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Calculating S Corp Accumulated Adjustment Accounts:

Mastering the Section 1368 Ordering Rules

TUESDAY, OCTOBER 27, 2020, 1:00-2:50 pm Eastern

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October 27, 2020

Calculating S Corp Accumulated Adjustment Accounts: Mastering the Section 1368 Ordering Rules

Professor Robert W. Jamison, CPA

Professor Emeritus of Accounting

Indiana University

[email protected]

Brian T. Lovett, CPA, JD

Partner

Withum Smith+Brown

[email protected]



Notice

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described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

Calculating S Corp Accumulated Adjustment

Accounts:Mastering the Section 1368 Ordering Rules

October 27, 2020

Robert W. Jamison, CPA

Brian T. Lovett, CPA, CGMA, JD

Copyright © Robert W. Jamison 5

Special discount offer for today’s participants



Outline

I. Accumulated adjustment account vs. shareholder basis

II. AAA when the S corporation has accumulated E&P

III. Impact of AAA on tax treatment of distributions for S corps

with E&P

IV. Calculating AAA

V. Ordering rules of Section 1368 and regulationsA. Income and gains

B. Losses and deductions

C. Non-dividend distributions

D. Net negative adjustments

VI. Other adjustments account issues

VII. Available elections


Benefits

•What is the interrelation between an S corp shareholder's stock basis and the S corp AAA balance?

•What is the impact of E&P on AAA calculations and on tax treatment of distributions from an S corp that has E&P?

•What are the ordering rules for allocating AAA adjustments of income, gain, and loss?

•What items are included in other adjustments accounts?


Introduction

•Corporations with no Accumulated Earnings and Profits• Stock Basis Governs• Distributions in Excess of Basis• Adjustments to Basis

•Corporations with Accumulated Earnings and Profits• First determine corporate source• Then compare with s/h basis, as adjusted for year (if not

dividend)


IRS Compliance Campaigns


• In 2017 the IRS Large Business & International division announced identification and selection of “campaigns.” • The campaign issues are selected according to perceived

compliance risks.

• By September 2020 there were approximately 60 campaigns, of which three specifically target S corporations and their shareholders.• The S corporation campaigns focus on:

1. Shareholder basis in S corporation stock and debt2. Treatment of distributions from S corporations to

shareholders, especially if the S corporation has accumulated earnings and profits from C corporation years.

3. The built-in gains tax imposed upon former C corporations in their first five S corporation years.

IRS Practice Units Relating Specifically to S Corporations


Category TopicConcept Unit SCO/C/53_4_1_3-03

Adjustment to Basis of Stock of, and Indebtedness Owing, Shareholders

Concept Unit SCO/C/53_4_2_2-05 Adjustments to Debt BasisConcept Unit SCO/C/53_4_1_2-02 Adjustments to Stock BasisConcept Unit SCO/C/53_4_1_1-01 Initial Stock BasisConcept Unit SCO-C-009 S Corporations General Distributions OverviewConcept Unit SCO/C/53_04_02_01-04 Valid Shareholder Debt Owed by S CorporationProcess Unit SCO/P/53_05_01_03-06 Losses Claimed in Excess of BasisTransaction Unit SCO-T-010 S Corporations Property DistributionTransaction Unit SCO-T-008 S Corporations with Accumulated Earnings & Profits

Transaction Unit SCO-T-007Taxability of Distributions Not From Accumulated Earning & Profits

New Disclosures

•Shareholders • If receive distributions from an S corporation, must

attach a basis schedule to Form 1040 or Form 1041• See Appendix A for basis schedules

• IRS

• AICPA

•S corporation•Disclose distributions on Schedule K, each K-1 and

Schedule M-2• If it has AE&P and makes a distribution it must file

Form 5452 along with Form 1120-S


Basis Reporting on Shareholder Tax Return


• See Appendix A for basis schedules• IRS• AICPA

Form 1120-s, Schedule K


Schedule M-2

16

Form 5452File with Form 1120-S in any year the corporation has AE&P and distributes cash or property


Corporations with Accumulated Earnings and Profits

•Distribution Hierarchy

•Accumulated Adjustments Account (AAA) Defined


Earnings and Profits

• The principal differences between taxable income and current earnings and profits:

1. Tax-exempt income is included in current earnings and profits, as are artificial deductions such as the dividends-received deduction.

2. Disallowed expenses, such as the federal income tax, meals and entertainment, excess capital losses reduce current earnings and profits.

3. Carryover deductions such as the net operating loss, net capital loss and excess charitable contribution are added to current earnings and profits in the year they are deducted.

4. Timing items, such as depreciation, installment sales and completed contract accounting are all recalculated in a manner that generally slows down deductions and speeds up income for current earnings and profits compared to taxable income.


