An S corporation generally avoids income tax at the corporate level. Income, expense, credit, and adjustment items flow through to the shareholders who pay any required tax due. The distributions from an S corporation could be taxable or not, depending on the shareholder’s basis in his or her S corporation stock. If the S corporation was previously a C corporation, or it acquired another C corporation with earnings and profits (E&P) under Internal Revenue Code (IRC) § 381, Carryovers in Certain Corporate Acquisitions, the distributions rule could be more complex.
If the S corporation has AE&P, the priority of distributions is determined as follows:
- A Nontaxable Distribution of the Accumulated Adjustments Account (AAA): The distribution is not taxable unless it is in excess of the shareholder’s basis. If the shareholder’s basis is less than the AAA, distributions are not taxable to the extent of the stock basis
- A Dividend: The remaining distribution is taxable as a dividend (the maximum tax rate on qualified dividends is 20% in 2016) to the extent of AE&P. This has no effect on the shareholder’s stock basis
- A Nontaxable Reduction of Any Remaining Basis: The distribution is a tax-free reduction of the shareholder’s basis in the corporation’s stock
- Capital Gain: Any distribution in excess of the shareholder’s stock basis is treated as gain (either short-term or long-term, depending on the holding period of the stock) from the sale or exchange of the underlying stock. The maximum tax rate on long-term capital gains is 20% in 2016.
It is important to know that E&P is not identical to either taxable income or retained earnings. E&P is an independent measure of a corporation’s economic income. It differentiates between the distributions made from earnings that must be taxed as a dividend and those that represent a return of shareholder capital that should not be taxed. A C corporation is required to compute its E&P every year by adjusting taxable income to reflect the economic effect of items of income, gain, loss, and deduction.
What Does CohnReznick Think?
A C corporation cannot avoid double-taxation by making the S election. On the date the S election is effective, any E&P accumulated through the election date will continue and be taxed as a dividend when distributed, even though the entity has become an S corporation.
If you are thinking about making an S election or acquiring a C corporation with AE&P, please consult with your CohnReznick tax professional to determine if any of the future distributions could be subject to double taxation.