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Tax Geek Tuesday: 2013 Tax Planning Is Not Finished For S Corporations - How To Purge Problematic Earnings and Profits

Feb 25 2014, 8:52am CST | by

In this week’s Tax Geek Tuesday, we take a look at one of the rarest of species in the tax world: the opportunity to implement an impactful tax planning strategy after year-end. Specifically, we’re...

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22 weeks ago

Tax Geek Tuesday: 2013 Tax Planning Is Not Finished For S Corporations - How To Purge Problematic Earnings and Profits

Feb 25 2014, 8:52am CST | by

In this week’s Tax Geek Tuesday, we take a look at one of the rarest of species in the tax world: the opportunity to implement an impactful tax planning strategy after year-end. Specifically, we’re going to discuss the opportunity for a calendar-year S corporation to elect to purge its accumulated earnings and profits as of December 31, 2013 even though New Years Eve has long since passed. As discussed in detail below, ridding an S corporation of any accumulated earnings and profits may be desirous for a number of reasons.

The strategy traverses subchapters C and S and touches on several complex and misunderstood topics, but hey…that’s what Tax Geek Tuesday is for. This ain’t for the faint of heart.

Let’s get to it.

Earnings and Profits, In General

The concept of a corporation’s “earnings and profits” was first introduced into federal tax law with the Revenue Act of 1916, yet in the near century that’s followed the term has never been formally defined by statute. Instead, earnings and profits (E&P) has been indirectly defined through its application and modification by various sections of the Code to represent the measure of a corporation’s ability to make distributions to its shareholders out of earnings, rather than by returning shareholders’ contributions to capital. As opposed to a corporation’s taxable income or “book” income — which are driven by tax policy and financial accounting considerations, respectively — the computation of E&P is concerned primarily with quantifying the corporation’s economic income, without regard to such considerations.

A corporation’s E&P determines the taxability of distributions made to its shareholders.  Section 316 defines a “dividend” as any distribution of property made by a corporation out of current or accumulated E&P.  In turn, Section 301(c) provides that any distribution constituting a dividend must be included in the gross income of the shareholder, while amounts distributed in excess of those considered a dividend are first treated as a nontaxable return of capital to the extent of the shareholder’s stock basis, with any remaining distribution treated as a gain from the sale of the stock, resulting in capital gain.

Example: Corporation X is wholly owned by A, an individual. In 2010, X’s first year of existence, X had $500 of E&P. As of December 31, 2010, before any adjustments for distributions made by X throughout the year, A had a basis of $300 in his X stock. X distributed $1,000 to A on December 31, 2010.

The taxability of X’s $1,000 distribution to A is determined under Sections 316 and 301(c). To the extent of X’s current E&P of $500, the distribution is treated as a dividend. Thus, A includes $500 in taxable income under Section 301(c)(1). Of the remaining $500 distribution, $300 is treated as a return of A’s capital, and reduces A’s stock basis from $300 to $0. The remaining $200 distribution is treated as the sale of the stock, generating capital gain.

The Relationship Between E&P, Taxable Income, and Retained  Earnings

A corporation’s E&P is neither its accumulated taxable income nor its retained earnings for financial accounting purposes. Rather, E&P is an independent measure of a corporation’s economic income for the purpose of separating those distributions which represent income derived from the conduct of business from those which represent returns of capital contributed by shareholders. Because E&P is concerned with economic effect of a particular item, E&P generally includes all items of income and expense resulting from the economic activities of a corporation, regardless of the treatment of such items in computing taxable income or retained earnings.

A corporation’s taxable income differs from its E&P primarily due to the tax policy considerations that override the determination of  taxable income — such as the exemption of certain state and local bond interest income and the disallowance of expenses for federal income taxes or penalties — that fail to reflect the economic effect of the underlying item of income or expense. As the computation of E&P is generally not concerned with such tax policy considerations,  adjustment are required to convert taxable income into E&P.

Example: In 2013, X, an accrual basis corporation, generated $20,000 of taxable income, giving rise to a $3,000 federal income tax liability. X also earned $10,000 of interest income on state and local bonds that was tax-exempt under Section 103. Assume X had no accumulated E&P as of December 31, 2002, and that there were no other items affecting X’s computation of E&P or taxable income in 2013. On December 31, 2013, X distributed $25,000 to its sole shareholder, A.

