This article originally appeared in the August 19, 2019, issue of Tax Notes Federal.
]Kenneth N. Orbach is a professor of accounting at Florida Atlantic University.
In this article, Orbach analyzes the tax consequences of capital gain redemptions under sections 302(a) and 303 during the post-termination transition period of S corporations.
Recently, the IRS released Rev. Rul. 2019-13, 2019-20 IRB 1179, which states, unsurprisingly, that section 1371(e)(1) applies to a cash section 302(d) redemption (that is, a noncapital gain redemption) during a post-termination transition period of a former S corporation. In other words, the cash distribution is treated generally as first coming out of the corporation’s accumulated adjustments account before being applied to the (now C) corporation’s current earnings and profits.1 This article examines the tax consequences of a section 302(a) or 303 redemption during an S year and during a post-termination transition period.
Ordinary Distributions
A C corporation’s distribution regarding its stock first comes out of current earnings and profits (CE&P), then out of accumulated earnings and profits (AE&P), followed by reduction of stock basis, and then (generally) capital gain.2 The rule for S corporations is similar,3 with some differences. First, an S corporation does not have CE&P. Second, a distribution generally first comes out of the corporation’s accumulated adjustments account (AAA) before AE&P. The AAA essentially keeps track of the corporation’s previously taxed undistributed net income. Distributions out of the AAA first reduce stock basis and then are generally capital gain. The purpose of the AAA is to prevent previously taxed undistributed net income from being taxed again when it is distributed (that is, out of E&P).
Suppose a corporation’s S election is terminated while it still has undistributed net income (that is, a positive AAA). Because the corporation now has C status, any distribution with respect to its stock would be a dividend to the extent of E&P, thereby potentially taxing the S income twice. To the rescue comes the post-termination transition period (PTTP). A PTTP comes in three flavors, the most important of which is the one-year PTTP.4 If a distribution of money (but not of other property) is made to a shareholder during a PTTP, the distribution first comes out of the AAA (to the extent of stock basis) before coming out of the C corporation’s CE&P and AE&P.5 Presumably, if there is an ordinary distribution during a PTTP of both property and cash in the same tax year, the cash first comes out of AAA (to the extent of stock basis); the property and any excess cash are then treated under subchapter C rules.
Redemptions
A section 302(d) redemption (noncapital gain treatment) receives similar treatment as a straight section 301 distribution.6 On the other hand, the treatment of a section 302(a) capital gain redemption or section 303 redemption to pay death taxes (redemption distribution) by an S corporation during its S period or during a PTTP is not entirely clear.
The rules regarding a redemption distribution of S stock have their genesis in regulations proposed in 1992.7 Prop. reg. section 1.1368-2(d)(1)(ii) generally would have applied rules similar to the E&P redemption rules of section 312(n)(7) to the AAA of an S corporation that had both ordinary distributions and section 302(a) redemptions in the tax year. The proposed regulations went as far as defining new terms — “current AAA” and “accumulated AAA” — as essentially the AAA analogues to current and accumulated E&P.8 The preamble to the proposed regulations stated that the method used in two revenue rulings to determine the E&P attributable to shares redeemed would apply to an AAA for S corporation redeemed shares.9 The preamble then stated, “The rules set forth in these revenue rulings, rather than the general rules previously described, also apply to determine the effect on the AAA for distributions made during the taxable year of the redemption.”
The preamble for this purpose then explicitly treated accumulated (current) AAA in the same manner as accumulated (current) E&P.
Fast forward about 18 months to when the final regulations were published (T.D. 8508). Responding to comments that the redemption rule in the proposed regulations was too complex, the final regulations “modify” the rule, but there is no mention of section 312(n)(7). Instead, the final regulations, with one subsequent modification, bring us to today: T.D. 8852 added the ordering rule of reg. section 1.1368-2(a)(5) to confirm that although the 1996 act changed the ordering rule for stock basis, it did not change the rule for AAA, and to take into account the net negative adjustment rule. Under the reg. section 1.1368-2(a)(5) ordering rule, adjustments to the AAA are made first for passthrough items, followed by ordinary distributions, and last to redemption distributions.10 The 1974 revenue rulings not only do not supplant the general AAA rules when there are both ordinary and redemption distributions, they have been rendered irrelevant for AAA purposes by T.D. 8508.11
Where do we stand now? As a matter of tax policy, a temporal method (that is, the tax treatment of a redemption distribution is a function, among other variables, of when during the year it occurs), like the one Treasury proposed in 1992 may be appropriate. However, the tax rules simply do not reflect the economic posture of the corporation immediately before a redemption distribution: The AAA is adjusted last by a redemption distribution, even after ordinary distributions that occur after the redemption.12 Thus, given the current regulations and their history, the reg. section 1.1368-2(a)(5) ordering rule should be followed: The timing of the redemption distribution should not be taken into account. A redemption distribution reduces the AAA by the amount of the AAA after all other adjustments under reg. section 1.1368-2(a)(5), multiplied by the ratio of shares redeemed over the number of shares immediately before the redemption.13
Example: S Corporation has two equal unrelated shareholders, A and B, and has AAA of $25,000 at the beginning of the year. During the year, S Corporation has $10,000 of taxable income, $12,000 of ordinary distributions, and redeems all of B’s stock. Immediately before the redemption, S Corporation’s AAA is $23,000 ($25,000 + $10,000 - $12,000), and the redemption reduces this amount by $11,500 (50 percent * $23,000). It doesn’t matter when the income is earned during the year, when the ordinary distributions occur, or when the redemption distribution takes place. The reg. section 1.1368-2(a)(5) ordering rule is strictly followed.
