Accounting for S corporation distributions.
Retained Earnings Accounts
S corporations could have four retained earnings accounts, but most will have fewer than this. These different accounts are required due to the Subchapter S Revision Act of 1982 (SSRA) and changes in corporate status. As to the latter, when a C corporation converts to S status, C year retained earnings remain on the books as "accumulated earnings and profits (AE&P)."(1)
As to SSRA, the accounting for S corporation retained earnings was dramatically changed for years beginning after 1982. Before SSRA, S corporation retained earnings were called "previously-taxed income (PTI)"(2); however, for S years beginning after 1982, SSRA replaced PTI with two new retained earnings accounts, but any preexisting PTI remains on the books until distributed.
One of the new accounts is called the "other adjustment account (OAA)" which contains any post 1982 undistributed net tax-exempt income.(3) The other new account, which contains the balance of the S corporation's post-1982 net undistributed income, is called the "accumulated adjustment account (AAA)."(4)
As alluded to above, many S corporations will have fewer than four retained earnings accounts. For example, if a corporation has been an S corporation from inception and began business after 1982, at most it will have two retained earnings accounts, namely AAA and OAA. Regardless of how many of the accounts a corporation has, keeping track of them is necessary because, as will be explained later, the shareholders' tax treatment depends on which accounts are being distributed.
Corporate Accounting for Cash Distributions
It is imperative that the corporate accountant be able to determine which retained earnings accounts are being distributed. Once this determination is made, a reduction in the appropriate retained earnings accounts is effectuated via year-end closing entries. The following example will be used throughout this segment to illustrate how cash distributions are accounted for on the corporate books.
Example 1: Sco, a calendar-year S corporation, had the following pre-distribution retained earnings accounts as of the end of 1991:
AAA $40,000 PTI 10,000 AE&P 105,000 OAA 7,000 Total Retained Earnings $162,000
During 1991 Sco distributed $25,000 per quarter to its shareholders; thus, at year end the retained earnings accounts must be reduced by a total of $100,000, but which accounts are reduced?
This question is clearly answered by the tax law. Specifically, retained earnings are considered to be distributed in the following order: (1) AAA until totally distributed, (2) PTI until totally distributed, (3) AE&P until totally distributed, and (4) OAA until totally distributed. Distributions in excess of retained earnings are considered to have come from paid-in capital (e.g., "paid-in in excess of par").(5)
Prior to applying these ordering rules, the pre-distribution, year-end balances of AAA and OAA must be ascertained.(6) But this cannot be determined until the year's income and expense accounts are closed. So, as distributions are made during the year, a temporary account such as "dividends paid" would be debited. Then at year end, this temporary account would be closed to the retained earnings accounts.
This process is illustrated here by showing how Sco in Example 1 above would close its $100,000 dividends paid account.
Dr. Cr. AAA 40,000 PTI 10,000 AE&P 50,000 Dividends Paid 100,000
Under the ordering rules, the $40,000 AAA account is considered to be distributed first; the next $10,000 comes from PTI; and the remaining $50,000 comes from AE&P. Since the entire $100,000 is accounted for in the first three categories, none of the OAA has been distributed. Therefore, at the end of the year, the balances of the retained earning accounts would be:
AAA $ -0- PTI -0- AE&P 55,000 OAA 7,000 Total Retained Earnings $62,000
Corporate Accounting for Noncash Distributions
For noncash distributions, a few other matters must be considered. First, PTI may only be distributed in cash, so the ordering rules change. Other issues to be grappled with include valuing the distribution, the effect of liability transfers, and gain or loss recognition. The following example will be used throughout this segment to illustrate how these issues are resolved.
Example 2: Xco, a calendar-year S corporation, distributed land ($40,000 value; $24,000 basis) and a building ($195,000 value; $170,000 basis) to one of its shareholders. The shareholder agreed to assume the $85,000 mortgage outstanding on the property. This was Xco's only distribution for the year. The year-end retained earnings accounts, prior to considering the distribution, are shown below:
AAA $107,000 PTI 4,500 AE&P 40,000 OAA 2,000 Total Retained Earnings $153,500
The corporate accountant must determine which retained earnings accounts are considered to have been distributed, the amount of the distribution and the resulting tax consequences to the corporation. The accountant's task, however, is an easy one since the Code unambiguously lays out the law in this area.
