including extensions) tax return.

The otherwise gloomy "sunset" of the preferential dividend rates as of December 31, 2010 provides a unique planning opportunity for S corporations with undistributed accumulated earnings and profits from any C corporation tax years. If your S corporation qualifies, proper planning and analysis of shareholder distributions could, pardon the pun, pay dividends today and save significant future tax dollars.

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