Redemption Distribution During a PTTP
Remember that a PTTP occurs after an S corporation’s election has terminated and while the corporation has C status. Thus, the subchapter C rules apply during a PTTP, with two exceptions. First, a shareholder’s disallowed loss under section 1366(d)(1) that is still suspended at the termination of S status is treated as incurred by the shareholder on the last day of any PTTP14 to the extent of the shareholder’s stock (not debt) basis at that time.15 Second, a distribution of money during a PTTP is deemed to first come out of the AAA before E&P.16
A redemption distribution is not one of the exceptions. The subchapter C rules apply to those redemptions. However, AAA also must be reduced by a redemption distribution during a PTTP and other C periods, as described in section 1368(e)(1)(B). There are several reasons for this: First, there may be ordinary cash distributions during subsequent PTTPs,17 and the tax treatment of those distributions is a function of the AAA. Second, if the corporation is an eligible terminated S corporation (ETSC),18 there may be a subsequent ordinary distribution of money during an ETSC period (not during a PTTP), and the tax consequence of that ordinary distribution is a function of the AAA and AE&P.19 A third reason may apply depending on which of two contrary views prevails. The IRS takes the position that the AAA of a former S corporation that reelects S status is reset to zero.20 The American Institute of CPAs recommends otherwise.21 If the AICPA view prevails, the AAA must be reduced as described in section 1368(e)(1)(B) for redemption distributions before the S reelection to properly reflect AAA on the first day of the new S election.
A redemption distribution during a PTTP should be deemed to occur after all ordinary cash distributions during the PTTP, in the same manner as reg. section 1.1368-2(d)(1)(ii). If the PTTP intersects two tax years, treat the two intersections separately.22 The same should be true for a redemption distribution by an ETSC during an ETSC period. Ordinary distributions (by other than an ETSC) outside PTTPs should have no effect on redemption distributions for AAA purposes.
Conclusion
Although not explicit in the code and regulations, a redemption distribution (under section 302(a) or 303) affects a former S corporation’s AAA during its C years. Ordinary cash distributions during a PTTP and by an ETSC during an ETSC period generally should be deemed to occur before a redemption distribution during those periods.
FOOTNOTES
1 See also Rev. Rul. 95-14, 1995-1 C.B. 169 (when an S corporation makes a section 302(d) redemption, the entire proceeds are treated as a section 1368 distribution).
2 Section 301(c), and reg. section 1.316-2.
3 Section 1368(c). See generally section 1371(a).
4 Section 1377(b)(1). The one-year PTTP begins on the corporation’s first day as a C corporation and ends 12 months later (or if later than the due date for filing the last S return, including extensions). There is also a 120-day audit-adjustment PTTP as well as a 120-day (previous) S termination PTTP.
5 Section 1371(e)(1). A shareholder receiving the distribution must have been a shareholder on the last day the corporation had S status for this rule to apply. Reg. section 1.1377-2(b). For an audit-adjustment PTTP, this rule applies only to the extent the AAA is increased by the adjustment. Section 1377(b)(3)(B). The corporation may elect not to apply the cash distribution rule. Section 1371(e)(2).
6 Rev. Rul. 95-14, 1995-1 C.B. 169; and Rev. Rul. 2019-13, 2019-20 IRB 1179.
7 Notice of Proposed Rulemaking, 57 F.R. 24426 (June 9, 1992).
8 Prop. reg. section 1.1368-2(d)(1)(ii)(A) (flush language).
9 Rev. Rul. 74-338, 1974-2 C.B. 101, and Rev. Rul. 74-339, 1974-2 C.B. 103. When both ordinary distributions and section 302(a) redemption distributions are made during the same tax year, the ordinary distributions take priority over the redemption distributions as to CE&P. Any excess CE&P is prorated to the date of the redemption, and the prorated amount is added to AE&P to determine the amount of E&P reduced under section 312(n)(7).
10 Distributions are taken into account first in the case of a net negative adjustment.
11 No change was made to E&P adjustments. E&P are adjusted under section 312, independently of adjustments to the AAA. Reg. section 1.1368-2(d)(1)(iii).
12 Reg. section 1.1368-2(d)(1)(ii).
13 Section 1368(e)(1)(B), and reg. section 1.1368-2(d)(1)(i).
14 A loss carryover cannot be used during an audit-adjustment PTTP. Section 1377(b)(3)(A).
16 See supra text accompanying note 5.
17 Or the same PTTP, if the latter intersects two tax years. A subsequent PTTP may also arise if an S corporation merges into the terminated S corporation. Reg. section 1.1377-2(b). The reduced AAA would not affect an ordinary cash distribution during a future audit-adjustment PTTP. Section 1377(b)(3)(B).
18 Sections 481(d) and 1371(f). An ETSC is a C corporation that was an S corporation on December 21, 2017; that revokes its election during the two-year period beginning on December 22, 2017; and that has the same shareholders (and in the same proportion) on the date the revocation is made as it did on December 22, 2017.
21 AICPA, “Letter to David J. Kautter, Assistant Secretary for Tax Policy” (Aug. 13, 2018).
22 In terms of a suspended loss carryover, only the intersection of the PTTP with the tax year that includes the last day of the PTTP is relevant. Section 1366(d)(3)(A).
END FOOTNOTES