An Overview of AAA
AAAs are used to track the cumulative taxable income earned by an S corporation but not yet distributed to its shareholders. Newly formed S corporations are deemed to start with an AAA balance of zero on their first day of existence [Treasury Regulations section 1.1368-(2)(a)(1)]. There are, however, multiple ways to increase or decrease AAA balance, and in turn basis, after the creation of an S corporation [Treasury Regulations section 1.1368-2(a)(2)-(3)]. AAA balance determines the portion of distributions that can be distributed tax-free from an S corporation to its shareholders. Distributions exceeding the AAA balance are a reduction in basis, assuming the entity has always been an S corporation, or a capital gain, if the S corporation has insufficient basis to cover the distribution [IRC section 1368(b)]. If the entity was formerly a C corporation that had undistributed earnings and profits (E&P), then the distributions in excess of the AAA balance (assuming a bypass election is not in effect) are taxed as dividend income to shareholders to the extent of the E&P [IRC sections 1368(c) and (e)(3)]. Any remaining distributions after the E&P has been exhausted are a return of capital or capital gain if there is not sufficient basis to cover the distribution.
If an S corporation converts to a C corporation, it can still make tax-free cash distributions to the extent of AAA during the PTTP. According to IRC section 1377(b)(1), the PTTP runs from the day after the last day of the corporation’s last taxable year as an S corporation to the later of one year after that day or the due date for filing the return, including extensions, for the corporation’s last year as an S corporation. The IRC also provides for PTTPs of 120 days if, after termination of the S election, an audit of the corporation adjusts an S item or if it is determined that the corporation’s election was terminated in a previous taxable year [section 1377(b)(1)(B)-(C)].
IRS Argument for Resetting AAA
The example used in CCA 201446021 concerns a taxpayer initially incorporated as a C corporation that then converted to an S corporation, and then back to a C corporation before electing to be treated as an S corporation for a second time. The company performed these switches to take advantage of the corporate and individual tax rates associated with each of these entity structures. During the switch from the taxpayer’s first S corporation to the second C corporation, some, but not all, of the AAA balance was distributed during the PTTP per IRC section 1377(b)(1). The corporation did not distribute the full amount of the AAA balance because it lacked sufficient cash. It was also suggested that the corporation needed the cash for “new market growth opportunities.” After the conversion from the second C corporation to the second S corporation, the taxpayer claimed that the remaining AAA balance, after the PTTP, carried over to the second S corporation from the first S corporation. This raised the question of whether the AAA balance from the first S corporation continued to exist between the PTTP and the formation of the second S corporation.
The IRS’s ultimate rationale for resetting AAA is to prevent taxpayers from toggling between S and C corporation statuses to receive lower tax rates while retaining the prior S corporation’s AAA balance.
The IRS’s OCC provided several reasons for its conclusion. Firstly, when Congress created subchapter S in the Technical Amendments Act of 1958, it referenced a concept similar to the notyet-in-existence AAA in section 1375(d) of the 1958 act (and, thereby, the IRC) called “undistributed taxable income previously taxed to shareholders” (PTI). The IRS reasoned that PTI applies to the resetting of AAA in this situation, since “the term ‘all prior taxable years’ does not include a taxable year to which the provisions of section 1375 do not apply and to taxable years prior to such year.” The IRS also stated that section 1375 is applicable for computing “a shareholder’s net share of previously taxed undistributed taxable income … excluding any taxable year prior to a break in the election.” Though the IRS noted there are differences between PTI and AAA, it reasoned that there is nothing within the statutory or legislative history since the 1958 Act that refutes its argument.
The IRS also contended that Congress originally considered the PTTP to be the appropriate time for an S corporation to decrease its AAA balance after it had terminated its election. Furthermore, by allowing AAA to survive the PTTP, certain events such as redemptions [IRC section 1368(e)(1)(B)] might create unintended tax consequences (CCA 201446021).
