1. Distributions From an S Corporation.
    1. In General.
      1. The taxability of distributions (whether in money or in kind) by an S corporation to its shareholders depends upon whether the S corporation has any accumulated earnings and profits (i.e., sub C E&P) (§ 1368(a)).
        1. It is important to note that the distribution rules discussed below apply only to distributions that would be considered dividends if made by a regular corporation (§ 1368(a)). They do not apply to redemptions treated as sales or exchanges under §§ 302(a), 303, or 304, and to liquidating distributions under § 331.
        1. The amount of a distribution is equal to the sum of any cash distributed plus the fair market value of other property distributed less any debt to which the distributed property is subject (§ 301(b)(1), § 301(b)(2)). In general, no distinction is made between distributions of cash or property. An S corporation that distributes appreciated property with respect to its stock, however, must recognize gain just as if the property had been sold to the distributee (§ 311(b)). In addition, tax may be imposed at the corporate level for certain built-in gains (§ 1374). Note also that only cash distributions qualify for return-of-capital treatment under the special rules of § 1371(e) concerning distributions made after termination of S corporation status.
      1. If the S corporation does not have any accumulated earnings and profits, distributions are taxed in the following manner:
        1. First, the distribution is tax free to the extent of the shareholder's adjusted basis in all of his stock (§ 1368(b)(1)). The distribution also reduces basis (§ 1367(a)(2)(A)).
        1. To the extent the distribution exceeds the shareholder's adjusted basis in all of his stock the distribution is treated as gain from the sale or exchange of stock (i.e., generally capital gain) (§ 1368(b)(2)).
          1. The gain could be ordinary income if the corporation is collapsible under § 341 or the stock is not a capital asset in the shareholder's hands, i.e., the shareholder is a dealer in the stock.
      1. If the S corporation, however, does have accumulated earnings and profits, there is a different result (§ 1368(c)).
        1. All earnings and profits are considered. Earnings and profits are determined in accordance with § 312.
        1. Generally, a corporation will not generate earnings and profits for taxable years beginning after 1982 if an S election is in effect (§ 1371(c)(1)).
        1. An S corporation may have earnings and profits from:
          1. Taxable years for which an S corporation election was not in effect; referred to as sub C E&P; and
          1. Tax-free corporate asset acquisition which result in a carryover of earnings and profits from the acquired corporation under § 381.
        1. Elimination of Sub S Earnings and Profits.
          1. The SBA provides that if a corporation is an S corporation for its first taxable year beginning after December 31, 1995, the accumulated earnings and profits of the corporation as of the beginning of that year is reduced by the accumulated earnings and profits (if any) accumulated in any taxable year beginning before January 1, 1983, for which the corporation was an electing small business corporation under subchapter S (commonly referred to as Sub S earnings and profits). Thus, an S corporation can only have accumulated earnings and profits from taxable years for which an S election was not in effect (commonly referred to as Sub C earnings and profits). This rule is generally consistent with the change adopted in 1982 limiting the S shareholder's taxable income attributable to S corporation earnings to his or her share of the taxable income of the S corporation.
      1. Distributions from an S corporation with accumulated earnings and profits are treated in the following manner:
        1. First, the distributions are treated as though made by an S corporation without accumulated earnings and profits to the extent of the S corporation's "accumulated adjustment account" (AAA) (§ 1368(e)(1)) as determined as of the end of the year in which distributions are made (§ 1368(c)(1)).
          1. To the extent of the S corporation's AAA, distributions are treated the same as a distribution from an S corporation without accumulated earnings and profits (i.e., distributions are tax free to the extent of stock basis and are treated as gain from the sale or exchange of stock to the extent the distributions exceed basis) (§ 1368(c)(1)).
        1. Second, distributions in excess of the AAA are treated as a dividend to the extent of any accumulated earnings and profits (§ 1368(c)(2)).
        1. Finally, distributions in excess of any accumulated earnings and profits are treated the same as a distribution from an S corporation without accumulated earnings and profits (§ 1368(c)(3)).
          1. This means that the distributions are treated first as a tax-free reduction to basis to the extent thereof and then as payment in exchange for the stock.
      1. Special rules are also provided for S corporations that have, with respect to one or more of their shareholders, previously taxed income (PTI) as defined under § 1375(d) prior to its amendment by the "Subchapter S Revision Act of 1982". These rules provide that a distribution by an S corporation in excess of the AAA is not included in the gross income of such a shareholder to the extent the distribution is an actual distribution of money and the portion in excess of the AAA does not exceed the shareholder's net share of the corporation's PTI immediately before the distribution (Reg. § 1.1368-1(d)(2)).
        1. Thus, in general, a distribution by an S corporation to a shareholder with PTI is treated as a distribution made out of PTI after the AAA has been exhausted, but before a distribution is deemed to be a dividend out of earnings and profits.
