S Corporation Distributions Part I: Taxable or Not Taxable, That Is The Question!

Kurt K. Ohliger, Jr., CPA, Partner (May, 2014)

Since the mid-1980s the S Corporation has probably been the most popular entity for new businesses.  Additionally, countless existing C Corporations have chosen to convert to S Corporations.  Why the popularity?  The S Corporation generally provides a single-level of taxation on income generated by the corporation, whereas the C Corporation produces a “double taxation” of its earnings.  S Corporation income “passes through” to the shareholders and is subject to tax on the shareholder’s individual income tax return.  C Corporation income is first taxed at the corporate level and then, when distributed to the shareholders, taxed again as a dividend.  When an S Corporation distributes its income to the shareholders, the distributions are tax-free.  Or are they?  As one of my partners often reminds me, the answer to every tax questions is “It depends.”  With respect to the taxability of S Corporation distributions, he is absolutely correct.  However, regardless of the facts and circumstances, there are only three possible tax consequences attributable to any S Corporation distribution: (1) tax-free, (2) taxable dividend, or (3) gain from the sale of the stock.  A distribution might result in one or more of these outcomes.  We will address the basic distribution rules in this article and cover more complicated, yet common, scenarios as well as some planning opportunities to mitigate potential tax implications, in our June edition.

As mentioned, the primary advantage of an S Corporation is that, generally, its income is taxed only at the shareholder level.  However, because distributions rarely, if ever, match the amount of income generated in a specific year, the calculation of the amount that can be distributed without any current tax effect is complicated.  Distributions may include amounts that have been taxed in a prior year (as pass-through income), amounts that are taxed in the current year, and/or amounts that have not been taxed at all.  As a result, “tiers” of distributions are created, each with its own tax implications.  The analysis is further complicated by whether or not the S Corporation previously existed as a C Corporation.  If so, the S Corporation may have accumulated earnings and profits (AE&P) from years in which it was a C Corporation (or AE&P from certain acquisitions of a C Corporation). 

Before discussing the general rules for taxation of S Corporation distributions, it is important to understand the relationship between stock basis, AE&P and the corporate-level accumulated adjustments account (AAA).  It is the relationship between these attributes that determines the taxable amount, if any, of a distribution.  Shareholders must adjust their stock basis annually.  Shareholders increase their stock basis for capital contributions, items of income (including tax-exempt income) and gain, and certain excess depletion deductions.  Shareholders decrease their stock basis for distributions, items of loss and deductions, nondeductible expenses and certain non-excess depletion deductions.  The income tax regulations provide a specific order in which these items are applied to adjust stock basis.  Accordingly, shareholder basis is first adjusted for the items that increase basis.  Second, basis is reduced for distributions that are not considered to be dividends (those not from AE&P).  Third, basis is reduced for nondeductible expenses and the depletion deduction.  Finally, basis is reduced for any item of loss and deductions.  Basis can never be reduced below zero.  In the event that losses exceed stock basis after reductions for distributions and nondeductible expenses, the excess is carried forward indefinitely.   If the corporation has outstanding indebtedness to the shareholder the excess losses can be applied to reduce the basis of the debt.  Any remaining excess is then carried forward indefinitely.

The AAA is used to track the cumulative taxable income generated by an S Corporation, but not yet distributed to the shareholders.  The AAA is important for S Corporations that have AE&P.  The balance in the AAA account becomes the threshold at which distributions could potentially become taxable.  Similar to stock basis, the AAA is adjusted annually.  AAA will be increased for the same items that increase basis except for capital contributions and tax-exempt income.  AAA will be decreased for the same items that decrease basis except for nondeductible expenses.  Unlike stock basis, the AAA may be reduced below zero, but only by losses and not by distributions. 

The required adjustments to the AAA also must be done in a specific order.  The ordering depends on whether the S Corporation has “net positive adjustments” or “net negative adjustments” for the year.  When the items that increase the AAA exceed items that decrease the AAA (excluding the distributions), the corporation has “net positive adjustments”.  Conversely, when the items that decrease the AAA (excluding the distributions) exceed the items that increase the AAA, the corporation has “net negative adjustments”. 

When the corporation has net positive adjustments for the year, AAA is increased for the net positive amount before reducing the AAA for any distributions.  By first increasing the AAA, there is a lower possibility that the distributions will exceed the AAA amount, potentially creating dividend income.  If the corporation has net negative adjustments for the year, the AAA is first reduced by the distributions before any reduction for the net negative amount.  Again, this ordering helps lower the possibility that some or all of the distributions will be a taxable dividend.

Understanding the mechanics of computing and adjusting both stock basis and the AAA is critical to determining the taxability of distributions.  The basic rules are then applied based on whether or not the S Corporation has AE&P.  The calculation of AE&P is beyond the scope of this article.  However, as mentioned above, an S Corporation can only have AE&P if it was a C Corporation prior to electing S Corporation status or it acquired AE&P as a result of certain acquisitions involving a C Corporation.  An S Corporation since inception can never have AE&P.

If an S Corporation does not have AE&P, the taxability of distributions is determined solely by reference to the shareholder’s stock basis.  Any distributions will be a tax-free reduction of the shareholder’s basis.  Any distribution in excess of the shareholder’s stock basis is treated as capital gain from the deemed disposition of stock.  The AAA is irrelevant in these situations, but must still be computed annually because it will be relevant if the S Corporation terminates or revokes its election.

When an S Corporation has AE&P, determining the taxability of distributions becomes more complicated.  We will address those issues in Part II, coming next month.  In the meantime, please consult your DB&B tax advisor for all your S Corporation concerns.

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