The IRS’s ultimate rationale for resetting AAA is to prevent taxpayers from toggling between S and C corporation statuses to receive lower tax rates while retaining the prior S corporation’s AAA balance. This could encourage a taxpayer to remain an S corporation in order to be able to distribute the entire AAA balance tax-free, especially if the account is substantial. In addition, administrative feasibility would be hampered if the AAA balance were to reset because any S corporation that terminated its election would have to ensure that distortions did not occur, even though the AAA balance cannot be altered during a C corporation’s life. This would have to be monitored in perpetuity unless the corporation became an S corporation. Thus, the IRS concluded that the AAA balance should be reset to zero after the PTTP when an S corporation later reelects S status.
Arguments against Resetting AAA
Many arguments can be made for not resetting AAA when an S corporation reelects S status. First, no new S corporation is created by the termination and reelection of the S status, only a new S period. It is not evident from IRC section 1368(e)(2) that the AAA balance would reset merely because of the new period. This subjective argument of how the Subchapter S Revision Act of 1982 was intended to be interpreted is difficult to prove, since the 1982 act clearly did not conceive that the S-to-C-to-S switch would be readily made—or, at the very least, did not provide for such a transition.
Moreover, since the mention of PTI in the 1958 act does clearly discuss that the “prior taxable years” must be consecutive, this act was superseded by the 1982 act, making the IRS’s argument irrelevant. AAA could be a replacement for PTI, indicating that the prior treatment of PTI is no longer proper for AAA. Furthermore, it should be noted that the PTI rules specifically denote prior taxable years, but the AAA ones do not. This could indicate that Congress believed that this should be relevant for AAAs.
The IRS might counter that PTTP bars the taxpayer from carrying over AAA balance to an S corporation that reelects S status. Treasury Regulations section 1.1368-2(a)(1) determines that “on the first day of the first year for which the corporation is an S corporation, the balance of the AAA is zero.” There is, however, no specific statement that terminating an S corporation to become a C corporation and then reelecting S corporation status creates a new S corporation. Because the law does not specifically state that the AAA balance is zero on the first day of the most recent S period, it can be argued that the change in periods is not relevant, especially given that an S corporation retains its employer identification number (EIN) and that IRC section 1368(e)(2) defines the S period as the most recent continuous period during which the corporation was an S corporation.
Resetting AAA for an S corporation reelecting S status could have a chilling effect on shareholders, who might have to pay tax on any C corporation E&P distributions.
Furthermore, the American Bar Association (ABA) Tax Section suggested in its technical comments to the 1982 act that the term S period “include the period from January 1, 1959, or the date a sub-chapter S election was made, if the election was in effect as of the effective date of this bill.” This further indicates that it might not have been Congress’ intention for PTI and AAA to be equivalent. The ABA Tax Section further commented about the ordering rules under PTTP, which were not explicitly included in the proposed sections 1371(e) and 1377(b) of the 1982 act, that “at a time when Congress is wrestling with ways to reduce the government burdens on small businesses, another may be to incorporate a reordering provision which allows such distribution to come ahead of a distribution out of accumulated earnings and profits if termination occurs … the better solution is to extend the withdrawal period for an unlimited period of time.”
The IRS also claims that IRC sections 1368(e)(1) and (2) should not be read in conjunction with each other because this would create an unfavorable ruling and could create “distortions” if the AAA survived when an S corporation became a C corporation. Reading section 1368(e)(1)(A) by itself, however, shows that the AAA “is adjusted for the S period in a manner similar to the adjustments under section 1367 (except that no adjustments shall be made for income which is exempt from tax under this title and no adjustment shall be made for any expense not deductible in computing the corporation’s taxable income and not properly chargeable to capital account).”
