New planning opportunities for distributions from S corporations.

Distributions from an S corporation may or may not be taxable to a shareholder, depending on the following factors: The shareholder's basis in the S stock (as defined by Sec. 1367), the balance in the S corporation's accumulated adjustments account (AAA) (as computed under Sec. 1368), and whether or not the S corporation has accumulated earnings and profits (AE&P) from a prior C corporation year, in which case Sec. 1368(c) applies.

Secs. 1366 and 1368, amended by the Small Business Job Protection Act of 1996 (SBJPA), contain specific ordering rules for the basic computations required of a shareholder to determine whether a distribution is taxable, and if it is taxable, whether it is from E&P and therefore taxable as a dividend or from AAA and taxable as capital gain. Due to the new provisions, it is possible that a shareholder will receive a tax-free distribution in excess of his tax basis in certain circumstances. In addition, the new provisions also make it possible for an S corporation with AEAP to make a distribution in excess of its AAA that will not result in a taxable dividend to the shareholder.

The first of these new amendments provides that the adjustment for distribution made by an S corporation during a loss year is taken into account before applying the loss limitations for that year (SBJPA) Section 1309(a)(1) and (2), amending Secs. 1366(d)(1)(A) and 1368(d). The House Ways and Means Committee Report states: "Thus, distribution during a year reduce the adjusted basis for purposes of determining the allowable loss for the year, but the loss for a year does not reduce the adjusted basis for purposes of determining the tax status of the distributions made during that year."

The second amendment provides that for S corporations with AE&P, net negative adjustments (i.e., the excess of losses and deductions over income) for the tax year are not taken into account when calculating the amount in the AAA for purposes of determining the tax treatment of distributions made during the year (SBJPA Section 1309(b), adding Sec. 1368(e)(1)(C)). Both amendments apply to tax years beginning after 1996.

The House Report has two examples showing the application of these new provisions. Using the facts and numbers from the two committee report examples, the schedules in Examples 1 and 2 on page 735 compare the results of distributions to shareholder X under both the new law (for tax years beginning after 1996) and current law.