Earnings and Profits (Continued)

•An S corporation generates no earnings and profits.

•However, any accumulated earnings and profits that existed on the date that a C corporation became an S corporation remain for treatment as taxable dividends if they are distributed.

1. The corporation must have accumulated earnings and profits either from its own years as a C corporation,

2. or from a C corporation acquired by the S corporation in a tax-free reorganization or liquidation.

3. This includes conversion to QSub status of a C corporation or a former C corporation.


Impact of AAA on Tax Treatment of Distributions for S Corporations with E&P


•Acts as “cushion,” or limit before distributions are dividends to shareholders

Table 9 - 1: HIERARCHY OF DISTRIBUTIONS OF CASH AND PROPERTY (S Corporation Taxation, 2020 p. 742)

Order Description of Distribution

Source of Distribution Taxability Effect on Basis

1. To all shareholders to the extent of AAA (See discussion at ¶905)*

AAA, as adjusted for current year’s income and loss items

Not taxable unless in excess of shareholder’s basis

Reduce basis to the extent thereof

2. To all shareholders in S corporations that have AE&P

AE&P Ordinary income

No effect on basis

3. All remaining distributions

Immaterial to determination of tax consequences



* Rules also apply to shareholders who have pre-1983 previously taxed income (PTI) accumulations. See ¶906.


Table 9 - 1: HIERARCHY OF DISTRIBUTIONS OF CASH AND PROPERTY (S Corporation Taxation, 2020 p. 742)

Order Description of Distribution

Source of Distribution Taxability Effect on Basis

1. To all shareholders to the extent of AAA (See discussion at ¶905)*

AAA, as adjusted for current year’s income and loss items



2. To all shareholders in S corporations that have AE&P

AE&P Ordinary income

No effect on basis

3. All remaining distributions

Immaterial to determination of tax consequences



* Rules also apply to shareholders who have pre-1983 previously taxed income (PTI) accumulations. See ¶906.


II. AAA Defined

• Equity account on the corporation's balance sheet (tax).• Reflects, but may not exactly duplicate, shareholder basis

adjustments for income and distributions.

• Reduced for all losses that pass through to shareholders, • reduce stock basis,

• reduce debt basis, or

• are suspended due to lack of shareholder basis.

• May have a negative balance. [Reg. 1.1368-2(a)(3)(ii)]

• No adjustment for tax-exempt income or expenses attributable.

• Differing treatments of losses for basis and AAA when the corporation has income items and loss items in the same year


AAA Defined

•No specific portions of the account that are identified with individual taxable years or individual shareholders.

•Unusual distributions, such as stock redemptions and complete liquidations, may have additional rules.


Effects of Corporate Level Taxes

•Taxes attributable to C Corporation years have no effect on AAA• LIFO recapture

• Reduces current E&P in final C corporation year

• Investment credit recapture• Amended C corporation years’ income after S election

takes effect.• These taxes reduce accumulated E&P in year of liability


Effects of Corporate Level Taxes

•Contrast with taxes imposed on S Corporation income

•Built-in gains tax• Treated as loss(es) in year of liability• Offset gains, in determining flow-through

•Passive investment income tax• Treated as a reduction of passive income flowthrough

•These taxes have negative effect on shareholder basis

•Thus they have effect of reducing AAA


Timing Problems

•The additions and reductions to an S corporation's AAA are determined by reference to the corporation's taxable income.

•Therefore, certain items of deferral permitted or required by the tax law will not affect the AAA until they are reported on the corporation's tax return. • For instance, the deferral of gain or loss under the

involuntary conversion or like-kind exchange rules will not have an immediate effect on the corporation's AAA.


Example 1

•Gerco is an S corporation.

• In 2020, Gerco's warehouse was destroyed by fire. • Gerco's adjusted basis in the building was $220,000 at the

time of the fire, and Gerco received $300,000 in insurance proceeds. • Gerco replaced the building within the time period

prescribed by Section 1033 and elected to defer the gain.

•The $80,000 deferred gain does not increase the shareholders' basis or the corporation's AAA.


Timing Problems (Continued)

•Similarly, the temporary disallowance of amounts accrued to shareholders or related parties requires coordination between the corporation's taxable income and its AAA. (See S Corporation Taxation Chapter 10 at ¶1003, for further discussion of this rule.)

•The expense reduces the AAA at the same time it is deducted on the corporation's tax return. [Code Sec. 267(a)(2)]


Example 2

• Ronico has one shareholder, Veronica.

• Ronico is an accrual-method, calendar-year taxpayer, whereas Veronica uses the cash method and the calendar year. • On December 31, 2019, Ronico has accrued $10,000 of salary

to Veronica. • Veronica receives the salary in January 2020.

•Under the rules of Section 267(a)(2), Ronico deducts the $10,000 in 2020.

