Avoiding taxable distributions when an S corporation does not have AE & P.

Facts: Dan owns all of the outstanding stock in D&E Inc., an S corporation that reports on a calendar-year basis. On Jan. 1, 1997, Dan has stock basis of $5,000. D&E has an accumulated adjustments account (AAA) balance of $3,000 and no accumulated earnings and profits (AE&P) on Jan. 1, 1997. * The company has net income of $24,000 for the first quarter and distributes $12,000 to Dan on April 1. The company experiences several business reversals, and during the last quarter of 1997, its tax adviser projects that the corporation will report a nonseparately stated (i.e., ordinary) loss of $28,000 for the tax year. Issue: How can the S shareholders avoid income recognition from distributions in a loss year?

Analysis

A distribution from an S corporation that does not have AE&P (or has negative AE&P) is a nontaxable return of capital to the extent of the shareholder's stock basis. Distributions in excess of stock basis are capital gains from the deemed disposition of stock. Basis is adjusted for the current year's items of income and gain before the effects of distributions in the current year are determined, i.e., basis is adjusted as follows:

1. increased by passthrough items of income and gain,

2. decreased by distributions (other than distributions of AE&P), and

3. decreased by passthrough items of loss and deduction.

The taxability of the distributions is determined as follows:

Basis in stock:

Basis, beginning of year          5,000
Income and gain items                --
Basis, before distributions
  and loss items                  5,000
Distributions (cannot
  reduce basis below zero)        5,000
Basis, before loss and
  deduction items                    --
Nonseparately stated
  loss (limited to
  basis in stock)
  (basis cannot be
  reduced below zero;
  the unused loss
  carries over to apply
  against basis in
  future years)                      --

Basis, end of year              $    --

Distributions:

First--nontaxable to extent
of stock basis                  $ 5,000

Second--remaining amount
is capital gain                   7,000

Total                           $12,000

The capital gain is reported on Schedule D of Dan's Form 1040.

The shareholders must report the capital gain even though they are unable to deduct all of the passthrough loss because of a lack of basis.

One planning strategy is to have the corporation lend, rather than distribute, funds to shareholders during the year. When the results of the year can be estimated reasonably, the corporation can make distributions to the shareholders, and they can use the distributed funds to pay back the prior loans. The loans should bear a fair rate of interest and be documented fully, and the notes should be executed properly. (The loans need not meet the straight-debt criteria of Sec. 1361(c)(5) (relating to the one-class-of-stock rule), which apply only to loans payable to the shareholders.)

Capital contributions made during the loss year would increase stock basis and would allow larger nontaxable distributions and loss deductions.

Note: The AAA balance is maintained on Schedule M-2 of Form 11205. However, the AAA does not affect the taxability of distributions unless the corporation has AE&P. Since D&E's current-year passthrough items of loss and deduction exceed its passthrough items of income and gain, distributions reduce AAA before it is adjusted for income and loss passthrough items. D&E's AAA is calculated as follows:

Balance, beginning
  of year                      $ 3,000
Distributions
  (to extent of AAA)            (3,000)
Balance, before income
  and loss items                    --
Income and gain items               --
Nonseparately stated loss      (28,000)
Balance, end of year          $(28,000)

Conclusion

The $12,000 distribution to Dan is nontaxable to the extent of $5,000 and is capital gain to the extent of $7,000. For tax years beginning after 1996, basis is increased by income and gain items and decreased by distributions before loss and deduction items are considered. This ensures that a shareholder in an S corporation that does not have AE&P can receive tax-free distributions of at least stock basis at the beginning of the year ($5,000 in this scenario).

Making loans to shareholders instead of making distributions during the year can be an effective tax planning device to ensure that inadvertent taxable distributions are not made.

In this case, if the company had loaned $12,000 to Dan, instead of distributing it to him as a dividend, and the company realized a loss for the entire year, no part of the $12,000 would have been taxable to Dan in 1997. Then, distributions by the company out of earnings in future years could be used by Dan to pay back the loan.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--S Corporations," 11th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 1997.