Question

How do earnings and profits affect distributions and adjustments from S Corp’s?

Answer 1

An S corporation generally avoids income tax at the corporate level. Income, expense, credit, and adjustment items flow through to the shareholders who pay any required tax due. The distributions from an S corporation could be taxable or not, depending on the shareholder’s basis in his or her S corporation stock. If the S corporation was previously a C corporation, or it acquired another C corporation with earnings and profits (E&P) under Internal Revenue Code (IRC) § 381, Carryovers in Certain Corporate Acquisitions, the distributions rule could be more complex.

Issue
If the S corporation has AE&P, the priority of distributions is determined as follows:

1. A Nontaxable Distribution of the Accumulated Adjustments Account (AAA): The distribution is not taxable unless it is in excess of the shareholder’s basis. If the shareholder’s basis is less than the AAA, distributions are not taxable to the extent of the stock basis
2. A Dividend: The remaining distribution is taxable as a dividend (the maximum tax rate on qualified dividends is 20% in 2016) to the extent of AE&P. This has no effect on the shareholder’s stock basis
3. A Nontaxable Reduction of Any Remaining Basis: The distribution is a tax-free reduction of the shareholder’s basis in the corporation’s stock
4. Capital Gain: Any distribution in excess of the shareholder’s stock basis is treated as gain (either short-term or long-term, depending on the holding period of the stock) from the sale or exchange of the underlying stock. The maximum tax rate on long-term capital gains is 20% in 2016.

It is important to know that E&P is not identical to either taxable income or retained earnings. E&P is an independent measure of a corporation’s economic income. It differentiates between the distributions made from earnings that must be taxed as a dividend and those that represent a return of shareholder capital that should not be taxed.