• The $10,000 has no effect on Ronico's AAA at the end of 2019, but will reduce it, as a component of Ronico's income or loss, in 2020.


Section 163(j)

•The business interest limitation imposed by Code Section 163(j) also affects the timing of the AAA calculations.• Any portion of the interest expense that is disallowed for

a taxable year will not reduce the AAA in the year of disallowance.• If the previously disallowed interest is deductible in a

later year, it will reduce the AAA in the year in which the deduction is allowed.


Example 3

• Jan Corporation is an S corporation.

• Jessie, Andrea and Norman are the three equal shareholders.

• In 2020, Jan is subject to the interest limit of Code Section 163(j). • Jan’s book income for the year is $600,000 but the

interest disallowance increases its taxable income to $660,000. • The difference of $60,000 is entirely due to the limitation

on business interest for Jan. • Jan carries this excess business interest forward to 2021.


Example 3 (Continued)

• Jan’s shareholders will report $660,000 ($220,000 each) in 2020. • Jan’s Accumulated Adjustments Account (AAA) will

increase by $660,000 in 2020, before considering any distributions to the shareholders. • The shareholders will each add $220,000 to their bases in

2020.

•The excess business interest does not flow through to the shareholders and has no effect on their income tax for 2020.



• In 2021 Jan’s book income is $800,000, adjusted taxable income is $850,000 and interest expense is $50,000. • 30% of Jan’s adjusted taxable income is $252,000. • Book income $800,000• Less 2021 interest ( 50,000)• Less carryforward from 2020 ( 60,000)• Taxable income 2021 $690,000



• Each shareholder treats $230,000 as a positive basis adjustment (before considering any distributions). • Jan’s AAA increases by $690,000 as a result of its taxable

income in 2021. • The excess taxable income in 2021 does not affect

shareholder basis or AAA.


V. Ordering Rules of Section 1368 and Regulations

•The ordering rules do not exactly duplicate the amendments to the basis ordering rules. • They provide that the AAA is to be increased for income

items, and then reduced for losses, before measuring the amount available for distributions. • AAA is measured without regard to any “net negative

adjustment.” • The net negative adjustment is defined as the excess of

reductions other than distributions over increases for the year. [Code Sec. 1368(e)(1)(C)(ii)]


Relationship of AAA to Shareholder Basis and Pass ThroughTable 9 - 5: RELATIONSHIP OF INCOME AND EXPENDITURES TO SHAREHOLDER BASIS AND CORPORATION’S AAA

(S Corporation Taxation, 2020 p. 782)

Type of Incomeor Expenditure

Effect onShareholder

Income

Effect onShareholder

Basis

Effecton

AAA Ordinary income Increase Increase Increase

Other taxable gains Increase Increase Increase

Ordinary loss Decrease, to extent of basis, amount at risk, Code Sec. 469, or other limits

Decrease, but not below zero, regardless of deductibility

Decrease for entire amount

Other deductible items

Same as ordinary loss



Tax-exempt income No effect Increase No effect

Expenses related to tax-exempt income

No effect Questionable No effect

Premiums paid for company-owned life insurance

Nondeductible Reduce * No effect

Charitable contribution of capital gain property

Deduct FMV, subject to shareholder limits

Reduce stock/debt basis by the corporation’s basis in contributed property

Reduce for corporation’s basis in contributed property

Other nondeductible expenses

Questionable Questionable Questionable

Contribution to capital

No effect Increase No effect

Deemed dividend election

Increase Increase No effect

However, see Code Section 1016(a)(1)(B), which precludes basis reduction for mortality charges. See discussion in Chapter 7 at ¶705.09.


Basis Ordering of Income, Losses and Distributions

1 Beginning basis (cannot be negative)

2 Add this year’s income (all, including exempt)

= 3 Basis before distributions

4 Less distributions (limited to basis)

= 5 Basis before losses (cannot be negative)

6 Less losses

a Nondeductible under general ordering rule (Cannot exceed 5)

b Deductible under general ordering rule (Cannot exceed 5 -6a)

a Deductible under elective ordering rule (Cannot exceed 5)

b Deductible under elective ordering rule (Cannot exceed 5 -6a)

7 Ending basis (cannot be negative)


AAAOrdering of Income, Losses and Distributions

1 Beginning balance (positive or negative)

2 Add this year’s income (excluding exempt)

= 3 Balance before losses

4

Less losses, excluding expenses connected with tax-exempt income (limited to income in line 2), shareholder ordering rule does not affect AAA

= 5 Balance before distributions (can be negative)

6 Less distributions, cannot exceed positive balance in 5

7 Less Net Negative Adjustment (only if losses exceed income in line 2), losses less line 4

8 Ending balance (can be negative)


Example 4

•Sayco is an S corporation that uses the calendar year. •At the beginning of the current year, Sayco’s AAA

was $110,000, and its accumulated earnings and profits were $250,000. • In the current year, the corporation had • $90,000 of Sec. 1231 gains, • Ordinary loss of $150,000 • Distributed $120,000 to Sally, its sole shareholder.

