Maximizing the investment interest expense deduction by electing to distribute AE&P before AAA.Fact: Dick is the sole shareholder of Esscorp and materially participates in its operations. Esscorp's net income is about $50,000 per year after Dick's salary of $125,000. Esscorp has $65,000 of accumulated ac·cu·mu·latev. ac·cu·mu·lat·ed, ac·cu·mu·lat·ing, ac·cu·mu·lates v.tr. To gather or pile up; amass. See Synonyms at gather. v.intr. To mount up; increase. earnings and profits (AE&P) (accumulated when it was a C corporation) and $80,000 of accumulated adjustments account (AAA AAA: see American Automobile Association. (Triple A) A common single-cell battery used in a myriad of electronic devices of all variety. Like its double A (AA) cousin, it provides 1.5 volts of DC power. When used in series, the voltage is multiplied. ). On his personal return, Dick has $30,000 of investment interest expense on debt incurred to carry an investment in land. He does not expect to receive any investment income in the foreseeable fore·see tr.v. fore·saw , fore·seen , fore·see·ing, fore·sees To see or know beforehand: foresaw the rapid increase in unemployment. future. His other itemized deductions Itemized Deduction A deduction from a taxpayer's taxable adjusted gross income that is made up of deductions for money spent on certain goods and services throughout the year. total $15,000. Dick wants to increase his disposable income disposable income Portion of an individual's income over which the recipient has complete discretion. To assess disposable income, it is necessary to determine total income, including not only wages and salaries, interest and dividend payments, and business profits, but also , and he is considering either increasing his salary by $30,000 or having Esscorp distribute an additional $30,000 to him annually. Issue: Can an S corporation generate investment income to offset investment interest expense by distributing AE&P? Analysis Investment interest expense generally is deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). only to the extent of investment income, which includes portfolio income (dividends). If Esscorp distributed AE&P to Dick, those distributions would be dividends. Thus, distributions of AE&P under these circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact. 2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or could permit deduction deduction, in logic, form of inference such that the conclusion must be true if the premises are true. For example, if we know that all men have two legs and that John is a man, it is then logical to deduce that John has two legs. of Dicks investment interest expense. Generally. AE&P is distributed after all of the AAA has been dlstr,lbuted, but an S corporation can elect to distribute AE&P before AAA. To increase Dick's disposable income, Esscorp can increase his salary, distribute AAA to him or elect to distribute AE&P to him. The results of the three alternatives on Dick's personal return are summarized as follows:
Increase Distribute Distribute
salary AAA AE&P
Salary $155,000 $125,000 $125,000
Passthrough 20,000 50,000 50,000
Dividend -- -- 30,000
Investment interest expense -- -- (30,000)
Other itemized deductions (15,000) (15,000) (15,000)
Taxable income
before exemptions $160,000 $160,000 $160,000
The AAA balance at the end of the year under each alternative is as follows:
Increase Distribute Distribute
salary AAA AE&P
Balance, beginning of year $ 80,000 $ 80,000 $ 80,000
Adjustment for income 20,000 50,000 50,000
Balance, before distributions 100,000 130,000 130,000
Distributions -- (30,000) --
Balance, end of year $100,000 $100,000 $130,000
The three choices produce the same tax results for Dick in the current year, except that by electing to distribute AE&P, the investment interest expense has been used, and Esscorp's AE&P balance has been reduced by $30,000. The AAA, however, remains at $130,000. Thus, the election to distribute AE&P before AAA can be an effective tax planning Tax planning Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. device that shows the shareholder to use deductions for investment interest that may otherwise have to be carried over and may never be used because of a lack of investment income. To the extent dividend income can be offset with otherwise unused investment interest expense, the dividend will have no current tax effect. Also, electing to distribute AE&P before AAA and distributing all of the AE&P eliminates the risk that the corporation will be subject to tax on passive income and the risk that the S election will terminate because excess net passive income was received for three consecutive tax years. Conclusion In this case, the corporation could distribute $30,000 of AE&P at no tax cost, because it would allow the deduction of the $30,000 investment interest expense. This would then leave $30,000 in the AAA account that could be distributed tax-free tax-free adj. Not subject to taxation; tax-exempt. tax-free Adjective not needing to have tax paid on it: a tax-free lump sum Adj. 1. at a later date. If this pattern continued, Esscorp could distribute its AE&P at the rate of $30,000 per year and thereby remove it without causing Dick to incur To become subject to and liable for; to have liabilities imposed by act or operation of law. Expenses are incurred, for example, when the legal obligation to pay them arises. An individual incurs a liability when a money judgment is rendered against him or her by a court. additional tax at the individual level. |
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