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Final regs. clarify basis and distribution issues, but leave unanswered questions.

EXECUTIVE SUMMARY

The first part of this two-part article, in the May issue, examined the final regulations under Sec. 1367, the election of an S corporation split tax year, stock and debt basis issues and adjustments, and accumulated adjustments accounts. In Part II, below, the many examples presented elucidate the workings of the Sec. 1368 final regulations and analyze the effects of distributions to shareholders on the corporation's accumulated adjustments account, accumulated earnings and profits and previously taxed income. Various bypass elections and planning opportunities are also discussed.

Distributions

Sec. 1368 provides two sets of rules for distributions to shareholders; which set applies depends on whether the S corporation has accumulated earnings and profits (AE&P). In addition, Regs. Sec. 1.1368-1 provides fairly complex rules regarding certain elections, noncash property distributions and the split-tax-year election.

S Corporations Without AE&P

Under Sec. 1368(b) (1), a shareholder who receives a distribution from an S corporation with no AE&P treats it as a tax-free return of capital to the extent it does not exceed his adjusted stock basis; any excess over basis is treated as gain from the sale or exchange of property. As was discussed in Part I, a shareholder adds to basis positive adjustments for income items and reduces it by negative adjustments for expenses and losses; a spillover rule applies when distributions allocated to a given share exceed basis, but the shareholder owns other shares with sufficient basis to absorb the distribution. Apparently, the Code's treatment of distributions in the absence of AE&P is sufficiently straightforward that the IRS saw no need for elaboration in the regulations(24); however, as is discussed below, additional guidance on proper (1) corporate accounting for distributions of depreciated property and (2) treatment of distributions of previously taxed income (PTI) accounts to shareholders would have been welcome.

S Corporations With AE&P

Sec. 1368(c) prescribes the following treatment for distributions from an S corporation having AE&P:

[] The portion of the distribution that does not exceed the corporation's accumulated adjustments account (AAA) is treated as provided in Sec. 1368(b) (nontaxable to the extent of basis, and the excess is capital gain).

[] If the corporation has both AE&P and PTI, according to Regs. Sec. 1.1368-1 (d) (2), the portion of the distribution remaining after the AAA is treated as a distribution of AAA under Sec. 1368(b) to the extent it is a distribution of money and does not exceed the shareholder's net share immediately before the distribution of the PTI. (PTI is defined in pre-Subchapter S Revision Act of 1982 (SSRA) Sec.1375(d) (2).)

[] Any remaining portion of the distribution is treated as a dividend to the extent it does not exceed the corporation's AE&P.

[] Any remaining portion of the distribution is treated under Sec. 1368 (b).

The Code and regulations are silent as to the corporate accounting for distributions that exceed E&P.(25)

The AAA is the central focus for any distribution from an S corporation with AE&P, because it provides a cushion from dividend treatment. The AAA may also be important for distributions in the post-termination transition period should the S corporation later terminate its S election.

Passive investment income: S corporations with AE&P from C corporation years are subject to tax under Sec. 1375(a) when passive investment income (PII) exceeds 25% of gross receipts.(26) In general, an S corporation cannot accumulate E&P after its S election takes effect, with two exceptions:

[] A corporation with an S election in effect before its 1983 tax year could accumulate E&P under the S corporation rules as they existed prior to the SSRA.

[] An S corporation that acquires a target corporation in a tax-free reorganization or liquidation obtains any E&P accumulated by the target.

Pre-SSRA Sec. 1377 required S corporations to calculate current E&P. Although most of an S corporation's current E&P were usually distributed as actual or deemed dividends, some items might not have been (e.g., depreciation in excess of straight line and tax-exempt income); E&P accumulated at the end of the 1982 tax year under pre-SSRA law remained intact until distributed as dividends. The SSRA removed the need for S corporations to compute current E&P.

The enactment of Secs. 1375 (to tax PII) and 1362 (to terminate the S election for PII) only affected S corporations that had AE&P as C corporations; AE&P generated under pre-SSRA law were disregarded. Although both types of AE&P are treated as dividends when they are actually distributed, the SSRA offered no guidance to distinguishing between the two types of accumulations if a corporation had been both a C and an S corporation under pre-SSRA law.

Example 8: P was a C corporation from its date of incorporation until its tax year ending Dec. 31, 1978, when it had $50,000 of AE&P. Between 1979 and 1982 (i.e., pre-SSRA), it accumulated $150,000 more E&R In 1996, P expects to generate PII in excess of 25% of its gross receipts. As of Jan. 1, 1996, P's AE&P remained at $200,000. P's shareholders are willing to report dividend income to avoid the PII tax, but would like to limit the dividend income to $50,000. Absent regulatory guidance, P would need to distribute its entire $200,000 AE&P balance to ensure that it had distributed all of its C AE&P.

Regs. Sec. 1.1368-1 (f) (2) (iii) provides that when a corporation has both C and pre-SRA AE&P, any dividend distribution is deemed to come first from C E&P. Thus, a corporation that manages its distributions carefully can limit its dividend distributions to its C E&P.

