S corporation loses AAA balance following revocation of status
Court ruling impacts corporations that toggle between S and C status
TAX ALERT |
Corporations that toggle back and forth between S corporation and C corporation status may sacrifice their ability to distribute previously taxed S corporation earnings to shareholders on a tax-free basis, according to a Sept. 27 federal district court decision.
The court in Tomseth v. United States (No. 6:17-cv-02017-AA (D. Or. Sept. 27, 2019)) agreed with the IRS’s assertion that an S corporation’s accumulated adjustments account (“AAA”), which measures the S corporation’s undistributed S corporation earnings, generally resets to $0 at the conclusion of the post-termination transition period (“PTTP”).1 The PTTP represents the period (usually the one-year period following the revocation or termination of a corporation’s subchapter S status) during which the corporation can make tax-free distribution of its AAA balance to its shareholders. The court ruled that any undistributed AAA at the end of the PTTP is lost, and was not available to cover distributions that the taxpayer made after it re-elect subchapter S status in a subsequent year.
The decision is consistent with internal IRS guidance outlined in CCA 201446021, but it is nonetheless significant because it is the first judicial decision that explicitly addresses the issue.
The implications of the decision ultimately depend on the specific circumstances of a former S corporation (or an S corporation considering a revocation of its election). It has no relevance to former S corporations that distribute their entire AAA balance during the PTTP. But it could have implications for former S corporations that do not, or cannot, distribute the entire AAA balance during the PTTP. If those entities re-elect subchapter S status in the future, the court’s decision provides further ammunition to the IRS to assert that any prior AAA balance would not be available to cover future distributions.
This decision highlights the importance of proper AAA planning for any S corporation, but particularly for those that might be contemplating a switch to C corporation status to take advantage of reduced corporate tax rates. Taxpayers who do so thinking that they can re-elect following the normal five-year waiting period should recognize that any remaining AAA from the prior S period likely will be lost.
1The Tax Cuts and Jobs Act provided a special rule for certain S corporations that chose to revoke their subchapter S status during the two-year window beginning on the date of enactment of the Act (Dec. 22, 2017). The provision allows those eligible terminated S corporations to treat distributions following the PTTP as coming from AAA and C corporation earnings and profits on a pro rata basis. As such, under this new rule the S corporation’s AAA technically would not reset to $0 at the end of the PTTP (i.e., under this revised rule AAA is available to offset distributions following the PTTP). Nonetheless, the court’s decision would still be relevant in the event the corporation were to re-elect subchapter S status in the future. In that case, it appears that the court would conclude that AAA would then reset to $0.