The IRS released long-awaited guidance clarifying the treatment of distributions made by former S corporations that revoked their pass-through tax status following enactment of the Tax Cuts and Jobs Act (TCJA). The guidance addresses three primary issues:
1. Definition of an eligible terminated S corporation (ETSC)
2. Rules relating to how ETSCs determine the source of distributions made following the revocation and after the end of the post-termination transition period
3. Revisions to rules regarding who can receive tax-free distributions during the post-termination transition period
Background
Following enactment of the TCJA, many pass-through entities such as S corporations and partnerships evaluated whether pass-through status was still beneficial in light of the significant reduction of C corporation tax rates to 21%. For S corporations that chose to revoke their subchapter S status, the TCJA included certain provisions that helped facilitate the entities’ ability to distribute their accumulated S corporation earnings tax-free to their shareholders. These proposed regulations would address many of the uncertainties with respect to those rules.
Guidance
The primary uncertainty involves the determination of the source of distributions made by a former S corporation after the end of its post-termination transition period. The statute indicates that such distributions are to be treated as coming from accumulated S corporation earnings (i.e., ‘AAA’) and from accumulated C corporation earnings (‘AE&P’) in the ratio that those amounts bear to each other. But the statute provides no guidance on when or how this ratio is to be computed.
The proposed regulations outline a taxpayer friendly ‘snapshot’ approach. Under this approach, an ETSC would measure its AAA and its AE&P at the beginning of the day on which the revocation is effective, compute the ratio of AAA to AE&P as of that date, and apply that ratio all future distributions until AAA is exhausted. This methodology would in most cases accelerate the use of AAA as the source of these distributions, thereby reducing the amount of taxable dividends to shareholders.
In addition to the distribution guidance, the proposed regulations also more clearly define an ETSC, outlining certain shareholder changes that will not prevent the corporation from qualifying for ETSC status. The proposed regulations also would eliminate the ‘no-newcomer’ rule that currently prevents those who acquire shares after the entity revokes its subchapter S status from receiving tax-free distributions from AAA. This change would apply both to distributions made during and those made after the post-termination transition period.
These regulations are proposed to apply to tax years beginning after their publication in final form. Taxpayers would have the option of applying the final rules to any tax year for which the statute of limitations had not closed at the time of final publication.
Takeaways
These regulations would help clarify many of the questions the ETSCs have been wrestling with following the revocation of their subchapter S status. If the rules are finalized in their current form, the guidance would be favorable to most ETSCs that want to get prior undistributed S corporation earnings out to their shareholders on a tax-free basis.