If E&P were synonymous with taxable income, X’s $25,000 distribution would be treated as a dividend to the extent of its taxable income of $20,000, with the remaining $5,000 distribution treated first as a reduction in A’s stock basis, then as capital gain to A.

Because a corporation’s E&P differs from its taxable income, however, certain adjustments must be made to convert X’s taxable income into E&P.

While X’s $10,000 of state and local interest income is excluded from taxable income by statute, it nevertheless increases the funds available for X to distribute to A. As a result, a $10,000 increase to X’s taxable income is required in computing E&P.  Similarly, while X’s $3,000 of federal income tax liability is not deductible in computing X’s taxable income pursuant to Section 275, the liability reduces the funds available for X to distribute to A. Thus, X must reduce its taxable income by $3,000 in computing its E&P for 2013.

After modifying taxable income for the aforementioned adjustments, X had $27,000 of E&P in 2013 ($20,000 + $10,000 -$3,000) Thus, X’s entire $25,000 distribution to A is one made from E&P that is taxed as a dividend, and is included in A’s taxable income pursuant to Section 301(c)(1).

A corporation’s E&P is also not identical to its retained earnings for financial accounting purposes, as fundamental differences exist between retained earnings and a corporation’s cumulative economic income available for distribution to shareholders. For example, retained earnings can be reduced by stock distributions or the establishing of a contingency reserve, neither of which impair a corporation’s ability to finance distributions to its shareholders. For these reasons, the 2nd Circuit  has stated that a corporation’s retained earnings is “not even prima facie evidence of E&P for income tax purposes.”/>/>

Example: On December 31, 2010, Corporation X had $100,000 of retained earnings for financial accounting purposes. On that day, X made a stock dividend to its shareholders that reduced its retained earnings by $40,000. Because the stock dividend did not impair X’s ability to fund a distribution to its shareholders, there is no reduction in X’s E&P.

Reasons For Computing Earnings and Profits

The primary purpose for computing a corporation’s E&P is to determine whether a distribution to its shareholders represents a taxable dividend, a nontaxable return of shareholder capital, or capital gain to the recipient shareholders, as discussed above.  A corporation’s E&P may have significance for reasons apart from determining the taxability of the corporation’s distributions, including the following:

  • Certain adjustments required in computing a corporation’s E&P are also required in computing adjusted current earnings (ACE), which plays a role in determining a corporation’s alternative minimum taxable income.
  • The accumulated earnings tax may be imposed on a corporation for a tax year if it is determined that the corporation has attempted to avoid tax to its shareholders by allowing its E&P to accumulate beyond the reasonable needs of its business.
  • Under Code Section 857(a)(2)(B), a real estate investment trust (REIT) must have no accumulated E&P from non-REIT years.
  • In the international arena, gain from the sale or exchange of stock in a controlled foreign corporation (CFC) may be treated as a dividend to the extent of the  CFC’s E&P.  In addition, dividends paid by a domestic corporation to foreign shareholders are generally subject to a withholding tax pursuant to Code Sections 1441 and 1442.

E&P for S corporations

While E&P is inherently a subchapter C concept, in certain situations, the presence of E&P may loom large over an S corporation’s operations or existence.

After January 1, 1983, an S corporation can no longer generate current E&P. An S corporation can possess accumulated E&P, however, in two scenarios:

1) The corporation had accumulated E&P from prior C corporation years on the date of the S election, or

2) The S corporation acquired substantially all of the assets of a C corporation in a transaction qualifying under Section 381, requiring the S corporation to succeed to the E&P of the target.

Stated in another manner, a C corporation cannot evade the double taxation regime of subchapter C merely by electing S status; rather, on the date the S election is effective, any E&P accumulated through the election date will survive the S election and, like the viral remnants of an ill-advised romantic encounter from a time gone by, will lie dormant until the most inopportune time, at which point it will reemerge and wreak havoc.

The problem this presents from a practical perspective is that most tax advisors loathe to track E&P for their C corporation clients. When that C corporation elects S status, most advisers breathe a long-awaited sigh of relief, believing they have dodged a bullet and survived their own indifference. The reality, however, is that every C corporation that makes an S election must compute a thorough E&P study on the date of the S election. Should the study reveal that the corporation has no accumulated E&P as of the election date, well… good for you; the S corporation avoids the pitfalls discussed throughout the remainder of this article, unless it happens to acquire the assets of a C corporation in a tax-free transaction.