Example 9: The facts are the same as in Example 8. P has no PTI and a zero-balance AAA. If P distributes $50,000 in 1996, it will have no C AE&P as of the end of that year and will permanently avoid the PII tax and potential termination of its S election.

Distributions of PTI: Under pre-SSRA law, S corporations did not pass through specific classes of income to shareholders. As under current law, the corporation was exempt from income tax, and shareholders included actual distributions of current income as dividends when received. If the corporation's distributions to its shareholders were less than its taxable income, pre-SSRA Sec. 1373(b) treated the difference as a dividend paid on the last day of the corporation's tax year, in proportion to each shareholder's percentage ownership of stock on that day; the deemed dividend was called "undistributed taxable income" (UTI).

Pre-SSRA Sec. 1371(f) allowed each shareholder a 2 1/2-month grace period after the close of the corporation's tax year to withdraw UTI. Pre-SSRA Sec. 1375(d) provided that if a shareholder did not withdraw his portion of UTI within that period, it was transferred to an account called "undistributed taxable income previously taxed to shareholders" (more commonly known as PTI). Each UTI and PTI account was personal to the shareholder who had reported the deemed dividend. Only cash distributions reduced PTI. A distribution came from PTI only if total S corporation distributions in any tax year exceeded that year's current E&P. Because a corporation would not normally determine its current E&P until after a year had closed, it was almost impossible to accurately predict whether a distribution was from current E&P or the recipient's PTI account. These awkward distribution rules were changed by the SSRA, which adopted the concept of the AAA. However, the SSRA recognized the existence of PTI accounts that had accumulated through the end of 1982 tax years, and Section 2 enacted Sec. 1379(c) to provide that PTI accounts could be withdrawn in post-1982 tax years. However, the SSRA offered no operating rules to determine the ordering of PTI, as opposed to the AAA, AE&P, and other corporate equity accounts.

Under pre-SSRA Sec. 1377(a), a distribution of PTI was treated as a reduction of shareholder basis. If a shareholder's basis was less than his PTI balance (a rare situation), the distribution was treated as a gain from the sale of stock. Thus, a distribution from PTI had the same effect on a shareholder as a distribution from AAA. However, there are two important distinctions between PTI and AAA:

[] The AAA, a corporate-level account, is transferable to new shareholders. By contrast, the PTI account may be distributed only to the shareholder who reported the deemed dividend in pre-1983 years.

[] The AAA account survives during the post-termination transition period (generally, one year after termination of the S election); a PTI account is extinguished immediately on S termination.

Given these distinctions, S corporations should make distributions from PTI accounts, not from the AAA, if a choice exists. In several issues of Publication 589, Tax Information on S Corporations, the IRS had (arbitrarily) stated that distributions come from a shareholder's PTI after the AAA has been exhausted. Regs. Sec. 1.1368-l(d)(2) adopts this same ordering rule, but it applies only to corporations with AE&P.

[] Observation: The Regs. Sec. 1.1368-1 (d) (2) ordering rule contains two apparent flaws:

1. Only distributions of money that exceed the corporation's AAA reduce PTI. This was the rule under pre-SSRA law, because noncash property distributions could escape corporate taxation under Sec. 311 (a), the General Utilities rule. After the Tax Reform Act of 1986's enactment of Sec. 311 (b), all corporations, including S corporations, have to recognize gain on nonliquidating distributions of noncash property. Thus, there is no longer a reason to distinguish between cash and noncash distributions in this context.

2. There is no guidance as to the distribution of PTI by an S corporation without AE&P. While there are likely to be few situations in which this has material impact, because all distributions from such corporations are treated as a return of capital to the extent of a shareholder's stock basis, and capital gain thereafter, it would be helpful to a corporation contemplating a merger or termination of its S election.

Distribution Elections

In most cases, the general ordering rule for distributions works to the shareholders' advantage. The income shareholders are required to report on their tax returns is reflected in AAA and adds to their stock bases; thus, distributions from the AAA are tax-free returns of capital.

AAA bypass election: There are times when shareholders would benefit from voluntarily taking a dividend and leaving the AAA intact. Sec. 1368(e) (3) allows an S corporation, with the consent of all shareholders, to elect to distribute AE&P before the AAA (AAA bypass election). The most likely benefit would occur when the corporation has C AE&P and PII in excess of 25% of its gross receipts. By distributing all AE&P (or at least the C portion) before the end of the year in which the PII ceiling would be exceeded, the corporation can avoid both the PII tax and possible termination of the S election.

The AAA bypass election may also be useful if a shareholder has excess investment interest, or is temporarily in a low tax bracket, and cannot foresee being able to receive AE&P with lower tax consequences. Alternatively, the AAA bypass election allows a shareholder to receive his PTI account; by distributing PTI, the corporation preserves its AAA.

As was discussed, this election is useful if there is (1) an anticipated change in ownership or (2) a termination of the S election.