Under the IRC section 1367 point of view, the distributions would have to be treated in a manner similar to the “adjustments to basis of stock of shareholders,” which is an account that continues to exist even after termination of the S corporation. Nowhere in section 1367 does it state that the basis of stock does not survive the S period, especially since the S period was introduced in section 1368(e)(2), which came after the creation of the AAA in section 1368(e)(1). To think otherwise creates a contradiction between the various sections, in that AAA balance cannot both be treated like basis of stock in section 1367 and be terminated under section 1368(e)(2). This indicates that having the AAA balance expire was not Congress’s intention.
Tax Effect of Resetting AAA
The IRS OCC stated that there is no real tax effect of resetting AAA. Distributions of AAA could be performed prior to the termination of the S corporation through cash or other distributions. Cash also could be borrowed in order to distribute AAA prior to the termination of S status or the PTTP, depending upon the benefits gained from the lower taxes-versus-interest rate. Cash collection could be sped up (e.g., through factoring) so that enough cash will be available in order to be eligible to distribute the AAA balance fully.
The IRS also noted that resetting AAA balance creates a timing difference, not a permanent one, as an S corporation that does not fully distribute its AAA balance would still be able to make tax-free distributions after the PTTP up to the shareholder’s basis so long as it distributes its entire C corporation E&P first. If the corporation does not distribute its AAA balance during the PTTP, the latter distribution would be treated as a dividend up to the E&P, then as return of basis, then as capital gain. The first and last of these are subject to the federal capital gains tax rate and the Medicare surtax on net investment income, if applicable.
The Exhibit illustrates the tax effects of converting from an S corporation to a C corporation and back to an S corporation, as well as the effect on AAA balance and E&P. The taxpayer will have a total tax burden of $1,000 (subject to her capital gains tax rate) if AAA is reset to zero upon reelection of S status. By carrying over a AAA balance from the prior S corporation, shareholders do not recognize dividend income until the AAA from the prior S corporation is exhausted. Doing so may potentially decrease the shareholder’s tax burden by $1,000 in the initial year following reelection of S status, assuming there is sufficient AAA balance to cover any distributions made to shareholders.
Contrary to the IRS’s claims, the S corporation and its shareholders do not have the opportunity to determine when E&P is exhausted, because it must be distributed first upon reelection of S status, even before reducing the shareholders’ stock basis. This can create a potential permanent tax hardship, depending upon the shareholders’ capital gain tax rate, especially if the termination of the first S status was involuntary, as predefined in IRC section 1361(b). If the AAA balance were carried over from the prior S corporation, the new S corporation could plan when E&P is distributed by utilizing either the AAA balance from the first S election or by utilizing the bypass election under IRC section 1368(e)(3). Resetting AAA does not afford the taxpayer any leeway in how distributions are taxed. Furthermore, an involuntary termination would force an S corporation to distribute its AAA within the PTTP in order to avoid losing its tax-free distributions, and this could result in the corporation having to borrow money. This would not be the case if the AAA balance were not reset.
There are some major ambiguities in the statutory and legislative history surrounding the tax implications of AAA. Although the IRS has provided its opinion, they have also agreed to some extent with the contrary arguments raised in this article.
Resetting AAA for an S corporation reelecting S status could have a chilling effect on shareholders, who might have to pay tax on any C corporation E&P distributions. This could also have a major tax impact on shareholders whose S election was terminated through no fault of their own. There are some major ambiguities in the statutory and legislative history surrounding the tax implications of AAA. Although the IRS has provided its opinion on the matter, they have also agreed to some extent with the contrary arguments raised in this article.
Because the OCC’s ruling cannot be cited as precedent by other taxpayers or by IRS personnel, another situation with similar facts heard by a court of original jurisdiction (e.g., Tax Court, District Court, etc.) could potentially result in a different finding. This poses a tax-planning risk to corporations. In the authors’ opinion, Congress or the Treasury Department should clarify IRC section 1368 so that its intention is indisputable. In the meantime, CPAs should proceed with care when advising corporate clients on transfers to or from S corporation status.