•Sally’s stock basis was $150,000 at the beginning of the year.


Compare Adjustments to AAA and Basis

Beginning of year

Add any current year income items:

Reduce for current year’s losses, limited to no net negative adjustment (AAA)

Balance before distributions

Distributions

< AAA

> AAA (dividend)

Total distribution

Basis before losses

Losses (150,000 total)

Allowable

Carry forward

Final Basis

Net negative adjustment (150,000-90,000)

Final AAA

Basis

$150,000

90,000

240,000

(110,000)

130,000

(130,000)

$ 0

AAA

$110,000

90,000

(90,000)

110,000

(110,000)

(60,000)

($60,000)

Basis

$110,000

10,000

$120,000

130,000

$20,000


Property Distributions

C Corporation Property Distribution Rules.

Adaptations to S Corporations.

Effects on the Shareholders

Distributions of Gain Property.

Distributions of Loss Property.


C Corporation Property Distribution Rules

• No gain or loss recognized by corporation §311(a)

Except

• Corporation recognizes all gains §311(b)

• Shareholder takes into account at fair market value


Adaptations to S Corporations

•Follow §311 rules

•All gains, no loss recognized by corporation

•Then apply to AAA, AEP, etc.


Effects on the Shareholders

•Take into account at FMV of property received

•Reduce basis in stock, then gain • (or dividend if AAA exhausted and corp. has AEP)


Distributions of Gain Property

•Under these rules, a corporation (C or S) recognizes gains on distributions of appreciated property, as if the corporation had sold the property to the recipient.• It is combined with the bottom line income or loss if

the gain is ordinary income, and separately reported if it is a capital or Section 1231 gain. •See S Corporation Taxation Chapter 10 on the

possible treatment of an otherwise Section 1231 gain as ordinary income, due to the rules of Section 1239.


Example 5

•Capcor, an S corporation, distributes land and building to its sole shareholder.

•At the time of the distribution, the land has a basis of $22,000 and fair market value of $30,000.

•The building has a basis of $16,000 and fair market value of $62,000



Capcor must recognize gains

Property

Land

Building

Total

Gain

$8,000

$46,000

$54,000

Basis

$22,000

$16,000

$38,000

Fair Market Value

$30,000

$62,000

$92,000



•The gain on the land would all be Section 1231.

•However, Section 1239 applies to dealings between corporations and their greater than 50% shareholders.

•According to this rule, all of the gain on the building is ordinary income, since the building will be depreciable to the new owner.

•Since the gain is passed through to the shareholders, it increases the basis of all shareholders, and accordingly increases the AAA.



1. Assume AAA was $50,000 before distribution (after year’s income and loss, and no net negative adjustment

• Effects on AAA:

• Balance before distribution

• Increase for gains

• Balance at moment before distribution

•Distribution (FMV)

• Ending AAA balance

$50,000

54,000

104,000

(92,000)

$12,000



2. Assume AAA was $50,000 before distribution (after year’s income and loss, and $40,000 negative adjustment

• Effects on AAA:

• Balance before distribution

• Increase for gains

• Less net negative adjustment triggered

• Balance at moment before distribution

• Distribution limited to AAA

• Ending AAA balance

• Distribution from AE&P ($92,000 - $64,000)

$50,000

54,000

(40,000)

64,000

(64,000)

$ 0

$28,000


Distributions of Loss Property

•No loss is recognized by a corporation on the distribution of economically depreciated property. [Code Sec. 311(a)]

•However a disallowed loss may reduce the corporation's AAA and the shareholders' stock basis.

• Code Sec. §1367(a)(2)(D) is broad enough that disallowed loss under Code Sec. 311(a) may be a “disallowed loss.”

• Reg. §1.1367-1(c)(2) lists some examples of disallowed losses but does not include or exclude losses disallowed on corporate distributions.


Example 6

• MBS Corporation, an S corporation, has 50 equal unrelated shareholders. • MBS owns a portfolio of mortgage-backed securities, with an

adjusted basis of $500,000 and fair market value of $50,000. • MBS distributes $1,000 worth of its portfolio to each of its

shareholders. • Even though none of the shareholders is treated as a related party,

the corporation may not recognize any loss, since the distribution is in the nature of a dividend.

• Each shareholder takes $1,000 of value into account as a distribution, and takes $1,000 as a basis in the securities received.

• $450,000 of the basis merely disappears without any tax benefit in the current year or at any time in the future.