Regs. Sec. 1.1368-1 (f) (2) (i) offers useful guidance on the AAA bypass election; in most cases, the election requires distributions to be taken first from E&P. However, under Regs. Sec. 1.1368-1 (f) (2) (ii), if a shareholder has a PTI account, a distribution is first deemed to have come from it, then from E&P, then from the AAA. The corporation can use the election to rid itself of PTI without adverse consequences to a shareholder.

Example 10: OLM has been a calendar-year S corporation since 1975; L is its sole shareholder. In 1996, OLM has a $50,000 AAA (including all anticipated adjustments for 1996) and $10,000 AE&P. L has a $15,000 PTI account from pre-1983 tax years. L is nearing retirement age and would like to begin transferring some of his stock to his son, M L's will leaves all of his stock to M.

Before considering any 1996 distributions, L has a $65,000 cushion ($50,000 AAA + $15,000 PTI) before distributions would be treated as dividends. If M were to receive all of the stock in OLM, however, his cushion would be only $50,000, because M has no PTI account.

L plans to take a $15,000 distribution from OLM. Under the general ordering rules, the distribution would reduce OLM's AAA to $35,000, leaving the PTI and AE&P intact; L would have a $50,000 cushion ($35,000 AAA + $15,000 PTI) after receiving the distribution. However, only the $35,000 AAA would be available to M L should thus consider taking the $15,000 distribution before giving any of his shares to M, and OLM should make an AAA bypass election. After the distribution, OLM's $50,000 AAA balance will be intact, giving L or M a $50,000 AAA cushion before any distribution would be treated as a dividend.

* Observation: When a corporation elects to bypass AAA, Regs. Sec. 1.1368-1 (f) (2) (ii) states that distributions are first made from PTI accounts, but does not require that such distributions be made in cash. Thus, a distribution of property, which would not come from PTI absent a bypass election, could come from PTI if the corporation made an AAA bypass election, a dichotomy that makes little sense.

There are also disadvantages to making an AAA bypass election in favor of PTI. First, not all shareholders may have PTI accounts; an election to bypass AAA would cause distributions to be tax-free returns of capital to shareholders with PTI accounts. A shareholder without a PTI account would be treated as receiving a dividend from the corporation's AE&P.

Example 11: The facts are the same as in Example 10. L gives 25% of his shares to M, and OLM subsequently makes a distribution of $15,000 to L and $5,000 to M. If OLM made an AAA bypass election for the year of the distribution, L would receive $15,000 from his PTI account as a return of capital; Ms distribution would be a dividend from AE&P.

A corporation that has both shareholders with and without PTI accounts might consider making distributions to the former, so that no shareholder would report a dividend, and the AAA would remain intact. However, unequal distributions from an S corporation raise the issue whether the corporation has more than one class of stock.(27)

Under Regs. Sec. 1.1361-1 (1) (2) (i), distributions that differ in timing or amount create a second class of stock only if there is a binding agreement with a principal purpose to circumvent the single class of stock rule. However, disproportionate distributions not subject to such an agreement are to be "given appropriate tax effect in accordance with the facts and circumstances."

Example 12: The facts are the same as in Example 11, except that OLM distributed $15,000 to L and zero to M. The distribution would be disproportionate across all shares, and could raise the following issues:

1. L and M entered into an agreement under which the rights of each shareholder to distribution and liquidation proceeds were not equal among all shares; thus, OLM may have two classes of stock.

2. If there is only a single class of stock, the "distribution" to L could be a loan, potentially subjecting both OLM and L to the Sec. 7872 imputed interest rules.

3. M constructively received a distribution of $5,000 and loaned it back to OLM. M may be required to report the distribution as ordinary income, because OLM elected to bypass its AAA.

4. M constructively received a distribution of $5,000 and contributed it back to OLM's capital. A disproportionate contribution to capital may be treated as a gift from the contributor to other shareholders.

The first possibility would terminate OLM s S election. The fourth is theoretically possible, but it treats the shareholder (i.e., the donee) as the donor of a forgone dividend. This "appropriate tax effect" certainly does not reflect the intent of the parties in this situation.

The second and third possibilities trigger compliance burdens under Sec. 7872. None of the possibilities allow OLM to achieve the desired objective of distributing the PTI account to L, while avoiding dividend treatment to M.

Fortunately, there is a window of opportunity during which L can accomplish the objective desired in Examples 10-12: OLM could make the distribution to L before M becomes a shareholder. Alternatively, OLM could base its distributions on the weighted average of shareholdings during the year of the distribution, or on the weighted average of shareholdings during the tax year prior to the distribution, without raising the possibility of a second class of stock.(28)

Example 13: The facts are the same as in Example 12. If OLM based distributions on the weighted average of each shareholder's ownership in 1995, when L was the only shareholder, the disproportionate distribution would create none of the problems encountered in Example 12. Thus, in 1995 or 1996, OLM could make a $15,000 distribution to L, make a proper AAA bypass election, make no other distributions and not incur any disproportionate distribution problems; the AAA would remain intact.

