Category: Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Here is a draft letter to your client concerning the federal income tax ramifications of an S corporation that has C corporation earnings and profits. I want to underscore something mentioned in my engagement letter; namely, my work deals only with federal income tax consequences. Since I practice all over the U.S., I am not equipped to handle the peculiarities of all the various state tax systems. I urge you to consider whether there may be any special state income tax rules that affect your client in this matter. For purposes of this memo, I will refer to the corporation whose stock your client will receive as XYZ. In addition, I have also sent a copy of this memo to you via e-mail for easy editing. Dear XXXXXX. Soon you will be the sole owner of XYZ, an S corporation. XYZ has approximately $200, 000 of accumulated earnings from years preceding its election to be taxed as an S corporation. These earnings are referred to as C corporation earnings and profits, or E&P for short. The purpose of this letter is explain the federal income tax ramifications of XYZ's E&P. As you well know, there are two taxing options for a corporation. A regular corporation (or C corporation) pays tax on its earnings at the corporate level. Then, a second tax is paid when those same earnings are distributed to the shareholders. This system of double taxation is precisely the reason many people choose the alternative form of corporate taxation offered by S corporation status. An S corporation typically pays no tax on its own; rather, income flows through to the shareholders, and they pay the tax personally. With an S corporation, there is typically only one level of taxation. The E&P concept is key to the double taxation system imposed on C corporations. When a C corporation makes a non-liquidating distribution of money or property to its stockholders, the question is what does the distribution really represent--a distribution of corporate earnings (i.e., a dividend), a return of the shareholder's stock investment, or a distribution in excess of that investment. Each category of distribution is taxed differently. The first and most important question is whether a distribution is really a dividend, and E&P is the yardstick used for that determination. The exact determination of E&P requires a rather complex compution that is more-or-less a hybrid between taxable income and financial statement net income. Conceptually, E&P represents the corporation's ability to pay dividends. A distribution is treated as a dividend (and taxed to the shareholders as ordinary income) to the extent the corporation has E&P either in the current year or accumulated from past years. Distributions in excess of current or accumulated E&P are treated as a nontaxable return of capital to the extent of the shareholder's stock basis. Beyond that, distributions are treated as a sale of the shareholder's stock, generally taxed as a capital gain. When a corporation has undistributed E&P, this is viewed for tax purposes as the potential for paying taxable dividends in the future. When such a corporation elects to be taxed as an S corporation, as XYZ did, that dividend-paying potential carries over to the S corporation. This is by far the most important ramification of having C corporation earnings and profits. As you know, S corporation shareholders are taxed on corporate earnings whether such earnings are distributed. When distributions are actually made from an S corporation, they are assumed to come first from income that has already been taxed but has remained undistributed. Thus, any distributions up to the amount of undistributed previously taxed income, are not further taxed. This rule applies whether or not the S corporation has E&P from C corporation tax years. The point of departure between S corporations with C corporation E&P and those without comes when there are distributions in excess of undistributed previously taxed income. An S corporation with C corporation E&P is required to maintain an account called the accumulated adjustments account. This account, commonly referred to as AAA, is a measure of the S corporation's previously taxed, but undistributed income. If an S corporation with C corporation E&P makes a distribution in excess of AAA, the excess is treated as a taxable dividend to the extent of C corporation E&P. The following example illustrates how distributions are treated depending on whether the corporation has C corporation E&P. Assume an S corporation is owned by a single shareholder. The shareholder's stock basis is $50,000 consisting of an initial investment of $10,000 plus $40,000 of undistributed S corporation income on which the shareholder has paid already paid tax. Assume the corporation makes a distribution of $70,000. If the corporation has no C corporation E&P, the first $50,000 of the distribution is tax-free. The corporation is simply distributing previously taxed earnings and then returning the shareholder's initial investment in his stock. The remaining $20,000 is treated as payment for the shareholder's stock. Absent some unusual circumstance, this payment would give rise to $20,000 of capital gain to the shareholder. On the other hand, suppose the corporation has $10,000 of C corporation E&P. The first $40,000 of the distribution represents payment of previously taxed earnings and is thus tax-free to the shareholder. The next $10,000 of the distribution would be considered a taxable dividend to the shareholder--this is the amount of C corporation E&P. The next $10,000 is a tax-free return of the shareholder's initial stock investment, and the final $10,000 represents a payment for the shareholder's stock, normally treated as capital gain. To summarize, existence of C corporation E&P simply means that distributions from the corporation in excess of undistributed previously taxed income will be considered an ordinary dividend to the extent of E&P. E&P must be distributed as a taxable dividend before the shareholder's can receive a tax-free return of their stock investment. Note that in the case of liquidating distributions, there is no distinction between S corporations with E&P and those without. All liquidating distributions are treated the same, typically capital gain to the shareholder, to the extent such distributions exceed stock basis. There is one additional ramification of having C corporation E&P. There is a penalty tax imposed at the S corporation level in the event the corporation earns too much passive investment income--interest, dividends, etc. If such income exceeds of 25% of total gross income, the penalty tax is imposed. If the excess passive income continues for three years in a row, S corporation status is lost. This rule only applies if the corporation has C corporation E&P. Since most companies have gross operating income far in excess of passive investment income, this provision is rarely applicable. When you have had a chance to digest this letter, I invite you raise any questions you may have. I look forward to speaking with you. Sincerely,
xxxxxx, CPA |