• There is no guidance as to the effect of this loss on shareholder basis and the corporation’s AAA.


Distributions of Loss Property: Effects on AAA

•Regulations §1.1368-2(c)(2) leaves some gaps.

• The IRS has opined that a loss disallowed by reason of Section 311(a) should be posted to the Accumulated Adjustments Account. [CCA 201421015]• This opinion seems to contradict the position of

Regulations §1.1368-2(c)(2), at least when the corporation distributes depreciated property and cash, and the total of the cash plus the property exceeds the corporation’s AAA.



• The fair market value of the distributed property is $50,000• The adjusted basis to the corporation was $500,000

before the distribution• The IRS opinion seems to be that the corporation

should reduce its AAA by $500,000, based on one of two theories:• There is a distribution of $50,000 and a disallowed loss of

$450,000OR

• There is some implied rule that the AAA rules would follow the C corporation rule of Code Sec. 312(f)(1)(B), which states that a corporation must reduce its earnings and profits to reflect the adjusted basis of distributed property



1. Assume the corporation’s AAA was $600,000.• The corporation reduces it’s AAA to $100,000

2. Alternatively assume that the AAA was $60,000.• Perhaps the AAA becomes ($440,000)



•Assume that the AAA was $60,000.•However, in addition to the securities the

corporation distributed $200 in cash to each shareholder ($10,000 total).• Now the corporation combines the two distributions• Cash $10,000• Noncash 50,000• Total $60,000

•The corporation reduces its AAA by $60,000!!!!•What happens to the $450,000 disallowed loss??•???????????????????????????????????????????


VI. Other Adjustments Account Issues


•The Other Adjustments Account (OAA) is a catch-all account for items that are recognized during S corporation years but do not appear in the AAA.• Tax-exempt income• Expenses related to production of tax-exempt income

VI. Other Adjustments Account Significance


•The OAA stands behind AE&P in the hierarchy of distributions. • Therefore this account has no significance on the

shareholders’ treatment of distributions.• However, the IRS examines this account, principally to

find expenses that should have reduced the AAA.

VII. Elections to Treat Distributions as Dividends

Election to Bypass AAA.

Election to Bypass PTI.

Deemed Dividend Election.


Election to Bypass AAA

•An S corporation, with the consent of all shareholders who receive distributions during a taxable year, may elect to distribute accumulated earnings and profits before AAA.

• Therefore, accumulated earnings and profits are placed before Accumulated Adjustments Account.

• There is no way to pick and choose among the shareholders as to who gets the dividend treatment and who gets AAA.

• There is no way to apply the elections to a portion, but less than all, of the distributions during the year.


Example 7

•OBX Corporation, begins 2020 with $50,000 AAA and $15,000 of AE&P

•OBX distributes $40,000 in 2020.

•OBX has $24,000 of income and no losses in 2020. • AAA before any distribution is $74,000.

• Distribution leaves $34,000 in the AAA and $15,000 of AE&P

•Assume that OBX is concerned about the possibility of excessive passive investment income for 2020. • Accordingly, the corporation elects to bypass AAA.

• The distribution first eliminates the AE&P balance of $15,000, and then reduces AAA by $25,000.


Election to Bypass PTI

•When an S corporation has Previously Taxed Income, and needs to exhaust its accumulated earnings and profits the election under § 1368(e)(3) is not sufficient to exhaust accumulated earnings and profits

•Each shareholder must consent to the election, and each shareholder must include the deemed dividend on his or her return for the year


Deemed Dividend Election

•Under Regulations §1.1368-1(f)(3), a corporation, with the consent of its shareholders, may make a deemed dividend election to distribute its earnings and profits.

•Each shareholder must consent to the election, and each shareholder must include the deemed dividend on his or her return for the year.


Side Effects of Deemed Dividend Election

•Since the shareholders did not actually received money or property, they are deemed to have contributed the dividend to the corporation’s capital on the date of the deemed receipt.• The contribution increases stock (not debt) basis.• The contribution has no effect on the corporation’s AAA.


Example 8

• Nopass Corporation, an S corporation, has $55,000 of AE&P at the end of 2019. • In early 2020, Nopass discovers its passive investment

income gross receipts exceed 25% of its total in 2019. • A bypass election could have exhausted the AE&P and eliminated the

passive investment income problems permanently. • Unfortunately Nopass did not make any distributions in 2019.

• Along with its 2019 return, Nopass can elect a deemed dividend. • Nopass has until the due date of its 2019, including an extension, to

make this election

• The effect of this election will be to require the shareholders to report a $55,000 dividend distribution, as if they had received it on the final day of 2019, in proportion to their share ownership on that date.