The PTI bypass election: In some situations, a corporation with both PTI and AE&P may want to distribute AE&P first. An AAA bypass election will not accomplish this, unless the corporation makes sufficient distributions to exhaust both PTI and AE&P. Regs. Sec. 1.1368-1 (f) (2) and (4) allow the corporation to bypass PTI and the AAA, so that a distribution is first from AE&P.

Example 14: X an S corporation, has a $45,000 AAA, including anticipated adjustments for current-year's income and deductions. X also has $25,000 in PTI accounts and $5,000 C AE&P. X is facing PII problems and would like to eliminate its AE&P. Currently, neither X nor its shareholders are concerned with PTI. If X elects to bypass AAA, it could make a $30,000 distribution and eliminate both its PTI accounts and its AE&P. If X elected to bypass AAA and PTI, it could distribute $5,000 and eliminate its AE&P. Any distribution in excess of $5,000 would then come from the AAA.

If a corporation has both C AE&P and pre-SSRA AE&P, Regs. Sec. 1.1368-l (f) (2) (iii) does not limit the dividend to the corporation's C AE&P; thus, if a corporation elects to bypass AAA, all distributions during the election year will be dividends to the extent of the combined total of the corporation's C AE&P and pre-SSRA S AE&P. C AE&P are deemed distributed first.

Example 15: XYZ, an S corporation, has $50,000 C AE&P and $150,000 pre-SSRA AE&P. XYZ distributes $100,000 to its shareholders in 1996. If XYZ elects to bypass AAA, it will eliminate all of its C AE&P; the entire distribution will be treated as a dividend, because XYZ's total AE&P exceed the distribution.

The deemed dividend election: Regs. Sec. 1.1368-1 (f) ((3) provides for a deemed dividend election, allowing an S corporation and its shareholders to act as though the corporation had distributed (and the shareholders received) all of its C AE&P on the last day of the tax year. The election is extremely useful for corporations with undistributed C AE&P and excess PII. The deemed dividend is treated as if it had been contributed to capital; the deemed contribution to capital adds to the shareholders' stock bases on the last day of the corporation's tax year.(29)

Example 16: P is a calendar-year S corporation. In February 1996, P's tax adviser discovered that P's PII exceeded 25% of its gross receipts in 1995. P also had $50,000 C AK&R If P had distributed at least $50,000 to its shareholders during 1995, it could have elected, with the consent of all shareholders, to bypass AAA, so that the distributions would exhaust the C AK&R If P had distributed less than $50,000, however, the election to bypass AAA would not exhaust the C AE&P, and P would be faced with PII tax or the potential loss of its S election.

Regs. Sec. 1.1368-1 (f) (3) provides that the amount of the distribution taken into account under the deemed dividend election is limited to the corporation's C AE&P, less any amounts actually distributed to the shareholders for the tax year in question. The deemed dividend election also gives rise to an AAA bypass election with respect to any distributions actually made during the year.

Example 17: The facts are the same as in Example 16, but P distributed $35,000 in 1995. A deemed dividend election would have the following effects:

1. P would have bypassed AAA with respect to the $35,000 distributed. 2. P would have constructively distributed $15,000 to its shareholders on the last day of 1995. 3. The shareholders would have constructively contributed $15,000 to P's capital on the last day of 1995.

* Planning opportunity: A deemed dividend election is most likely to be useful when the corporation needs to avoid PII, and also if shareholders have losses in excess of basis and do not foresee being able to use them. The deemed dividend election would give the shareholders basis, as of the last day of the tax year, and would allow them to deduct additional losses equal to the deemed dividend.

The deemed dividend election does not give rise to an election to bypass PTI.(30) Thus, a corporation could distribute PTI as part of a succession plan, and then make a deemed dividend election to eliminate C AE&P.

Effect of election to split year: As was discussed in Part I of this article, if there is a complete termination of a shareholder's interest, or a substantial disposition of stock in a tax year, the S corporation may account for its income and other items as if the tax year consisted of two separate years. Under Regs. Sec. 1.1368-1 (f) (5) (iv), a split-year election is disregarded for bypass and deemed dividend election purposes, an inconsistency that seems unwarranted, for the following reasons:

[] Regs. Sec. 1.1368-1 (g) (1) states that "this section applies as if the taxable year consisted of separate taxable years...." As the rules applicable to bypass elections are all contained in Regs. Sec. 1.1368-1 (i.e., "this section"), the split-year election should apply to bypass and deemed dividend elections.

[] Regs. Sec. 1.1368-1 (g) (2) (ii) provides that a corporation electing to split tax years must treat the tax year as separate ta-x years in making adjustments to the AAA, E&P and basis.

* Observation: The ban on making bypass or deemed dividend elections for different portions of a split year precludes negotiation between a buyer and seller for the disposition of the corporation's E&P in the year of sale. Thus, a seller of the stock cannot agree to take the AE&P before a transfer of shares via a deemed dividend election; however, this result can be accomplished by having the buyer and seller agree to a bypass election, and having the corporation distribute all of its AE&P before the sale.

