Chapter 12

Key Terms

A special account is used to track undistributed earnings of an S corporation that have been taxed to shareholders previously. Distributions from this account, known as the accumulated adjustments account (AAA), are tax-free. Essentially, the AAA is the cumulative total of undistributed nonseparately and separately stated items for S corporation taxable years beginning after 1982. Thus, the account parallels the calculation of C corporation AEP. Calculation of the AAA applies to all S corporations, but the AAA is most important to those that have been C corporations. The AAA provides a mechanism to ensure that the earnings of an S corporation are taxed to shareholders only once.

The amount of any distribution to an S corporation shareholder is equal to the cash plus the fair market value of any other property distributed. How the distribution is taxed depends upon whether the S corporation has C corporation accumulated earnings and profits (AEP, described in Chapter 4).

Without the built-in gains tax (§ 1374), it would be possible to avoid the corporate double tax on a disposition of appreciated property, by electing S corporation status.

With the consent of all of its shareholders, an S corporation can elect to have a distribution treated as if it first were made from AEP rather than from the AAA. This mechanism is known as an AAA bypass election. This election may be desirable as a simple means by which to eliminate a small AEP balance.

Schedule M–2.  S corporations report changes in the AAA on Schedule M–2 of Form 1120S. Schedule M–2 contains a column labeled Other adjustments account (OAA). This account includes items that affect basis but not the AAA, such as tax-exempt income and any related nondeductible expenses. For example, life insurance proceeds received and insurance premiums paid are traced through the OAA. Distributions are made from the OAA after AEP and the AAA are depleted to zero. Distributions from the OAA are generally tax-free.

Passive Investment Income Limitation.  The Code provides a passive investment income (PII) limitation for S corporations that were previously C corporations or for S corporations that have merged with C corporations. If an S corporation has C corporation E & P and passive income in excess of 25 percent of its gross receipts for three consecutive taxable years, the S election is terminated as of the beginning of the fourth year.23

Distribution Ordering Rules.  A cash distribution from an S corporation with AEP comes first from the AAA (limited to stock basis). The distribution is then deemed to be made from previously taxed income (PTI)33 generated under old S corporation rules (pre-1983). Distributions from the AAA and PTI are tax-free. The remaining distribution is taxed as a dividend to the extent of AEP. After AEP is fully distributed, any residual amount is applied against the shareholder’s remaining stock basis. This amount is a tax-free recovery of capital.34 Any distributions in excess of stock basis are taxed as capital gains.

Another alternative, the S corporation, provides many of the benefits of partnership taxation and at the same time gives the owners limited liability protection from creditors. The S corporation rules, which are contained in Subchapter S of the Internal Revenue Code (§§ 1361–1379), were enacted to minimize the role of tax considerations in the entity choice that businesspeople face. Thus, S status combines the legal environment of C corporations with taxation similar to that applying to partnerships. S corporation status is obtained through an election by a qualifying corporation with the consent of its shareholders.

To achieve S corporation status, a corporation first must qualify as a small business corporation. If each of the following requirements is met, then the entity can elect S corporation status.

Another alternative, the S corporation, provides many of the benefits of partnership taxation and at the same time gives the owners limited liability protection from creditors. The S corporation rules, which are contained in Subchapter S of the Internal Revenue Code (§§ 1361–1379), were enacted to minimize the role of tax considerations in the entity choice that businesspeople face. Thus, S status combines the legal environment of C corporations with taxation similar to that applying to partnerships. S corporation status is obtained through an election by a qualifying corporation with the consent of its shareholders.

Voluntary Revocation.  A voluntary revocation of the S election requires the consent of shareholders owning a majority of shares on the day that the revocation is to be made.20 A revocation filed up to and including the fifteenth day of the third month of the tax year is effective for the entire tax year, unless a later date is specified. Similarly, unless an effective date is specified, revocation made after the first 2½ months of the current tax year is effective for the following tax year.


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