First, since PTI may not be reduced by noncash distributions, the ordering rules change to: AAA, AE&P and OAA;(7) as to the amount of the distribution, use the net value of the property (i.e., value net of liabilities distributed);(8) and finally, any appreciation must be recognized as gain.(9)
For Xco in Example 2 above, the entry to reflect these rules would be:
Dr. Cr. Mortgage Payable 85,000 Land 24,000 Building 170,000 Gain 41,000 Dividend Paid 150,000
This entry was made by going from the known to the unknown. That is, obviously the liability and the assets must be removed from the corporate books, so this is done first. Then the appreciation, computed below, is recognized as gain.
Value Land $ 40,000 Building 195,000 $235,000 Adjusted Basis Land $ 24,000 Building 170,000 $194,000 Gain Recognized $ 41,000
The entry is completed by debiting $150,000 to the "dividends paid" account. Note, $150,000 is the net value of the distribution. (i.e., $235,000 Value - $85,000 liability transfer).
At year end, Xco would close the dividends paid account as follows:
Dr. Cr. AAA 148,000 AE&P 2,000 Dividends Paid 150,000
The $148,000 debit to AAA represents the balance in that account after adjusting it for the gain on distribution. That is, the year-end balance of AAA, which was $107,000 prior to considering the distribution, is increased to $148,000 due to the $41,000 gain recognition. Pursuant to the ordering rules, the other $2,000 of the $150,000 distribution is considered to have come from AE&P.
That leaves the following retained earnings accounts at the end of the year:
AAA $ -0- PTI 4,500 AE&P 38,000 OAA 2,000 Total Retained Earnings $44,500
As illustrated above, the distribution of appreciated property causes gain recognition. This gain will be passed through to the shareholders on a Schedule K-1. However, if loss property is distributed (i.e., the basis exceeds the value of the property), the corporation cannot recognize the loss.(10) Therefore, property distributions are a lose-lose proposition: gains result in taxable income but losses do not result in tax deductions. So, absent a unique situation--such as valuable corporate land desired by a shareholder--the corporation should not distribute property.
Shareholder Accounting for Cash Distributions
At the end of the year, the S corporation will send each shareholder a Schedule K-1 and possibly a Form 1099-DIV (hereinafter referred to as "K-1" and "1099" respectively). The K-1, in addition to showing the shareholder's pro rata of income and expenses, shows the amount of the distribution that did not come from AE&P (for the 1991 K-1 see line 17). The 1099, on the other hand, show the amount of the distribution that did come from AE&P.(11) From these documents, the shareholder's accountant can determine the appropriate journal entry to make for his client's share of the distributions.
To the extent that AE&P has been distributed, dividend income must be recognized. So the amount on the 1099 is recorded as dividend income, and the rest of the distribution (i.e., the amount on the K-1) reduces the shareholder's stock basis; however, if the basis is reduced to zero, any excess distribution must be recognized as a capital gain.(12) The next two examples illustrate these rules.
Example 3: In 1991, Mr. Smith received $2,500 per quarter from Sco. The entire $10,000 distributed to him appeared on his K-1; thus, none of the distribution was from AE&P. If Smith's stock basis at year end--after adjusting for any capital contributions and for the year's net income or loss but before adjusting for distributions--was $7,800, his accountant would make the following journal entry:
Dr. Cr. Cash 10,000 Sco Stock 7,800 Capital Gain 2,200
Note that Smith now has a zero basis in his Sco stock.
Alternatively, if Smith's accountant had been recording the cash received on a quarterly basis, he will have to make a year-end adjustment in accordance with the tax forms. For example, assume that the four quarterly cash distributions had been recorded by crediting dividend income; in this case the year-end adjustment would be:
Dr. Cr. Dividend Income 10,000 Sco Stock 7,800 Capital Gain 2,200
Appropriately, this zeros out the dividend income account.
Example 4: In 1991, Mr. Smith received $2,500 per quarter from Sco. At year end, Sco sent him a 1099 in the amount of $3,700 and a K-1 showing distributions not from AE&P to be $6,300. If Smith's stock basis at year end--after adjusting for any capital contributions and for the year's net income or loss but before adjusting for distribution--was $7,800, his accountant would make the following journal entry:
Dr. Cr. Cash 10,000 Dividend Income 3,700 Sco Stock 6,300
Note that Smith's year-end stock basis is $1,500 (i.e., $7,800 - $6,300).
