Converting an S Corporation to a C Corporation Eliminates Certain Tax Benefits, According to the IRS, Even If the Corporation Converts Back to S Status

345829246_a7434a76dc_z.jpgElecting “subchapter S” status has many benefits for a corporation and its shareholders, although it is subject to certain limitations on the number and type of shareholders. If a corporation’s S status is revoked, it may be able to make the election again at a later date, but that raises the question of whether tax benefits available to shareholders during the original subchapter S election are still available. The Office of Chief Counsel for the Internal Revenue Service (IRS) recently issued a memorandum on this question with regard to corporate earnings for which shareholders paid income tax, but that they did not receive as dividends. IRS regulations assign a special account for these funds and allow shareholders to withdraw them tax-free in later tax years. The account does not, however, survive the revocation of subchapter S status, meaning that shareholders lose tax-free access to those funds.

Shareholders of S corporations pay taxes on corporate income, similar to partnership taxation. They are responsible for paying income tax on their pro rata share of corporate income even if they do not receive dividends during that tax year. The IRS allows S corporation shareholders to withdraw dividends for previous tax years without incurring additional tax liability, since that money was already taxed. IRS regulations define an “accumulated adjustments account” (AAA) as containing the amount of corporate earnings taxed to shareholders but not yet paid out to them. 26 U.S.C. §§ 1366(a)(1), 1368(e)(1); 26 C.F.R. § 1.1368-2. The account is not apportioned among the shareholders.

The question presented to the IRS was whether an S corporation’s AAA survived “beyond the post-termination transition period into a subsequent S period.” In Memorandum No. 201446021 (PDF file) (“IRS Memo”), issued on November 14, 2014, the IRS concluded that the AAA does not survive this transition.

The taxpayer at issue originally incorporated as a C corporation and later elected to be taxed as an S corporation. It was turning a profit at the time it made the subchapter S election, and it continued to do so afterwards. The shareholders revoked the corporation’s S status, which began a period known as the “post-termination transition period” (PTTP). 26 U.S.C. § 1377(b). Federal tax law allows a corporation to distribute the balance of the AAA to shareholders during the PTTP without incurring any additional tax liability. 26 U.S.C. § 1371(e). The corporation made distributions to its shareholders during this time, but it did not have enough cash on hand to distribute the full balance of the AAA. It elected subchapter S taxation again, after the end of the PTTP, and requested a ruling on whether it could distribute the remainder of the balance of the AAA.

The IRS memorandum reviewed the legislative histories of the 1958 bill creating subchapter S and the 1982 bill creating the AAA concept. It found that they indicate an intent for “undistributed taxable income [to] expire at the end of any given S period.” IRS Memo at 5. The IRS therefore concluded that any remaining balance in the corporation’s AAA was no longer available to its shareholders, at least free of tax.

Business law attorney Samuel C. Berger represents New York and New Jersey entrepreneurs and businesses in a variety of legal matters through fixed-fee legal-service packages. Contact us today online or at (212) 380-8117 to schedule a confidential consultation with an experienced and skilled business advisor.

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Photo credit: Phillip Ingham [CC BY-ND 2.0], via Flickr.