Should the computation reveal that the corporation does in fact have a positive balance in its accumulated E&P balance on the date of the S election, well…then the tax advisor better know what he or she is doing, because the future S corporation returns just became a lot more complicated.

While operating as an S corporation, the presence of accumulated E&P from prior C corporation years is potentially harmful (or fatal) in three ways:

  1. An S corporation with accumulated E&P may be subject to corporate level tax on its “excess passive investment income” pursuant to Section 1375.
  2. A corporation’s S election will terminate if the corporation has accumulated E&P and passive income in excess of 25 percent of its gross receipts for three consecutive years.
  3. To the extent an S corporation with accumulated E&P makes distributions in excess of its “accumulated adjustments account,” the distributions are taxed as dividends to the extent of the accumulated E&P.

Let’s take a closer look at these three items:

Section 1375: Corporate Level Tax on Excess Net Passive Income

The purpose of Section 1375 is to discourage a C corporation with accumulated E&P from becoming a holding company in order to obtain favorable tax treatment under Subchapter S. Since an S corporation is not subject to the personal holding company tax, an S election would avoid  the personal holding company tax on income earned during an S corporation tax year if not for the imposition of the corporate-level tax of Section 1375.

In general terms, the passive investment income  of an S corporation – items like interest, dividends, rents, royalties, and annuities — is subject to a corporate-level tax when the amount of passive investment income is more than 25% of the S corporation’s gross receipts. What is often misunderstood by tax advisers, however, is that Section 1375 applies ONLY when an S corporation has accumulated E&P. No E&P, no Section 1375 tax.

Section 1362: Termination of S Status Resulting from Excess Net Passive Income

For purposes of computing an S corporation’s tax liability under Section 1375, excess net passive income cannot exceed the corporation’s taxable income. Thus, no tax is imposed if the corporation’s taxable income for the year is zero or a loss. That does not mean, however, that the S corporation is in the clear./>/>

Pursuant to Section 1362(d)(3), even if no corporate level tax is imposed under Section 1375 because of the taxable income limitation, when an S corporation has excess net passive income for three consecutive years, the S election will terminate. Note, however, that just as was the case with Section 1375, the termination occurs only if the S corporation has accumulated E&P at the end of each of the three consecutive years. No E&P, no termination.

Effect of Accumulated E&P on Distributions

While the effects of E&P within an S corporation can be cataclysmic when coupled with excess net passive income, the presence of E&P can also cause a slow death to shareholders and their tax advisors, as the presence of E&P can add significant complexity to determining the taxability of the S corporation’s distributions.

When an S corporation with no accumulated E&P makes a distribution, determining the taxability of that distribution is about as straightforward a process as exists under the tax law. Pursuant to Section 1368, the distribution is first treated as a tax-free reduction of a shareholder’s stock basis, and to the extent the distribution exceeds the shareholder’s stock basis, it generates capital gain.

When an S corporation makes a distribution in a year in which it has E&P, however, the process of determining the taxability of the distribution becomes much more involved. Every distribution made by an S corporation with accumulated E&P from prior C corporation years must be analyzed and bifurcated (trifurcated?) in order to determine its source. This is done in order to preserve the different treatment of distributions of S corporation income, which generally should not be taxed a second time when received by the shareholder, from distributions of C corporation E&P, which must be taxed as a dividend to the recipient shareholder.

Section 1368(c) accomplishes this task by dividing a distribution made from an S corporation with accumulated E&P into three tiers and determining the taxability to the recipient shareholders as follows:

Tier 1: To the extent of the positive balance of the accumulated adjustments account (AAA), the distribution is treated as if made by an S corporation with no accumulated E&P.

Tier 2: Distributions in excess of AAA are treated as dividends to the extent of the accumulated E&P balance.

Tier 3: Distributions in excess of accumulated E&P are treated as made by an S corporation with no accumulated E&P.

As you can see, the presence of E&P creates more than a few headaches for S corporation shareholder and, from a much more selfish perspective, their tax advisors. For starters, the presence of E&P means that we must now track and understand a little thing called the “accumulated adjustments account, (AAA)” which science has revealed is understood by only 6% of the tax community.*

*may be a made up statistic.