Alternatively, if his accountant had recorded the $10,000 as dividend income, the following adjusting entry would be required:
Dr. Cr. Dividend Income 6,300 Sco Stock 6,300
Note that this will leave $3,700 in the dividend income account.
Shareholder Accounting for Noncash Distributions
As explained earlier in this article, corporations usually will not make noncash distributions because of the horrible tax consequences. But if such a distribution occurs, the shareholder's accountant will have to look beyond the 1099 and K-1. In other words, the value of the property becomes the shareholder's basis,(13) and corporate liabilities assumed by the shareholder must be accounted for, but this information is not on the 1099 nor is it on the K-1.
Example 5: In 1991 Xco, an S corporation, distributed land and a building to Mr. Smith, a 20% shareholder. His year-end stock basis prior to considering this distribution was $110,000. Smith's 1991 Form 1099 shows $2,700 of dividend income and his 1991 Schedule K-1 shows nondividend distributions of $120,300.
After contacting Xco, Smith's accountant determines that Smith agreed to assume a $59,000 mortgage on the property and that the date of distribution values and adjusted bases ("AB") are:
AB VALUE Land $20,000 $65,000 Building 83,000 117,000 Total $103,000 $182,000
Since the corporation recognized a gain of $79,000 on the distribution (i.e., $182,000 Value - $103,000 AB), Smith's 20% share of this gain (i.e., $79,000 x 20% = $15,800) would be recorded as follows:(14)
Dr. Cr. Xco Stock 15,800 Gain 15,800
The character (capital or ordinary) of this gain is dependent upon whether or not Smith materially participated in the corporate affairs.
The above journal entry increased Smith's stock basis to $125,800. Now, given this adjusted stock basis, the distribution itself can be recorded:
Dr. Cr. Land 65,000 Building 117,000 Mortgage Payable 59,000 Dividend Income 2,700 Xco Stock 120,300
Smith's accountant arrived at this journal entry through various sources. From the 1099 he knew that dividend income was $2,700. The $120,300 reduction in stock basis was dictated by the K-1. The information for the asset bases and the liability assumption was provided by Xco. Note that Smith's stock basis is now $5,500 (i.e., $125,800 - $120,300)
Initially, accounting for S corporation distributions appears to be difficult, but, as explained and illustrated above, these rules can be mastered by anyone with an accounting background. Until this mastery is accomplished, however, it would be prudent to have this article available for quick reference.
1 Internal Revenue Code of 1986 section (hereinafter "IRC sec.") 312 and sec. 1371(c).
2 IRC sec. 1379(b) and IRC of 1954 sec. 1375(d).
3 1991 Form 1120S instructions, page 20. These instructions state that corporations without AE&P need not maintain an OAA account, but it behooves all S corporations to maintain such an account. This is so because of distributions during the "post-termination transition period." Discussion of this topic is beyond the scope of this article--see IRC sec. 1371(e) for more information.
4 IRC sec. 1368(e)(1).
5 IRC sec. 1368(a), (b), (c) and 1379(b). 1991 Form 1120S instructions, page 21.
6 IRC sec. 1368(d)(2) and 1991 Form 1120S instructions, page 20.
7 IRC sec. 1379(b) and prior law's reg. sec. 1.1375-4(b).
8 IRC sec. 301(b) and 1371(a)(1).
9 IRC sec. 311(b) and 1371(a)(1).
10 IRC sec. 311(a) and 1371(a)(1).
11 Instructions for 1991 Forms 1099, 1098, 5498, and W-2G, page 10.
12 IRC sec. 1368(b) and (c); 1991 Shareholder's Instructions for Schedule K-1 (Form 1120S), page 7.
13 IRC sec. 301(d) and 1371(a)(1).
14 IRC sec. 1367(a)(1).
William C. Hood, CPA, JD, MS-taxation, is an associate professor of accounting at Central Michigan University. He has published in numerous professional journals.
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|Author:||Hood, William C.|
|Publication:||The National Public Accountant|
|Date:||Jul 1, 1993|
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