S CORPORATION MUST REDUCE ACCUMULATED ADJUSTMENTS ACCOUNT BY AMOUNT OF STOCK REDEMPTION.

Rev. Rul. 95-14

ISSUE

If an S corporation shareholder receives proceeds in a redemption that is characterized as a distribution under section 301 of the Internal Revenue Code, is the redemption treated as a distribution for purposes of section 1368 that reduces the corporation's accumulated adjustments account?

FACTS

A, and A's child B, together own all of the stock of X, a corporation that files returns for a calendar year. X has a valid S election in effect. X redeems for cash a portion of A's stock at fair market value. There are no facts present that cause the redemption to be treated as a sale or exchange under section 302(a) or section 303(a). X makes no other distributions during the taxable year.

At the end of the year, A has a basis in X stock in excess of the amount of the distribution made by X during the year. In addition, X has an accumulated adjustments account (AAA) in excess of that distribution. X also has subchapter C earnings and profits.

LAW AND ANALYSIS

Section 1371(a)(1) provides that except as otherwise provided in the Code, and except to the extent inconsistent with subchapter S, subchapter C applies to an S corporation and its shareholders.

Under the rules of subchapter C, a redemption is treated either as a sale or exchange under section 302(a) or section 303(a), or as a distribution of property to which section 301 applies. See section 302(d). Because the redemption of A's stock is not treated as a sale or exchange under section 302(a) or section 303(a), the redemption is treated, under section 302(d), as a distribution of property to which section 301 applies.

Section 301(a) provides that a distribution of property (as defined in section 317(a)) by a corporation to a shareholder with respect to its stock is treated in the manner provided in section 301(c).

Section 301(c) provides that, in the case of a distribution to which section 301(a) applies: (1) the portion of the distribution that is a dividend (as defined in section 316) is included in gross income; and (2) the portion of the distribution that is not a dividend is applied against and reduces the adjusted basis of the stock. The portion of the distribution that is not a dividend, to the extent that it exceeds the adjusted basis of the stock, is treated as gain from the sale or exchange of property.

Section 1368(a) provides that a distribution of property made by an S corporation with respect to its stock to which (but for section 1368(a)) section 301(c) would apply is treated in the manner provided in section 1368(b) or (c), whichever applies.

Section 1368(b) provides that, in the case of a distribution described in section 1368(a) by an S corporation that has no accumulated earnings and profits, the distribution is not included in gross income to the extent that it does not exceed the adjusted basis of the stock. If the amount of the distribution exceeds the adjusted basis of the stock, the excess is treated as gain from the sale or exchange of property.

Section 1368(c) provides that, in the case of a distribution described in section 1368(a) by an S Corporation that has accumulated earnings and profits: (1) that portion of the distribution that does not exceed AAA is treated in the manner provided by section 1368(b); (2) that portion of the distribution that remains after the application of section 1368(c)(1) is treated as a dividend to the extent it does not exceed the accumulated earnings and profits of the S corporation; and (3) any portion of the distribution remaining after the application of section 1368(c)(2) is treated in the manner provided by section 1368(b).

Section 1368(e)(1) provides that the term "accumulated adjustments account" means an account of the S corporation that has adjustments for the S period similar to the adjustments under section 1367 (except that no adjustment is made for income (and related expenses) that is exempt from tax under the Code, and the phrase "but not below zero" is disregarded in section 1367(b)(2)(A)), and no adjustment is made for federal taxes attributable to any taxable year in which the corporation was a C corporation.

An S corporation's AAA tracks the amount of undistributed income that has been taxed to the shareholders, similar to the manner in which earnings and profits generally track a C corporation's undistributed income (whether or not taxable). AAA is the mechanism that allows previously taxed but undistributed income to be distributed tax-free to S corporation shareholders. It is an account of the S corporation and is not apportioned among shareholders. Section 1.1368-2(a).

Section 1368(e)(1)(B) provides a special rule to determine the adjustment to AAA in the case of a redemption that is treated as an exchange. In the case of any redemption that is treated as an exchange under section 302(a) or section 303(a), the adjustment to AAA is an amount that bears the same ratio to the balance in the account as the number of shares redeemed bears to the number of shares of stock in the corporation immediately before the redemption. Section 1368(e) does not provide a specific rule for adjusting AAA in the case of a redemption treated as a section 301 distribution.

Because X has subchapter C earnings and profits, distributions are treated in the manner provided in section 1368(c). A has an adjusted basis in X stock in excess of the amount of the distribution made by X during the year and X has AAA in excess of the amount of that distribution. Thus, under section 1368(c)(1), the distribution is not included in A's income.

Section 1368(e)(1)(A) provides that AAA is adjusted in a manner similar to the adjustments under section 1367. Section 1367(a)(2)(A) requires an S corporation shareholder to decrease basis in S stock for distributions by the corporation that were not includible in the shareholder's income because of section 1368. Section 1.1368- 2(a)(3)(iii) provides that AAA is decreased (but not below zero) by any portion of a distribution to which section 1368(b) or section 1368(c)(1) applies. Because, under these facts, section 1368(b) and section 1368(c)(1) apply to the entire distribution, X's AAA is reduced by the full amount of X's distribution in redemption of A's stock. The provision of section 1368(e)(1) that refers to redemptions does not apply on these facts because this is not a redemption that is treated as an exchange under section 302(a) or section 303(a).

HOLDING

When an S corporation shareholder receives proceeds in a redemption that is characterized as a distribution under section 301, the entire redemption is treated as a distribution for purposes of section 1368 that reduces the corporation's AAA.

DRAFTING INFORMATION

The principal author of this revenue ruling is Brad K. Saunders of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling contact Armando Gomez at (202) 622-3050 (not a toll-free call).