Example 9

• Jay is the sole shareholder in Silver Corporation, an S corporation.• Silver had been a C corporation and had accumulated

$200,000 AE&P before electing S corporation status. • In 2019, Silver’s losses had exceeded Jay’s basis by $140,000. • In 2020 Silver reports a loss of $60,000.

• Jay has substantial sources of other income and is in the 39.6% marginal income tax bracket. • He is also subject to the Net Investment Income tax.

• Silver is having cash flow problems and is unable to make any distributions to Jay. • Jay does not want to make any further investments or

loan any funds to Silver.



• If Silver makes no elections, Jay will have no income or loss from the corporation this year. •However, if Silver elects a deemed dividend, Jay will

report $200,000 of income and receive $200,000 of new basis in Silver. • His federal income tax on the dividend would be $47,600

($200,000 x 23.8%) • The tax effect of the loss deduction would be $79,200

($200,000 x 39.6%).

•Thus the deemed dividend election causes tax savings of $31,600, with no effect on Jay’s nontax cash flow.


Example 10

• Leo is the sole shareholder in Lecor, a calendar-year S corporation. • At the end of 2020, Leo has no basis in Lecor stock or

debt. • Lecor has an ordinary loss of $30,000 for 2020. • Lecor also has AE&P of $25,000 from prior C corporation

years.

• In addition, Leo has $15,000 of investment interest for 2020 and no investment income. • Leo has received no distributions from Lecor in 2020.



•Absent a deemed dividend election, Leo will have no taxable income or loss from Lecor and will not be able to deduct his investment interest.

• The deemed dividend election would cause Leo to report $25,000 of dividend income.• He would increase his year-end basis to $25,000 and would be

able to deduct $25,000 of the corporation’s loss.• In addition, he would deduct $15,000 of investment interest.

• Thus, the deemed dividend election creates a net $15,000 deduction for Leo in 2020.

•He would also deduct the ordinary loss, at the cost of a reported dividend.


Net Present Value of Deemed Dividend Election

•The deemed dividend is permanent, and the freed-up loss deductions may only be temporary.

• If prospects for short term profitability are good, the corporation and shareholders may want to forego the election.

•However, if profitability is unlikely, the election should be beneficial.


Bypass Election and Property Distributions

• The bypass election can apply to noncash as well as cash distributions. [Ltr. Ruls. 8917025, 9003042, 9149030]

•When the distribution consists of high-basis, low-value property, the bypass election puts E&P ahead of AAA.

• Code Sec. 312(f)(1)(B)states that a corporation must reduce its earnings and profits to reflect the adjusted basis of distributed property.

• The IRS has applied this rule to a bypass election and distribution of depreciated property. [Ltr. Rul. 9221011.]


Example 11

• KW is an S corporation that uses the calendar year. •At the beginning of the current year, the corporation

has $50,000 AE&P. • KW also owned land that had a basis of $50,000 and fair

market value of $30,000. • In the current year, KW makes an election to distribute

its AE&P before its AAA. • KW distributes the land to Kevin. • The amount of the distribution is $30,000, the FMV of

the property. • KW reduces its AE&P by the property's adjusted basis of

$50,000.


Other Issues Affecting AAA


•Stock Redemptions

•Acquisitive Reorganizations

•Divisive Reorganizations

•Effect of S Election, Termination and Reelection: Tomseth

Stock Redemptions, Nonliquidating

•A stock redemption is defined as a transaction whereby a corporation buys its own stock from a shareholder. [Code Sec. 317(b)] • That term redemption, however, does not distinguish

between an exchange and a distribution.

• In some cases a redemption may be treated as an ordinary distribution:• Dividend to extent of E&P if C corporation• Usual sequence for S corporation:

• AAA, AE&P, etc.

• In other situations it is treated as a sale by the shareholder


Stock Redemptions, Nonliquidating

• Section 302(b) gives four tests for determining whether the transfer will qualify for exchange treatment. • Three of the tests are made by measuring the effects at the

shareholder level:• “Not essentially equivalent to a dividend”—Section 302(b)(1)

• “Substantially disproportionate”—Section 302(b)(2)

• “Complete termination”—Section 302(b)(3)

• The fourth test is made at the corporate level:• “Partial liquidation”—Section 302(b)(4)

• In addition Section 303 allows exchange treatment when corporation to use corporate assets to redeem stock of the surviving shareholders in order to pay certain estate and inheritance taxes, within certain limits.


