S corporation AAA resets to zero after the post-termination period

Plain-English summary

A corporation had an S period, revoked its election, left some accumulated adjustments account balance undistributed after the post-termination transition period, and later elected S status again. Chief Counsel concluded that the old AAA does not survive into the later S period. IRC § 1368(e)(2) limits the relevant S period to the most recent continuous S period, and the regulations start the first S year with a zero balance. Previously taxed income may still be distributed tax-free to the extent of shareholder stock basis, but corporate earnings and profits must be distributed first.

Ruling snapshot

• Question: Does an S corporation’s old AAA survive a C corporation interval and reappear after a later S election?
• Outcome: Advice given, no, the AAA resets to zero after the post-termination transition period
• Key authorities: IRC §§ 1368(e), 1371(e), and 1377(b); Treas. Reg. § 1.1368-2

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 201446021
       Release Date: 11/14/2014
       CC:PSI:1                                              Third Party Communication: None
       POSTU-127766-14                                       Date of Communication: Not Applicable

UILC: 1368.01-00

date: July 23, 2014

 to:   Kathryn Patterson, Associate Area Counsel (Dallas) (LB&I)

from: Bradford Poston, Senior Counsel (CC:PSI:3)

subject: -------------------------------------------------------

       This Chief Counsel Advice may not be used or cited as precedent.

       LEGEND

       X                 =        -------------------------------------------------------
                                  EIN: ---------------

       Date 1            =        ------------------

       Date 2            =        ---------------------

       Date 3            =        ---------------------

       Date 4            =        ---------------------

       n                 =        -------------

       o                 =        --------------

       p                 =        --------------

       q                 =        --------------

       ISSUE

POSTU-127766-14 2

Does an S corporation's accumulated adjustments account survive beyond the
post-termination transition period into a subsequent S period?

CONCLUSION

Section 1368(e)(2), which defines the term “S period” as the most recent continuous
period during which the corporation has been an S corporation, requires that AAA be
“reset” at the end of the PTTP. The AAA would thus be zero after the corporation
re-elects S corporation status after an intervening C corporation period.

FACTS

The taxpayer, X, was incorporated as a C corporation on Date 1. It operated as a C
corporation until it made its first election to be treated as an S corporation effective Date

2. At that time, the taxpayer had accumulated earnings and profits (E&P) of $n. After
   its S election, the taxpayer continued to generate annual profits. The taxpayer had a
   AAA balance of $o when its majority shareholders revoked its S election effective Date
3. During the PTTP, the taxpayer distributed $p of its AAA to its shareholders pursuant
   to § 1371(e), leaving $q of undistributed AAA related to its initial S period. The taxpayer
   represents that it did not distribute all of the AAA during the PTTP because it did not
   have the cash equal to its AAA to distribute. Furthermore, the taxpayer represents that
   it needed to retain cash to capitalize new market growth opportunities.

The taxpayer made another S election effective Date 4, and continues to operate as an
S corporation today. The taxpayer represents that it converted from C to S to C and
back to S to take advantage of individual and corporation tax rates available at the time
of each conversion. The taxpayer requested a ruling regarding whether its AAA
balance from its first S period ($q) survived the period between the end of the PTTP and
Date 4.

LAW AND ANALYSIS

An S corporation’s AAA is an account of the S corporation not apportioned among the
shareholders. All S corporations start with a AAA balance of zero on the first day of
their S status. For S corporations with E&P from a prior period as a C corporation or a
merger with a C corporation, the AAA tracks the corporation’s ability to make tax free
distributions to shareholders. To the extent that a corporation has a positive AAA, and
the distribution does not exceed a shareholder’s basis in the stock, the S corporation
can make tax-free distributions to that shareholder.

When an S corporation’s S status terminates it goes through a PTTP determined by
§ 1377(b)(1). During the PTTP the former S corporation can continue to take
advantage of some of the benefits associated with its S status. Specifically, under
§ 1371(e), the shareholders will be able to make tax free distributions to the extent the
corporation has a positive AAA balance.
POSTU-127766-14 3

Section 1371(e) provides that any distribution of money by a corporation with respect to
its stock during a PTTP shall be applied against and reduce the adjusted basis of the
stock, to the extent that the amount of the distribution does not exceed the AAA (within
the meaning of § 1368(e)). The question addressed by this memorandum is whether
the AAA disappears forever after the PTTP, or if it reappears upon a subsequent S
election.

