The shareholders of a corporation that has elected to be treated as an S corporation are taxed each year on the corporation’s taxable income. In general, the corporation itself does not pay income taxes. A shareholder who pays tax on an amount of income but does not receive a distribution equal to the full amount of this income may withdraw the taxed amount in a later year, free of additional taxes. These previously taxed amounts are tracked through an account called the “Accumulated Adjustments Account” or “AAA.” These amounts used to be referred to as “previously taxed income,” which actually seems like a more logical description.
In November 2014, the IRS’ Office of Chief Counsel issued written advice (CCA 201446021) relating to an S corporation that had a positive AAA account balance when its majority shareholder revoked the corporation’s Subchapter S election. The corporation became a C corporation following the revocation but subsequently made a new election to be treated as an S corporation. After the re-election, the corporation’s shareholders sought to withdraw the AAA amounts that had built up during the first period in which the corporation was an S corporation.
The IRS concluded that the AAA amount from the prior years did not carry over to the period when the corporation’s status as an S corporation was reinstated. It pointed to language in the Code that describes the AAA amount as being attributable to a “continuous period” during which a corporation is treated as an S corporation. The IRS reasoned that shareholders’ income tax basis in their shares reflects the amount in the AAA account so that they can ultimately withdraw that amount tax-free, even without the amount still being in the AAA account. In this case, however, the corporation had accumulated earnings and profits (essentially retained earnings) from the years it was a C corporation (i.e., the years in between its two periods of S corporation treatment). Any withdrawals by the shareholders in excess of the current year’s earnings are deemed to come from earnings and profits to the extent thereof, and are subject to tax as a dividend. When all of the C corporation earnings and profits have been distributed, future distributions would be tax-free as a recovery of tax basis, to the extent of the shareholders’ tax basis in their shares.
The shareholders of the corporation could have avoided this negative result had they availed themselves of special rules that control the transition period after a corporation’s status as an S corporation ends. If a corporation distributes cash to its shareholders within one year after the end of its S corporation status, that distribution will be treated as coming from the AAA account to the extent of the balance in that account. The distribution will therefore be tax-free to the shareholders even if it has earnings and profits from earlier C corporation years. Because distributions of property other than money do not qualify for this special treatment, this tax-free distribution can be made only if the corporation has access to sufficient cash to distribute the AAA amount.