S corporation AAAs and C corporation AE&Ps.

The proposed Sec. 1368 regulations released June 9, 1992 for S distributions apparently might require combining positive and negative accumulated adjustment accounts (AAAs) of constituent S corporations after a merger of the corporations (Prop. Regs. Sec. 1.1368-2(d)(2)). Previous guidance under Sec. 1368 included Letter Ruling 9009.051, which concluded that the positive AAAs of constituent S corporations in a statutory merger should be combined. However, Letter Ruling 9046036 concluded that the positive and negative AAAs of constituent S corporations would be segregated after a merger, citing Sec. 381(c)(2). Prop. Regs. Sec. 1.1368-2(d)(2) refers to a merger of the AAAs of a distributor or transferor corporation in a liquidation or reorganization into the AAA of an acquiring S corporation. The text of the regulation does not specifically address the situation in which one constituent corporation held a negative AAA and the other positive AAA, nor do the examples in Prop. Regs. Sec. 1.13683.

For subchapter C purposes, Sec. 381(c)(2)(B) segregates the accumulated earnings and profits (AE&P) deficit of one constituent corporation from the positive AE&P of the other constituent corporation until the deficit AE&P has been offset by earnings and profits accumulated after the corporate combination. This provision evidently codifies the case of Phipps, 336 US 401 (1949), which held that a parent corporation could not offset its positive AE&P by the AE&P deficit of a subsidiary corporation that had been liquidated into the corporation under the nontaxable controlled subsidiary liquidation provision. The objective of Sec. 381(c)(2)(B) is to treat distributions as taxable dividends by a C corporation so long as they can be sourced to the positive AE&P account.

The IRS issued Rev. Rul. 79-52 under old subchapter S law. The ruling provided that the surviving S corporation after a statutory merger could make postmerger nondividend distributions under old Sec. 1375(d) from the previously taxed income (PTI) of pertinent shareholders and under old Sec. 1375(f) from the undistributed taxable income (UTI) of the merging S corporation.

The proposed Sec. 1368 regulations otherwise conform to subchapter C analogies. Thus, Prop. Regs. Sec. 1.1368-2(d)(3)follows Sec. 319.(h) and Regs. Sec. 1.312.-10(a) in allocating the AAA in a corporate division based on the fair market value of the assets held in each resulting corporation. This treatment is consistent with Letter Ruling 819,8041, which concluded that the PTI of an old shareholder whose stock in an old law S corporation was retired in a Sec. 355 transaction could be applied to distributions from the controlled corporation whose stock was received by the shareholder in the corporate division.

In like manner, Prop. Regs. Sec. 1.1368-2(d)(1) allocates AAA in a stock redemption in the ratios that the shares redeemed bear to the total shares outstanding before the redemption, consistent with Sec. 312(n117), effective for post-July 1984 distributions by a C corporation.

The positive AAA of one S corporation should be segregated from the negative AAA of another S corporation after a combination of S corporations in order to assure nondividend treatment of postmerger distributions from the positive AAA, consistent with Sec. 381(c)(2)(B) which treats distributions from the segregated positive AE&P as taxable dividends. From Laura M. MacDonough, CPA, Cincinnati, Ohio