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

Section 1368(b) provides that in the case of a distribution described in § 1368(a) by an
S corporation which has no accumulated earnings and profits--(1) the distribution shall
not be included in gross income to the extent that it does not exceed the adjusted basis
of the stock. (2) If the amount of the distribution exceeds the adjusted basis of the stock,
such excess shall be treated as gain from the sale or exchange of property.

Section 1368(c) provides that in the case of a distribution described § 1368(a) by an S
corporation which has accumulated earnings and profits--(1) that portion of the
distribution which does not exceed the accumulated adjustments account shall be
treated in the manner provided by § 1368(b). (2) That portion of the distribution which
remains after the application of § 1368(c)(1) shall be treated as a dividend to the extent
it does not exceed the accumulated earnings and profits of the S corporation. (3) Any
portion of the distribution remaining after the application of § 1368(c)(2) shall be treated
in the manner provided by § 1368(b). Except to the extent provided in regulations, if the
distributions during the taxable year exceed the amount in the accumulated adjustments
account at the close of the taxable year, for purposes of § 1368(c), the balance of such
account shall be allocated among such distributions in proportion to their respective
sizes.

Section 1368(e)(1) defines the AAA as an account of the S corporation which is
adjusted for the S period in a manner similar to the adjustments under § 1367 (except
that no adjustment shall be made for income (and related expenses) which is exempt
from tax under Title 26 and the phrase “(but not below zero)” shall be disregarded in
§ 1367(a)(2)) and no adjustment shall be made for Federal taxes attributable to any
taxable year in which the corporation was a C corporation.

Section 1.1368-2(a)(1) provides that on the first day of the first year for which the
corporation is an S corporation, the balance of the AAA is zero.

Section 1368(e)(2) defines the term “S period” as the most recent continuous period
during which the corporation has been an S corporation. Such period shall not include
any taxable year beginning before January 1, 1983.
POSTU-127766-14 4

Section 1.1368-2(a)(2) provides that the AAA is increased for the taxable year of the
corporation by the sum of the following items with respect to the corporation for the
taxable year: (i) The items of income described in § 1366(a)(1)(A) other than income
that is exempt from tax; (ii) Any nonseparately computed income determined under
§ 1366(a)(1)(B); and (iii) The excess of the deductions for depletion over the basis of
property subject to depletion unless the property is an oil or gas property the basis of
which has been allocated to shareholders under § 613A(c)(11).

Section 1.1368-2(a)(3)(i) provides that the AAA is decreased for the taxable year of the
corporation by the sum of the following items with respect to the corporation for the
taxable year-- (A) The items of loss or deduction described in § 1366(a)(1)(A);
(B) Any nonseparately computed loss determined under § 1366(a)(1)(B); (C) Any
expense of the corporation not deductible in computing its taxable income and not
properly chargeable to a capital account, other than-- (1) Federal taxes attributable to
any taxable year in which the corporation was a C corporation; and (2) Expenses
related to income that is exempt from tax; and (D) The sum of the shareholders’
deductions for depletion for any oil or gas property held by the corporation described in
§ 1367(a)(2)(E).

Section 1.1368-2(a)(3)(ii) provides that the AAA may be decreased below zero under
§ 1.1368-2(a)(3)(i). The AAA is decreased by noncapital, nondeductible expenses under
§ 1.1368-2(a)(3)(i)(C) even though a portion of the noncapital, nondeductible expenses
is not taken into account by a shareholder under § 1.1367–1(g) (relating to the elective
ordering rule). The AAA is also decreased by the entire amount of any loss or
deduction even though a portion of the loss or deduction is not taken into account by a
shareholder under § 1366(d)(1) or is otherwise not currently deductible under the Code.
However, in any subsequent taxable year in which the loss, deduction, or noncapital,
nondeductible expense is treated as incurred by the corporation with respect to the
shareholder under § 1366(d)(2) or § 1.1367–1(g) (or in which the loss or deduction is
otherwise allowed to the shareholder), no further adjustment is made to the AAA.

Section 1.1368-2(a)(3)(iii) provides that the AAA is decreased (but not below zero) by
any portion of a distribution to which § 1368(b) or (c)(1) applies.

The concept of AAA was added to the Code as part of the 1982 Act. However, nothing
in the legislative history from 1982 or subsequent revisions includes a more detailed
definition of “S period” or indicates whether Congress intended the AAA to survive a
break in S status.

