Former S Corp Must Reduce AAA for Distribution in Post-Termination Transition Period

(Parker Tax Publishing May 2019)

The IRS ruled that, if, during a former S corporation's post-termination transition period, the corporation distributes cash in redemption of a shareholder's stock and the distribution is characterized as a distribution under Code Sec. 301, the corporation should reduce its accumulated adjustments account to the extent of the proceeds of the redemption pursuant to Code Sec. 1368. Rev. Rul. 2019-13.

Facts

X is a corporation that once was a C corporation and later elected to be an S corporation under Code Sec. 1362(a). X's S election terminated under Code Sec. 1362(d) and it is now a C corporation. An individual, Al, owns all 100 shares of the outstanding stock of X. X is a calendar-year taxpayer. At the time of its conversion to an S corporation, X had accumulated earnings and profits (E&P) of $600 and no current E&P. At the time of the termination of its S election, X's accumulated adjustments account (AAA) was $800 and its accumulated E&P was still $600. During X's post-termination transition period, it redeems 50 of Al's 100 shares of X stock for $1,000. X makes no other distributions during the post-termination transition period. Pursuant to Code Sec. 302(d), the redemption is characterized as a distribution subject to Code Sec. 301. For the tax period that includes the redemption, X has current E&P of $400.

Analysis

Generally, under Code Sec. 1371(e), any distribution of cash by a former S corporation with respect to its stock during the post-termination transition period (as defined in Code Sec. 1377(b)) is applied against and reduces the adjusted basis of the stock to the extent the distribution does not exceed the corporation's AAA. Code Sec. 1368(e) defines the AAA as an account of the S corporation, which is adjusted for the S period in a manner similar to the adjustments under Code Sec. 1367 (except that no adjustment is made for income and related expenses exempt from tax and the phrase "(but not below zero)" is disregarded in Code Sec. 1367(a)(2)). Additionally, no adjustment is made for federal taxes attributable to any tax year in which the corporation was a C corporation. The term "S period" is defined in Code Sec. 1368(e)(2) as the most recent continuous period during which the corporation has been an S corporation.

The IRS was asked to address the following question: If, during a former S corporation's post-termination transition period, the corporation distributes cash in redemption of a shareholder's stock and the distribution is characterized as a distribution under Code Sec. 301, should the corporation reduce its AAA pursuant to Code Sec. 1368.

The IRS concluded that, in such situations, the corporation should reduce its AAA to the extent of the proceeds of the redemption pursuant to Code Sec. 1368. The redemption of 50 of Al's 100 shares of X stock for $1,000, the IRS said, is characterized as a reduction of X's $800 of AAA with the remaining $200 characterized as a dividend under Code Sec. 301(c)(1).

For a discussion of distributions during an S corporation's post-termination transition period, 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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