Example 18: S has agreed to sell all of his shares in X a calendar-year S corporation with $50,000 C AE&P, to B, on Apr. 1, 1997. S will take all of X's AK&R Thus, X would want to elect to split its tax year on Apr. 1, 1997, and make a deemed dividend election on that date, but Regs. Sec. 1.1368-1 (g) (2) (ii) forbids it. However, the parties could accomplish this result by other means: 1. X distributes a note to S by Apr. 1, 1997, and makes an AAA bypass election for 1997. B will not be subject to dividend treatment on any distribution from X. Under Regs. Sec. 1.316 2(b), AE&P are not apportioned among distributions, but are exhausted in the chronological order of distributions made during the year. B would then purchase the stock and the note from S.(31) 2. Because a bypass election will not apply solely to the first portion of the year, and would eventually bear the burden of dividend treatment, the parties could negotiate a reduced price.

* Caution: In Waterman Steamship Corp.,(32) a C corporation target distributed a promissory note to the selling shareholder immediately before being sold. The purchaser then advanced funds to the target to enable it to pay the note, a pre-sale dividend. The IRS (and ultimately, the Fifth Circuit) treated the dividend as part of the sale, disallowing a dividends-received deduction (DRD). In Waterman, the seller could take advantage of the DRD, which yielded better results than a gain from the sale of stock; in Example 18, however, there would be no DRD, because S is an individual. However, the IRS could apply Waterman Steamship to the sale of X's stock, if the arrangement between B and S appeared to present a tax avoidance scheme. Currently, no cases have applied that holding to the sale of an S corporation's stock. Because a DRD would never apply to a seller of S stock, the IRS would have little incentive to apply the Waterman rationale.

Similarly, a buyer of S corporation stock might want the seller to exhaust his PTI account in the year of sale; an AAA bypass election for the portion of the tax year the seller owned the stock would be ideal, but not attainable. Therefore, sophisticated buyers should pursue one of the actions suggested in Example 18; less-informed buyers will lose a valuable opportunity to limit taxes.

Procedural aspects of bypass elections: Regs. Sec. 1. 1368-1 (f) (5) (iii) provides that a bypass election is made for a distribution by attaching a statement of election to a timely filed original or amended return, signed by a corporate officer, under penalties of perjury, and consented to by all shareholders who received distributions during the year. While Sec. 1368(e) (3) does not provide that the election is irrevocable, Regs. Sec. 1.1368-1 (f) (5) (iv) so states (with no apparent authority).

* Observation: The IRS issued liberalized final regulations defining PII(33); the preamble specifically allowed the revocation of a bypass election on an amended return, and the IRS has permitted revocations of bypass elections in these circumstances.(34) Therefore, it appears that the election is revocable, but only when an S corporation seeks retroactive application of the PII rules.

Special Distribution Situations

Distributions of noncash property: The S corporation rules do not explain the treatment of noncash property, other than to treat all cash and property distributions uniformly; thus, with respect to the general and elective ordering rules, property and cash distributions are treated similarly. However, distributions of noncash property pose two problems: ( 1 ) the corporation and shareholders must determine the amount of the distribution and (2) the corporation must determine the appropriate tax treatment of any gain or loss on the distribution.

The C corporation rules address both of these problems, since the S corporation rules are silent. Under Sec. 1371 (a) (1), an S corporation is subject to the C corporation rules, which are as follows:

[] Under Sec. 30 1 (b) ( 1) , the shareholder must take a distribution into account at its fair market value (FMV) on the date of the distribution.

[] Under Sec. 311 (b) ( 1 ), if the property's FMV exceeds its basis, the corporation must recognize gain.

[] Under Sec. 311(a), if the property's basis exceeds its FMV, the corporation will not recognize loss.

The Code offers no guidance on the proper corporate-level accounting treatment for a distribution of property. Obviously, little guidance is needed if property is distributed with an FMV in excess of predistribution basis--the corporation recognizes gain as if the property were sold to a shareholder. Generally, the character of the gain is determined by the property's character in the corporation's hands; thus, the corporation would recognize ordinary income, Sec. 1231 gain, capital gain, or any appropriate combination thereof.(35) The gain recognized would add to the corporation's AAA, either as part of the corporation's ordinary income or as a separately stated item. The corporation would then combine the FMV of the property distribution with all other distributions of cash and property made during the year, and determine the hierarchy.

By contrast, if the distributed property has a basis in excess of its FMV on the date of distribution, the corporation recognizes no loss. The amount distributed (and the shareholder's basis in the property received) is the FMV. The shareholder would receive no benefit from the corporation's disallowed loss in the event of a future sale of the property at a gain, as would be the case if the loss were disallowed under Sec. 267(a) (1). There is a need for guidance here on the proper corporate-level accounting treatment.

