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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 earnings and profits (AE&P) (accumulated when it was a C corporation) and $80,000 of accumulated adjustments account (AAA). 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 future. His other itemized deductions total $15,000. Dick wants to increase his disposable income, 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?


Investment interest expense generally is deductible 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 could permit deduction 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 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.


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 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 additional tax at the individual level.
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Title Annotation:accumulated earnings and profits, accumulated adjustments account
Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Date:Apr 1, 1997
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