Effects of a Stock Redemption on the AAA

• If a redemption does not meet the tests of a sale or an exchange, the corporation's AAA and other equity accounts will be affected in the exact same manner as any other distribution. [Rev. Rul. 95-14, 1995 CB 169; Ltr. Rul. 9810020]• If a redemption is treated as an exchange, however,

Subchapter S provides two rules:1. The corporation's AAA is reduced by the percentage of outstanding stock redeemed.2. The corporation must make a “proper adjustment” to its AE&P. [Code Sec. 1368(e)(1)(B). Code Sec. 1371(c)(2)]


Effects of a Stock Redemption on the AAA, When Redemption is Exchange of Stock

•A redemption is treated as if it were the final event in the corporation's taxable year, following all adjustments to the AAA for income losses, deductions, and all nonredemption (“ordinary”) distributions. [Reg. §1.1368-2(d)(1)(ii)]

•Thus, the time at which the redemption occurs during a taxable year is generally irrelevant in determining the adjustment to the AAA, unless the corporation closes its books at the date of the redemption.


Example 12

•Mary owns 35 percent and Lars owns 65 percent of the stock in ML Corporation, an S corporation. • The corporation uses the calendar year. •On December 31, 2013, ML's AAA balance is $25,000.

On May 26, 2014, ML redeems all of Mary's shares, • The redemption qualifies as a complete termination of

Mary's interest under Section 302(b)(3). •ML made no ordinary distributions in 2014, and the

corporation did not elect to close the books as of the date of the redemption. •ML's net income for the entire year of 2014 was

$50,000.



AAA beginning balance

Current year's income

Balance before redemption

Portion attributable to shares redeemed

AAA balance after redemption

$25,000

50,000

75,000

(26,250)

$48,750

(75,000 ×.35)



Assume redemption price was $24,000





Limit to total consideration


$25,000

50,000

75,000

(24,000)

$51,000

(75,000 × .35)



Assume redemption price was $30,000

Also assume $15,000 ordinary distributions in year



Ordinary distribution




$25,000

50,000

(15,000)

60,000

(21,000)

$39,000

(60,000 × .35)


Acquisitive Reorganizations

•All pre-reorganization AAA balances, whether positive, negative, or mixed, are combined into a single account after the reorganization. [Reg. §1.1368-2(d)(2).]

•Therefore, if two S corporations merge, or combine in a Type C or Type D reorganization, a positive balance in the AAA of one of the corporations offsets a negative balance in the AAA of another corporations.


Divisive Reorganizations

•An S corporation that engages in a divisive reorganization must allocate both its AAA and its AEP between the surviving corporations in proportion to the fair market value of assets held by each. [Reg. §1.1368-2(d)(3), Reg. §1.312-10(a)]•Apparently, a negative AAA balance is not allocated

between the surviving corporations, but remains with the original corporation. [Reg. §1.1368-2(d)(3) refers to Reg. §1.312-10(a) for the manner of allocation. Reg. §1.312-10(a) holds that a negative balance in earnings and profits remains with the original corporation.


Distribution from Eligible Terminated S Corporations

• In order to be an eligible terminated S corporation (ETSC), the corporation must meet these requirements:• It must have been an S corporation on December 22, 2017.

• It must revoke its S election on or before December 22, 2019.

• The same persons must hold shares in identical proportions on December 22, 2017 and the date of revocation.

•After the post-termination transition period ends, the ETSC prorates distributions between the corporation’s AAA and accumulated earnings and profits (AE&P) based on the ratio of AAA to AE&P.


ETSC Proposed Regulations

• In 2020 the IRS issued Proposed Regulations thatcover distributions during the PTTP. [Prop. Reg.§§1.1371-1, 1.1371-2.]•These Proposed Regulations adopt a workable

formula.• On the last day of S corporation status, the corporation

must measure its AAA and its accumulated earnings andprofits.• It will then reduce the AAA for any distributions within

the PTTP.


ETSC Proposed Regulations

•After the post-termination transition period ends,the ETSC prorates distributions between thecorporation’s AAA and accumulated earnings andprofits (AE&P) based on the ratio of AAA to AE&P.• This ratio does not change until distributions chargeable to

AAA have exceeded its final balance.• Distributions during the PTTP do not affect the ratio.• Earnings and profits from years after the termination do

not affect the ratio


Effect of S Election, Termination and Reelection: Tomseth

•3 S corporations

•Each started as C

•Each elected S

•Each terminated S

•Each elected S again

•Each terminated S again• [Tomseth v. U. S., 2019-2 USTC ¶50,257 (DC OR)]


Effect of S Election, Termination and Reelection: Tomseth Issues

1. Did prior S period AAA survive C period and become available again in later S period?

2. Could IRS impute a negative AAA that was not subject to statute of limitations?


Tomseth: LS Warehouse, per Shareholders

Date Status AAA Distribution Balance

1958 - 1986 C corp.

1987 - 1993 S corp.51,627,736 26,743,007 24,884,729

1993 – 2008 C corp.

2009 - 2012 S corp.17,563,554

+24,884,7292013 C corp.

PTTP 42,443,028 ** Mostly nontaxable distribution of AAA


Tomseth: LS Warehouse, per IRS


1958 - 1986 C corp.

