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S Corporation's AAA Resets to Zero after a Post-Termination Transition Period
(Parker Tax Publishing October 2019)
A district court held that, where an S corporation doesn't distribute all of its accumulated adjustments account (AAA) within the post-termination transition period, it cannot distribute its remaining AAA balance tax-free if it reelects to become an S corporation. The court also held that the IRS cannot recalculate a corporation's taxable income in a year beyond the statute of limitations to determine the corporation's tax liability of a year within the limitations period. Tomseth v. U.S., 2019 PTC 399 (D. Ore. 2019).
Background
Matthew Tomseth and his wife, Diana, are shareholders in three family-owned corporations: Les Schwab Warehouse Center, Inc. (LS Warehouse), Les Schwab Tire Centers of Washington, Inc. (LS Washington), and Les Schwab Tire Centers of Portland, Inc. (LS Portland). Throughout their history, these Les Schwab tire companies went back and forth between operating as S corporations and operating C corporations so that the companies could use each designation's tax benefits.
While income of an S corporation is generally only taxed at the shareholder level whether it is distributed or not, income of a C corporations is generally taxed at both the corporate level and, when distributed, at the shareholder level. S corporations sometimes retain their taxed earnings instead of distributing them to their shareholders. Code Sec. 1368(e) requires these taxed but undistributed earnings to be kept in a separate accumulated adjustments account (AAA). The Code also allows corporations to go back and forth between S corporation and C corporation designations. As a result, an issue can arise about the status of these taxed but undistributed AAA funds. Code Sec. 1371(e) allows for an S corporation's AAA balance to be distributed tax free, even after it becomes a C corporation, as long as the distribution happens within a one-year post-termination transition period (PTTP). Thus, it allows distributions up to the value of the AAA balance to escape dividend treatment under subchapter C.
In 2013, the Tomseths received $9.3 million in distributions from all three corporations, which the IRS characterized as taxable dividends. The corporations were C corporations at the time of the distributions and the distributions were within the PTTP. In previous years, however, the corporations had twice operated as S corporations and calculated their AAA funds at the beginning of their most recent S election year as the sum of the AAA balances during these two S corporation periods.
For example, LS Warehouse, which was incorporated as a C corporation in 1958, elected to be an S corporation for the first time in 1987 (the "First S Period"). It then reelected to be taxed as a C corporation in December 1993. As of December 31, 1993, LS Warehouse had a balance in its AAA of $51.6 million and distributed $26.7 million to its shareholders during its PTTP, leaving $24.9 million of undistributed AAA. LS Warehouse continued as a C corporation from 1994 through 2008 and reelected to be an S corporation on January 1, 2009 (the "Second S Period"). It then carried over the First S Period's AAA and added it to the new 2009 AAA balance at the start of the Second S Period. At the end of 2012, considering solely the AAA funds generated during its Second S Period, LS Warehouse had an AAA balance of $17.6 million. But in 2013, LS Warehouse again reelected to become a C corporation and distributed $42.5 million - roughly the sum of its First and Second S Period AAA balances (i.e., $24.9 million plus $17.6 million) - to its shareholders, of which the Tomseths received $7.4 million. The IRS determined that $4.3 million of the $7.4 million was a taxable dividend rather than a tax-free AAA distribution. LS Washington and LS Portland followed the same pattern of corporate changes as LS Warehouse.
According to the Tomseths, none of the 2013 distributions were taxable dividends because the distributions were already taxed when the three corporations were operating as S corporations. They initially calculated their 2013 tax liability as they assumed the IRS would calculate it - they treated the corporations' distributions as taxable and included "disclosure statements with the relevant tax returns stating that [they believed] that the distributions from the Corporations' old AAA were nontaxable and [that they] intended to file claims for refund."