Regs. Sec. 1.1368-2 (c) provides a sensible rule that is overly constrained; the corporation must reduce its AAA by the FMV of the property distributed. This rule is appropriate, in that it reduces the AAA by no more than the shareholder's new basis in the property distributed, but it only applies if the corporation meets all of the following:

[] Has AE&P at the end of the tax year of the distribution (Regs. Secs. 1.1368-2(c) (1) and -1 (d) (1)).

[] Makes both cash and property distributions (Regs. Sec. 1.1368-2(c)(1)(i) and (ii)).

[] The total distribution exceeds the amount of the corporation's AAA properly allocable to it (Regs. Sec. 1.1368-2(c) (1) (iii)).

The regulations are silent as to the proper corporate-level accounting treatment if these three conditions are not met, but the Code is clear; Secs. 1368(e) (1) (A) and 1367(b) (2) (A) require the AAA to be reduced for any distribution not included in the shareholder's gross income. Thus, the shareholder's basis, and the AAA, are reduced for the FMV of noncash distributions.

* Observation: Regs. Sec. 1.1368-2(c) (1) would provide better guidance on the distribution of loss property if it merely stated that the corporation reduces the AAA by the FMV of the property distributed. Any loss disallowed by reason of Sec. 311 (a) should most likely be posted to the OAA, although there is no guidance. If Regs. Sec. 1.1368-2(c) (1) stated this, neither the shareholder who receives the loss property nor any shareholder who receives a distribution in the future would be penalized by the combination of the step-down in basis and excessive reduction of the AAA.

Adjustment for stock redemptions: Under Regs. Sec. 1.1368-2(d) (1), a redemption by an S corporation is subject to the C corporation tests under Secs. 302 and 303 in determining exchange or dividend treatment; a redemption that fails to meet one of those exchange tests is treated as a dividend. Shareholders in C corporations with current E&P or AE&P are well served by structuring a redemption as an exchange, for three reasons: 1. The shareholder recovers basis in an exchange, but is taxed on the entire proceeds of a dividend. 2. Any gain in excess of basis on an exchange of stock is usually capital gain, while a dividend is ordinary income. 3. A shareholder whose stock basis exceeds the proceeds received from the corporation may recognize loss if the transaction is an exchange (subject to certain related-party disallowance rules); if the redemption is not an exchange, the entire proceeds are treated as ordinary income.

If a shareholder receives proceeds from an S corporation stock redemption, there may be little (if any) preference for exchange treatment, especially if the corporation has significant AAA and little or no AE&P. The shareholder would recover basis and report any excess as gain from the sale of stock. In some cases, when a shareholder has less than all of his stock redeemed, a distribution that fails all exchange tests may be preferred. If a portion of the stock is redeemed in an exchange, basis must be allocated between the specific shares redeemed and those retained; by contrast, a distribution is tax free to the extent of the shareholder's basis in shares.

When an S corporation has little or no AAA, and significant AE&P, the shareholder whose stock is redeemed, as well as the continuing shareholders, will want to employ the same strategies as if the corporation were a C corporation. A redemption that does not pass one of the sale or exchange tests will be combined with other distributions made by the corporation during the tax year. The corporation's AAA must be allocated proportionately to all distributions made during the year. If the total distributions, including the redemption, exceed the AAA, the excess portions of the distributions must be allocated to AE&P, in chronological order. If the corporation makes an AAA bypass election in the year of a redemption, the AE&P must first be allocated to the distributions in chronological order. The AAA would then be allocated to the distributions in excess of AE&P, in proportion to the total amount of each.

The allocations of AAA and AE&P are different if the redemption qualifies as a sale or exchange. Sec. 1368(e) (1) (B) requires that the AAA be reduced in proportion to the percentage of outstanding shares redeemed, but there is no Code guidance on how to calculate the appropriate AAA balance at the time of a redemption.

Regs. Sec. 1.1368-2(a) (4) (iv) treats a redemption as the last event of the corporation's tax year. Accordingly, the AAA is first adjusted for income, second for losses, deductions and other expenses, third for nonredemption ("ordinary") distributions and finally, for redemptions.

Example 19: XYZ is a calendar-year S corporation. X a shareholder, had a basis of $42,000 in his XYZ stock at the beginning of 1997. XYZ's AAA at the end of 1996 (before reduction for distributions) was $120,000 ($50,769 beginning balance + $69,231 of 1997 income). XYZ's AE&P at the beginning of 1997 was $16,000.

At the beginning of 1997, X held 50 shares of XYZ (50% of the outstanding stock). On Aug. 7, 1997 (after exactly 60% of the year had elapsed), XYZ redeemed 25 of X's shares for $50,000. The redemption reduced X's ownership to 1/3 (25/75). X's share of XYZ's net income for the current year was $29,908 ( [ (0.5 X 0.6) + (0.33 X 0.4)] X $69,231).