When Congress enacted subchapter S in 1958, § 1375(d) referenced a concept similar
to AAA called “undistributed taxable income previously taxed to shareholders” (PTI).
The Senate Report accompanying the 1958 technical amendments, S. Rep. No. 85-
1983, at 223 (1958), provided that:
POSTU-127766-14 5

   Section 1375(d) of the new subchapter S provides rules whereby a
   shareholder’s “net share of undistributed taxable income” of an electing
   small-business corporation for prior years may be distributed under
   regulations prescribed by the Secretary or his delegate, to such
   shareholder in a later year (with respect to which the election is still in
   effect) free of dividend consequences to the shareholder. . . . The term “all
   prior taxable years” does not include a taxable year to which the
   provisions of § 1375 do not apply and to taxable years prior to such year.

   Thus, under § 1375(d)(2) a shareholder’s net share of previously taxed
   undistributed taxable income is computed by first determining the total
   amount of the corporation’s undistributed taxable income which has been
   actually included in his gross income for all his prior taxable years in which
   or with which ended a taxable year of the corporation with respect to
   which an election was in effect, excluding any taxable year prior to a break
   in the election. . . .

   It will be noted that under new § 1375(d) an individual who becomes a
   shareholder in an electing small business corporation will not be entitled to
   the benefits of § 1375(d) until, at the earliest, the year following a year in
   which he has included in his gross income a share of the corporation’s
   undistributed taxable income and then only to the extent, at most, of his
   share of such undistributed taxable income. However, if such an
   individual was formerly a stockholder in the corporation during a taxable
   year as to which it was an electing small business corporation and the
   election has been in effect continually since such previous year, he would
   be entitled to the benefits of § 1375(d) with respect to distributions not in
   excess of amounts of undistributed taxable income of the corporation
   included in his gross income for such previous year. (Emphasis added.)

The emphasized portions of the legislative history quoted above seem to indicate
Congress’ intention that the undistributed taxable income expire at the end of any given
S period. Specifically, this is evident where the Senate Report refers to years “prior to a
break in the election” and the requirement that the election be in effect “continually.”1

We understand that some taxpayers may argue that §§ 1368(e)(1) and (2) should be
read in conjunction with one another. Section 1368(e)(1) provides that AAA is adjusted
for the S period in a manner similar to the adjustments under § 1367 and that no
adjustment will be made for federal taxes attributable to any taxable year in which the
corporation was a C corporation. Section 1368(e)(2) defines “S period” as the most
recent continuous period during which the corporation has been an S corporation.

1
Despite their similarities, however, PTI and AAA have notable differences. Specifically, PTI was a
shareholder account that could not be transferred. Conversely AAA is a corporate account, and when a
shareholder transfers stock to another person, distributions made to the shareholders including the
transferee are governed by the corporate account and not with reference to the transferor.
POSTU-127766-14 6

Reading §§ 1368(e)(1) and (2) together, one could argue that the statute merely intends
that the corporation’s AAA will not be adjusted during any period that the corporation is
not an S corporation. However, we believe this reading is overly narrow. If AAA
survives the PTTP, but may not be adjusted during the C corporation period under
§ 1368(e), certain events, such as redemptions, occurring while the taxpayer is a C
corporation may economically require the adjustments forbidden by the statute, leading
to distortions.

Additionally, a shareholder’s outside basis in his S corporation stock generally will
reflect taxable income of the corporation while it is an S corporation, and that outside
basis will not disappear when the S corporation status changes. Even though, at first
blush, it might appear that a corporation that fails to distribute its AAA during the PTTP
will lose the ability to make tax-free distributions of previously taxed income when it re-
elects S corporation status in a subsequent period, we do not believe this is the case.
Rather, the corporation retains the ability to make tax-free distributions from the
shareholder’s outside basis, it simply must distribute out of its E&P first. Thus, we
believe the question becomes one of a timing difference, not a permanent difference in
the taxability of corporate distributions.

Finally, the plain language of the statute states that the AAA will reset to zero when the
PTTP ends. Section 1368(e)(2) defines the “S period” as the most recent continuous
period during which the corporation has been an S corporation. (Emphasis added.)
Section 1.1368-2(a)(1) states that on the first day of the first year for which the
corporation is an S corporation, the balance of the AAA is zero. We also note that
because the statute specifically grants a PTTP, this implies that the PTTP is the only
time the corporation may draw down its AAA by making distributions after termination of
S corporation status.

Therefore, we conclude that an S corporation's AAA is reset to zero after the PTTP and
remains zero into a subsequent S period.

Please call (202) 317-6850 if you have any further questions.