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S corporation distributions may be in the form of cash or property. How S corporation distributions to a shareholder are taxed depends on whether the corporation has earnings and profits.
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Earnings & Profits
An S corporation is not considered to have earnings and profits for tax years beginning after 1982 in which it was an S corporation. However, an S corporation can have earnings and profits from Quoted from S corporations Utah Gouvernement
(1) Liquidations, redemptions, and reorganizations governed by the rules of Sub-chapter C of the Code,
(2) Tax years in which the corporation was not an S corporation,
(3) Any of the S corporation’s tax years that began before 1983, or
(4) A corporate acquisition that results in a carryover of earnings and profits under §381 Quoted from S corporations Utah Gouvernement.
Note: The existence of earnings and profits is also important to an S corporation if it has passive investment income. The presence of earnings and profits can mean that a distribution is a taxable dividend or the corporation is liable for a tax on its excess net passive income. Quoted from S corporations Utah Gouvernement.
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IRS concludes that S corporation AAA balance expires after a post-termination transition period
After an S election terminates, the corporation can make tax-free money distributions to the extent of any previously undistributed accumulated adjustments account (§1371(e)). This privilege extends only during the “post-termination transition period.”
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The post-termination transition period starts on the day after the last day of the corporation’s last tax year as an S corporation. It ends on the later of:
(1) One year after the effective date of the termination, or the due date for the last S corporation return, whichever is later, or
(2) 120 days after a determination that the S corporation’s election had terminated for a previous year. Original text
Note: A determination is defined as a court decision that becomes final, a closing agreement, or an agreement between the corporation and the IRS that the corporation did not qualify.
For taxable years beginning after December 31, 1996. The definition of post-termination period is expanded to include the 120-day period beginning on the date of any determination pursuant to an audit of the taxpayer that follows the termination of the S corporation’s election and that adjusts a sub-chapter S item of income, loss or deduction of the S corporation during the S period (§1377(b)(1)(B)). IRS original
If an S corporation has income and profits but has not elected to distribute them first, discussed above, any distribution it makes will come from one or more of the following sources in the order indicated.
1. First, a distribution is treated as coming out of the accumulated adjustments account. Distribution out of AAA is applied against and reduces the shareholder’s adjusted stock basis. Distribution out of AAA more than the shareholder’s adjusted stock basis is treated as gain from the sale or exchange of property. The AAA has a reduction in the amount of the distribution treated as coming from it. If distributions during the tax year exceed the AAA at the close of the tax year (figured before the distributions), the AAA is allocated to each distribution made during the year in proportion to the sizes of the distributions.
2. Second, if the S corporation shareholder has previously taxed income (PTI) in the corporation, the PTI is the next source for distribution.
Note: The PTI account relates to the rules used for Subchapter S corporations before the Subchapter S Revision Act of 1982 became effective. As a result, it rarely exists today. However, if the S corporation has earnings and profits, a distribution from PTI is important to a shareholder because an S corporation shareholder who has PTI may receive a nontaxable distribution from PTI.
Distribution out of PTI is applied against and reduces the shareholder’s basis in the stock. Distribution out of PTI more than the shareholder’s basis in the stock is treated as gain from the sale or exchange of property. The shareholder’s PTI account must be reduced by the amount of the distribution made from PTI.
3. Third, a distribution is treated as coming out of the S corporation’s earnings and profits. A distribution is treated as a dividend up to the number of the corporation’s earnings and profits.
4. Fourth, a distribution is applied against and reduces the shareholder’s basis in the stock.
5. Fifth, the distribution is treated as a sale or exchange of property.
No Earnings & Profits
If the company has no earnings and profits, all distribution a shareholder receives is a return of basis in the shareholder’s stock in the S corporation, and, as such, it reduces the adjusted basis of his or her stock in the S corporation. At the close of an S corporation’s tax year, the shareholder must adjust his or her basis in the S corporation stock for all increases and decreases. This does not include the decrease to an adjusted basis for any distributions during the S corporation’s tax year. Quoted from: https://corporations.utah.gov
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The shareholder then uses this adjusted basis to figure the tax treatment of any distributions received during the S corporation’s tax year. If the distributions are less than or equal to the adjusted basis, they are a return of capital. The adjusted basis of the shareholder’s stock after being reduced for the distributions is next year’s beginning adjusted basis. If the distributions are more than the adjusted basis of the shareholder’s stock, the excess is gaining from the sale or exchange of property. As such, the gain is long- or short-term capital gain. The next year’s beginning basis for shareholder’s stock is zero.
Acme, an S corporation, has no earnings and profits. Acme distributes $80,000 to its only shareholder, Betty. Her adjusted basis in the stock is $50,000. The amount of the distribution that exceeds her adjusted basis in the stock, $30,000 ($80,000 minus $50,000), is taxable as a gain from the sale or exchange of property.
Appreciated Property Distributions
If the corporation distributes cash, the shareholder uses the amount received to figure the tax effect and the adjusted basis of his or her stock. If property other than cash is distributed, the amount the shareholder uses as a distribution is the fair market value of the property. When an S corporation distributes appreciated property, the S corporation will be treated as if it had sold the property to the shareholders at fair market value. Appreciated property is S corporation property that has a fair market
value that is more than its adjusted basis to the S corporation. The amount the shareholder uses as a value to figure the tax treatment of the property distribution is the same fair market value that the S corporation used when it treated the property as if it had been sold to the shareholder for fair market value. 9-54
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