1987 - 1993 S corp.51,627,736 26,743,007 24,884,729

1993 – 2008 C corp.

2009 - 2012 S corp. 17,563,5542013 C corp.

PTTP 42,443,028 ## Mostly taxable distribution of E&P


Tomseth: LS Warehouse, Outcome

• IRS was correct.

•AAA resets to zero when S election terminates. Operates only as measurement of distributions during PTTP.


Tomseth: LS Washington, per Shareholders


1968 - 1987 C corp.

1987 - 1991 S corp. 19,862,658 19,862,6581992 – 2008 C corp.

PTTP 10,225,694 9,636,9642009 - 2012 S corp.

15,104,172+ 9,636,964

2013 C corp.PTTP 24,692,889 *

* Mostly nontaxable distribution of AAA


Tomseth: LS Washington, per IRS


1968 - 1987 C corp.

1987 - 1991 S corp. 19,862,658 19,862,6581992 – 2008 C corp.

PTTP10,225,694 9,636,964

2009 - 2012 S corp. 15,104,1722013 C corp.

PTTP24,692,889 #

# Only about 60% distribution of AAA


Tomseth: LS Washington, Outcome

• IRS was correct.

•AAA resets to zero when S election terminates. Operates only as measurement of distributions during PTTP.


Tomseth: LS Portland, per Shareholders


1973 - 1987 C corp.

1987 - 1993 S corp. 56,645,199 56,645,199

1992 – 2003C corp.PTTP 31,916,781 22,728,418

2004 - 2012 S corp. 21,950,729** 1,968,878 *

2013C corp.PTTP 4,162,185 *

* Nontaxable distribution of AAA in 2005, from old AAA** Accumulation after 2004


Tomseth: LS Portland, per IRS

Date Status AAA Distribution Balance1973 - 1987 C corp.1987 - 1993 S corp. 56,645,199 56,645,1991992 – 2003 C corp.

PTTP 31,916,781 22,728,4182004 - 2012 S corp.

0 1,968,878 # ($1,968,878)2013 C corp.

PTTP 4,162,185 ### IRS recalculated distribution as mostly taxable, after statute of limitations expired. IRS reduced AAA to ($1,968,878). Treated this deficit as a “suspense” account which is not subject to statute of limitations## Offset 2004 – 2012 AAA with 2005 deficit


Tomseth: LS Portland, Outcome

• IRS could not ignore statute of limitations and require negative AAA balance to offset future distributions.


The Alternative Minimum Tax

•AICPA Technical Resource Panel has requested guidance on maintenance of separate AAA for AMT.•No response for years •And years•And years

Start all over again!!


Appendix A

• Basis calculations


Basis Reporting on Shareholder Tax Return

•Basis Schedule, AICPA

•For AICPA Tax Section members:

•https://www.aicpa.org/interestareas/tax/resources/compliance.html#scorp


https://www.aicpa.org/interestareas/tax/resources/compliance.html#scorp

Basis Reporting on Shareholder Tax Return.

AICPA Basis ScheduleDeveloped by AICPA S Corporation Technical Resource Panel (TRP)

Alternate schedule is available for shareholders who elected to reduce basis for deductible items first.



IRS Stock Basis ScheduleIncluded with Instructions for Schedule K-1 (2019)



IRS Debt Basis ScheduleIncluded with Instructions for Schedule K-1 (2019)



IRS Loss LimitIncluded with Instructions for Schedule K-1 (2019)


Stock Basis Governs

• Code Sec. 1368(b)

• For each shareholder• Distribution stock basis

• Tax-free, reduce stock basis

• Distribution > stock basis

• Gain from deemed sale of stock

• Nearly always capital gain

• Note: may be NII depending on composition of assets, or degree of shareholder participation in corporation's activities

• Debt basis does not affect treatment of distributions


Adjustments to Stock Basis

• General ordering of basis adjustmentsProblem: One year’s (distributions + loss) exceed basis

• Rules changed as of 1/1/97

• Old rules govern basis adjustment in pre 97 years.

•Do not include in s/h basis• Income excluded from cancellation of corporate debt• Exclusion for the value of improvements made by a lessee


Basis Ordering of Income, Losses and Distributions

1 Beginning basis (cannot be negative)

2 Add this year’s income (all, including exempt)

= 3 Basis before distributions

4 Less distributions (limited to basis)

= 5 Basis before losses (cannot be negative)

6 Less losses

a Nondeductible under general ordering rule (Cannot exceed 5)

b Deductible under general ordering rule (Cannot exceed 5 -6a)

a Deductible under elective ordering rule (Cannot exceed 5)

b Deductible under elective ordering rule (Cannot exceed 5 -6a)

7 Ending basis (cannot be negative)


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