Later in 1997, XYZ distributed $100,000 to all the shareholders, excluding the amount distributed in the redemption. If the redemption did not qualify as an exchange under Sec. 302 or 303, the AAA and AE&P would be allocated as though all the distributions were ordinary.(36) XYZ does not elect to terminate its tax year under Regs. Sec. 1.1368-1 (g). If the redemption qualifies as a substantially disproportionate distribution under Sec. 302 (b) (2), the effect of XYZ's 1997 activity on its AAA would be:

Beginning AAA balance $ 50,769 1997 income 69,231 Less: ordinary distributions (100,000) Balance before redemption $ 20,000 Reduction for redemption (25%, corresponding to percentage of outstanding shares redeemed) (5,000) AAA balance at end of 1997 $ 15,000

XYZ would also reduce its AE&P by 25% ($4,000) to reflect the percentage of shares redeemed. X would need to determine his gain or loss on the stock redemption, and so would need to observe the separate-share rule for basis in the redeemed shares.

Effects when AAA is negative: When a corporation has sustained losses in excess of its income, the AAA may have a negative balance. According to Regs. Sec. 1.1368-2(d) (1) (i), the corporation reduces the negative balance by the percentage of shares redeemed.

Effect of a termination of year on redemptions: When a redemption is treated as a sale or exchange, and equals or exceeds 20% of the outstanding shares, the corporation may elect to split its tax year into two portions under Regs. Sec. 1.1368-1 (g) (2) (i); similarly, a redemption may be a complete termination of a shareholder's interest. If the corporation elects to close its year as of the date of the redemption, the redemption will be the final event in the corporation's short period; the corporation will need to adjust its AAA separately for each such period.

Adjustments for tax-free reorganizations: Regs. Sec. 1.1368-2(d) provides simple and workable rules for both acquisitive and divisive reorganizations.

Acquisitive reorganizations: Under Regs. Sec. 1.13682(d) (2), regardless of whether the S corporation is the target or the survivor of a reorganization, the survivor's postacquisition AAA is the sum of the AAAs of all predecessors. If a C corporation in a reorganization has a negative E&P balance and the other corporation has a positive balance, the two are not combined. If two S corporations merge, or combine in a C or D reorganization, a positive balance in one of the corporation's AAA offsets a negative balance in the other corporation's AAA.

* Planning opportunity: If an S corporation with positive AAA intends to combine with an S corporation with negative AAA, the parties should carefully plan any distributions before consummating the reorganization. If the corporation to be extinguished in the reorganization has a positive AAA, and distributes cash or other property before the reorganization, the shareholders will reap the benefit of the entire positive AAA. If the distribution occurs after the reorganization, and the amount distributed exceeds the postcombination AAA of the surviving corporation, the shareholders may have to report dividend income, which could have been avoided if the distribution occurred before the reorganization.

Divisive reorganizations: A divisive reorganization occurs when a corporation transfers one or more trades or businesses to a controlled subsidiary, and then distributes all the stock in the subsidiary to its shareholders. On the surface, an S corporation appears to be ineligible to participate in a divisive reorganization, because it cannot be a member of an affiliated group; however, the IRS has often ruled that S corporations can undertake such transactions, achieve momentary ownership, and yet not lose S status.(37) Numerous letter rulings have allowed the original corporation to retain its S election and the newly formed subsidiary to make an S election for its first tax year.(38) While Sec. 312(h) provides some guidance on the allocation of AE&P between two or more corporations resulting from a divisive reorganization, it is silent on the allocation of AAA among the corporations when the distributing corporation is an S corporation. Regs. Sec. 1.1368-2(d) (3) adopts a sensible rule that parallels the law governing the allocation of E&P. Thus, if there is positive AAA prior to the reorganization, it must be allocated under Regs. Sec. 1.312-10(a) among the surviving corporations in proportion to the FMV of the assets held by each. If the prereorganization AAA is negative, there is no allocation to any new corporations; the balance remains with the original corporation.

Situations Not Addressed in the Regulations

Distribution of noncash property in the year of a bypass election: The regulations do not address the accounting treatment of a distribution of loss property when the corporation elects to bypass AAA. In Letter Ruling 9221011,(39) a corporation distributed loss property and elected to bypass AAA. The IRS ruled that AE&P had to be reduced by the predistribution basis of the loss property. Regulations to this effect would have been welcome.

Limitation on reductions of AAA and AE&P for redemption: If a C corporation redeems shares in a Sec. 302 or 303 exchange, but the total redemption proceeds are less than the percentage of E&P that would otherwise be redeemed, the corporation reduces its E&P by the entire redemption proceeds.(40) The Code and regulations, however, provide no such limitation on the reduction of AAA. Similarly, the regulations do not address the situation in which the redemption proceeds are less than the combined ratable portions of AAA and AE&P.

Effects of a redemption on PTI: The regulations offer no guidance on the effect of a redemption on the PTI account of the shareholder whose stock is redeemed. While it might appear logical that a redemption would reduce this account, in the absence of formal guidance, it is necessary to turn to pre-SSRA S corporation law, under which a redemption treated as an exchange under Sec. 302 or 303 did not reduce PTI. A distribution reduced PTI only if it would have otherwise been a dividend.(41) Thus, it appears that a stock redemption that passes any of the exchange tests will not affect a shareholder's PTI account.