The maintenance of the AAA is critical when an S corporation possesses accumulated E&P because it is the AAA balance that will serve as the line of demarcation between those distributions made from S corporation income, which should not be taxed a second time, from those made from C corporation E&P, which must be taxed as a dividend to the recipient shareholders. For a detailed discussion of how to determine the taxability of an S corporation’s distributions, see the Tax Adviser for the months of January and February for a two-part article by some guy named Nitti.

Getting Rid Of E&P

As the previous 3,000 words have indicated, possessing E&P within an S corporation is a giant pain in the ass. Thus, an S corporation with accumulated E&P may wish to rid itself of its E&P as soon as possible, whether it’s to avoid a corporate-level tax under Section 1375, a potential termination under Section 1362, or rising rates on dividend income, as was slated to occur at the end of 2012 prior to the 11th hour deal cut by Congress.

The only way to purge E&P is to distribute it to the shareholders, who will report the income as a dividend. Of course, if the individual shareholder has a net operating loss, he might be indifferent to a dividend, or if rates are indeed going to rise, he will prefer paying a 20% preferential rate over a rate that will be significantly higher in the future.

An S corporation with significant AAA, however, will face challenges in distributing its E&P, because under the general rules, a corporation must first distribute its AAA balance before it is deemed to have made a taxable dividend that decreases its E&P balance. This can be an issue if the S corporation does not possess the requisite cash necessary to distribute the balances of both the AAA and the E&P. Fortunately, the regulations provide elections that enable a corporation to reverse the general ordering rules and distribute E&P prior to distributing AAA./>/>

Pursuant to Reg. Section 1.1368-1(f)(2), a corporation may elect to distribute AAA after E&P. Thus, the first dollars distributed during the year will be taxed as a dividend, and only after E&P is fully purged will a distribution be treated as having been made from AAA.

Example: S Co., an S corporation, has $40,000 of AAA and $20,000 of E&P on December 31, 2012. S Co. distributes $20,000 to its shareholders during 2012.

Fearing rising tax rates on dividend income, S Co. makes the election to bypass AAA and have the distribution treated as having been made first from E&P. As a result, the entire $20,000 distribution is taxed as a dividend to S Co.’s shareholders, reducing S Co.’s E&P balance from $20,000 to $0.

If a corporation does not have the cash necessary to purge its E&P balance, the regulations permit the corporation to make a deemed distribution of all or part of its E&P balance. The deemed distribution is treated as having been received by the shareholders and immediately recontributed to the S corporation, providing the recipient shareholders with an increase to their basis in the stock.

Upon making this election, the corporation is treated as having also made the election to bypass AAA.

Example: S Co., an S corporation, has $40,000 of AAA and $20,000 of E&P on December 31, 2012. S Co. does not have any cash available to distribute, but fearing termination of its S election under Section 1362 because of the presence of passive net income, S Co. wishes to fully purge its E&P. S Co. files an election under Reg. Section 1.1368-1(f)(3) to make a deemed dividend of $20,000. As a result, S Co. is treated as having made a cash distribution of $20,000 to its shareholders, who in turn are treated to have immediately recontributed the $20,000 to S Co.  S Co.’s E&P is fully eliminated, and as a result, S Co. no longer has to worry about a termination under Section 1362, a corporate level tax under Section 1375, or future distributions being taxed as dividends.

These elections are irrevocable and apply only for the year for which they are made. Both elections must be made on an original or amended return by the extended due date of the tax return for that tax year, and each shareholder who received an actual or deemed distribution during the year must consent to the election.  This required timing provides the benefit of hindsight. For example, an S corporation that does not make a cash distribution in 2013 may discover in 2014 that it needs to get rid of its E&P, and fast. Provided the deemed dividend election is made on an original or amended return prior to the extended due date for the 2013 tax return,  S Co. may purge its E&P as of December 31, 2013.

This presents the rare opportunity for an S corporation shareholder to implement a meaningful tax planning strategy for 2013 despite the fact that we are days away from March of 2014. Because of the detrimental role accumulated E&P plays in the S corporation arena, it is an opportunity that must be given careful consideration.

Got an idea for a Tax Geek Tuesday topic? Send it along to anitti@withum.com or on twitter @nittigrittytax

Source: Forbes Business

 
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