In April 2015, the Tomseths filed a Form 1040X and claimed a refund for the taxes paid under the theory that the AAA never expires and funds in the AAA are thus available for tax-free distribution once the corporations began their Second S-Periods. Although the IRS first issued them a refund for $2.3 million, it then audited the Tomseths' tax returns and concluded that the refund was mistakenly issued. It reached this determination based on a 2014 IRS Chief Counsel Advice (CCA 201440621), which concludes that AAA funds expire if the corporation does not distribute them within the PTTP.
The IRS demanded that the Tomseths repay the $2.3 million. Additionally, during the same audit, the IRS discovered that, in 2005, LS Portland had another tax deficiency of $357,000. According to the IRS, LS Portland started its Second S period in 2004 with an AAA balance of $0. As a result, it didn't have sufficient AAA funds to make its 2005 distribution of $2 million tax free. The IRS claimed that a large portion of that distribution was taxable. However, the IRS conceded that, in 2013, it was too late to assess the tax that should have been reported and paid in 2005. It thus reduced LS Portland's AAA balance to a negative balance of $2 million in 2005. That negative balance was carried forward to reduce the AAA available in 2013, which therefore made $1.8 million of the distributions in 2013 taxable to LS Portland's shareholders, with $357,000 being Tomseths' pro rata share. The Tomseths disputed the IRS's actions and took their case to a district court.
Besides arguing that AAA never expires, the Tomseths argued that Code Sec. 6501 bars collection of any back-taxes outside that provision's three-year limitations period and the IRS should not be allowed to sidestep this limitations period by carrying forward LS Portland's AAA deficit in 2005 and applying it to its 2013 AAA distribution. The government responded that courts can examine tax liability for a year not in suit to better determine the correct tax liability for a year in suit. It explained that although Code Sec. 6501 bars tax "assessments" outside the statute of limitations, it doesn't bar "recalculations." According to the government, the IRS can recalculate taxable income in a year beyond the statute of limitations to determine tax liability within the limitations period.
The district court was asked to decide: (1) whether a corporation that doesn't distribute all of its AAA within the PTTP can still distribute its remaining AAA balance tax-free if it reelects to become an S corporation, and (2) whether the statute of limitations barred the IRS from collecting tax on certain improperly distributed AAA funds by LS Portland in 2005.
The district court held that a corporation that doesn't distribute all of its AAA within the PTTP cannot later distribute its remaining AAA balance tax free if it reelects to become an S corporation. The court found CCA 201440621 to be compelling, noting that it includes over a dozen paragraphs of legal analysis over the course of four pages and assesses the interplay between the AAA provision of Code Sec. 1368(e)(2) and Reg. Sec. 1.1368-2(a)(l). Code Sec. 1368(e)(1), the court noted, defines AAA as an account of the S corporation which is adjusted for the S period. Under Code Sec. 1368(e)(2), the term "S period" means the most recent continuous period during which the corporation has been an S corporation. The phrase "of the S corporation," the court noted, implies that the AAA can necessarily only exist while there is an S corporation in existence, i.e., an AAA does not continue to exist after the S corporation becomes a C corporation. Otherwise, the court stated, the AAA would not belong to the S corporation and therefore could not be "of the S corporation." According to the court, this is the only interpretation that gives effect to the phrase "of the S corporation," and keeps the Tomseths from carrying over AAA from previous S corporation periods absent an exception to this general rule, e.g., if the shareholder distribution is within the PTTP.
With respect to the IRS's assessment on LS Portland, the court held that LS Portland was in a new S period when it made the 2013 distributions to shareholders. At that point, the court said, any unused AAA from the previous S period that was not distributed during the previous PTTP had disappeared, and there was no negative AAA balance to carry over to the most recent S corporation period. Thus, the tax on LS Portland was outside the limitations period and the Tomseths were owed a refund for amounts paid with respect to that assessment.
For a discussion of AAA accounts and CCA 201440621, see Parker Tax ¶32,110. For a discussion of the PTTP, see Parker Tax ¶34,580.
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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