Redemption in a tax year in which the corporation makes an AAA bypass election: There is no explicit coordination of the stock redemption and AAA bypass election rules. Logically, it would seem that a corporation that makes a bypass election and redeems stock in the same year would do the following:

[] If the ordinary distributions were sufficient to exhaust the corporation's AE&P, there would be no reduction in AE&P for the stock redemption.

[] If the ordinary distributions were not sufficient to exhaust the corporation's AE&P, the corporation would reduce the AE&P balance (after reduction for the ordinary distribution) by the appropriate percentage.

[] If the corporation made a deemed dividend election for the year, there would be no C AE&P at the time of the redemption, but there might be SE&P. The corporation would reduce its SE&P proportionately to reflect the redemption.

[] In all of these situations, the corporation would also reduce the AAA proportionately to reflect the percentage of shares redeemed. The AAA would be adjusted for the current-year's income and loss, and the AAA would be reduced for ordinary distributions only if they exceeded the corporation's AE&P.

Effective Dates

According to Regs. Sec. 1.1368-4, all of the distribution and AAA rules are in effect for tax years beginning after 1993. For all earlier years, taxpayers must take a reasonable position, based on the language of the statute and the legislative history. All the rules contained in Regs. Secs. 1.1368-1, -2 and-3 are reasonable positions, except for the Regs. Sec. 1.1368-1 (f) (3) deemed dividend rule. Thus, under the regulations, an S corporation cannot make a deemed dividend election for any year before 1994; however, it may be possible to receive a favorable ruling on a deemed dividend election for 1992 or 1993, because the Sec. 1368 proposed regulations contained a deemed dividend election.

(24) Regs. Sec. 1.1368-1 (c) states only that such distributions are treated in the manner provided in Sec. 1368(b).

(25) The 1995 Instructions to Form 1120S, p. 23, state that these distributions may come from the "other adjustments account" (OAA); however, the Sec. 1368 regulations make no reference to the OAA.

(26) Sec. 1362(d)(3)(A)(i) provides that if an S corporation has AE&P and its PII exceeds 25% of its gross receipts for three consecutive years, the S election is lost at the beginning of its next tax year. Section 214 of S. 1690, the S Corporations Reform Bill of 1993, would repeal the S termination rule; however, the tax on PII would increase (up to 85%) on a graduated-rate scale based on the number of consecutive years in which PII exceeded the 25% ceiling.

(27) Regs. Sec. 1.1361-1 (1) (1) requires that all shares have equal rights to distribution and liquidation proceeds. (28) See Regs. Sec. 1.1361-1 (1) (2) (iv). Since there are no reporting requirements under this provision, OLM should be able to substantiate the propriety of the distribution formula in corporate minutes. (29) Regs. Sec. 1.1368-1 (f) (3) states that for all Code purposes, the deemed dividend is treated as received by the shareholders and contributed to capital. (30) Regs. Sec. 1.1368-l(f)(3) states that the corporation will be considered to have made the election in Regs. Sec. 1368-1 (f) (2) to bypass AAA in favor of PTI. (31) The IRS might view the transactions as steps in a single transaction (i.e., that the dividend is really part of the purchase price); see Waterman Steamship Corp., 430 F2d 1185 (5th Cir. 1970) (26 AFTR2d 70-5185, 70-2 USTC [Paragraph]9514), rev'g 50 TC 650 (1969). (32) Waterman Steamship Corp., id. (33) TD 8449 (11/Y4/92) (34) See IRS Letter Ruling 9312027 (12/29/92). (35) Special recharacterization rules (e.g., Sec. 1239) may also apply (36) See Rev. Rul. 95-14, 1995-1 CB 169. (37) See, e.g., Rev Rul. 72-320, 1972-1 CB 270, which permits momentary affiliation during a divisive reorganization. (38) See, e.g., IRS Letter Rulings 9333040 (5/25/93), 9335002 (5/18/93), 9338038 (6/28/93), 9340006 (6/24/93), 9344022 (8/6/93), 9344034 (8/11/93), 9350039 (9/23/93), 9402029 (10/20/93) and 9403031 (10/28/93) (all holding that there was a valid reorganization and permitting momentary affiliation without loss of S status). (39) IRS Letter Ruling 9221011 (2/18/92). (40) This rule does not appear in the Code; however, the legislative history to the Tax Reform Act of 1984 provides for this result. See Staff of the Joint Committee on Taxation, General Explanation Of the Revenue Provisions Of the Tax Reform Act Of 1984, p. 181. (41) Regs. Sec. 1.1375-4(b), issued under pre-SSRA Sec. 1375.
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Title Annotation:part 2
Author:Duncan, William A.
Publication:The Tax Adviser
Date:Jun 1, 1996
Words:7717
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