On April 28, 2020, the Arkansas Department of Finance and Administration issued a letter ruling in which it determined that distributions made by an S corporation were not taxable dividends for Arkansas individual income tax purposes, because the S corporation’s state-specific Accumulated Adjustments Account (AAA) was sufficient to absorb the distributions.
The S corporation at issue requested a ruling on whether it needed to report distributions to its individual owners as taxable dividends rather than as non-taxable returns of capital in circumstances where the S corporation had negative federal AAA but positive state-specific AAA. The S corporation was a manufacturer, which claimed bonus depreciation under section 168(K) on its 2019 federal tax return. As a result, the S corporation had zero basis in its assets for federal purposes and negative AAA. Accordingly, for federal income tax purposes, the S corporation reported distributions to its shareholders as taxable dividends under section 1368(c)(2). However, because Arkansas does not conform to the federal bonus depreciation rules, the S corporation maintained positive AAA and stock basis if computed on a separate pro forma basis for state tax purposes. Accordingly, if the determination of the character of the distributions was made at the state level instead of the federal level and state-specific AAA and stock basis was used for that determination, the distributions would be treated as non-taxable returns of capital under sections 1368(c)(1) and (b)(1) for Arkansas income tax purposes.
In a ruling favorable to the taxpayer, the department found that, while Arkansas does generally conform to the S corporation provisions in the IRC, AAA must be determined on a separate state basis to account for federal-to-state adjustments, including the state’s bonus depreciation decoupling provisions. Further, the department found that an S corporation with a positive state-specific AAA balance is not required to report distributions as taxable dividends to the extent those distributions do not exceed state-specific adjusted stock basis. For this purpose, the department determined that the federal calculations and reporting method on the federal returns were not controlling for state income tax purposes. Accordingly, the department ruled that, depending on the S corporation’s facts and circumstances, it was proper for the S corporation to treat the distributions as non-taxable returns of capital for state income tax purposes.
There are millions of S corporations doing business and filing tax returns in the United States. Virtually all of these companies file both federal and state returns of some kind. The treatment of AAA balances and stock basis at the state-level is often overlooked when characterizing and reporting S corporation dividends. In states that do not conform to federal bonus depreciation, as in this case, federal-to-state differences can be substantial, and distributions could be taxable dividends for federal purposes but not for state purposes. An analysis of an S corporation’s AAA balance and stock basis under the tax laws of the states in which it does business is critical to avoid over or underpaying state income taxes. S corporations should consult with their tax advisors for more information about this issue.