        1. The portion of a distribution treated as a distribution made out of PTI decreases the adjusted basis of the shareholder's stock and, if that portion exceeds the adjusted basis of all of the shareholder's shares, the excess is treated as gain from the sale or exchange of property.
        1. Distributions made from PTI do not decrease the AAA and earnings and profits of the corporation (Reg. § 1.1368-1(d)(2)).
      1. Reg. § 1.1368-1(e) provides that the tax effect of a distribution to a shareholder is determined only after taking into account the adjustments to the basis of the shareholder's shares of stock for the items described in § 1367 for the corporation's taxable year (without regard to distributions made during the taxable year).
        1. Section § 1368(e)(1)(C) provides that in determining the amount in the accumulated adjustment account for purposes of determining the tax treatment of distributions made during a taxable year by an S corporation having accumulated earnings and profits, net negative adjustments (i.e., the excess of losses and deductions over income) for that taxable year are disregarded. This means that if the S corporation has a AAA account and accumulated earnings and profits, and losses for the year, the distribution reduces the AAA account before the gains and losses are taken into account, thereby reducing the amount that may be characterized as a dividend distribution.
          Example 15: X is the sole shareholder of corporation A, a calendar year S corporation with no accumulated earnings and profits. X's adjusted basis in the stock of A on January 1, 2003, is $1,000 and X holds no debt of A. During 2003, A makes a distribution to X of $600, recognizes a capital gain of $200 and sustains an operating loss of $900. X's adjusted basis in the A stock is increased to $1,200 ($1,000 plus $200 capital gain recognized) pursuant to § 1368(d) to determine the effect of the distribution. X's adjusted basis is then reduced by the amount of the distribution to $600 ($1,200 less $600) to determine the application of the loss limitation of § 1366(d)(1). X is allowed to take into account $600 of A's operating loss, which reduces X's adjusted basis to zero. The remaining $300 loss is carried forward pursuant to § 1366(d)(2).
          Example 16: The facts are the same as in Example 15, except that on January 1, 2003, A has accumulated earnings and profits of $500 and an accumulated adjustments account of $200. Because there is a net negative adjustment for the year, no adjustment is made to the accumulated adjustments account before determining the effect of the distribution under § 1368(c).
          As to A, $200 of the $600 distribution is a distribution of A's accumulated adjustments account, reducing the accumulated adjustments account to zero. The remaining $400 of the distribution is a distribution of accumulated earnings and profits (E&P) and reduces A's E&P to $100. A's accumulated adjustments account is then increased by $200 to reflect the recognized capital gain and reduced by $900 to reflect the operating loss, leaving a negative balance in the accumulated adjustment account on January 1, 2004, of $700 (zero plus $200 less $900).
          As to X, $200 of the distribution is applied against X's adjusted basis of $1,200 ($1,000 plus $200 capital gain recognized), reducing X's adjusted basis to $1,000. The remaining $400 of the distribution is taxable as a dividend and does not reduce X's adjusted basis. Because X's adjusted basis is $1,000, the loss limitation does not apply to X, who may deduct the entire $900 operating loss. X's adjusted basis is then decreased to reflect the $900 operating loss. Accordingly, X's adjusted basis on January 1, 2004, is $100 ($1,000 plus $200 less $200 less $900).
        1. In addition, Reg. § 1.1368-1(e) provides that the determination of the source of a distribution is made only after the AAA has been adjusted to reflect:
          1. Increases for income items (other than income that is exempt from tax) and the excess of the deductions for depletion;
          1. Decreases for nondeductible, non-capital expenses (other than Federal taxes attributable to any taxable year in which the corporation was a C corporation and expenses related to income that is exempt from tax);
          1. Decreases for certain oil and gas depletion deductions; and
          1. Decreases for items of loss or deduction.
    1. Elections Under § 1368.
      1. Elections to Modify the Rules for Determining the Source of Distributions.
        1. The general rule of § 1368 and the regulations have the effect of treating distributions by an S corporation with earnings and profits as made first from AAA until the AAA is exhausted and only then from earnings and profits. Although this ordering rule normally produces a taxpayer favorable result, there are circumstances where the rule may not be to the taxpayer's advantage.
          1. For example, if an S corporation with C corporation earnings and profits has passive investment income in excess of a certain threshold, § 1375 imposes a corporate level tax on a prescribed portion of the passive investment income.
          1. If the corporation has excess passive investment income for three consecutive taxable years, the corporation's S election terminates under § 1362(d)(3).
        1. A corporation that seeks to avoid these adverse effects by distributing its C corporation earnings and profits may find it desirable to treat a distribution as made first from C corporation earnings and profits. This greatly simplifies the procedures for shareholders of S corporations that wish to rid themselves of Sub C earnings and profits in order to avoid the passive income tax of § 1375 or disqualification, if excess passive income is received for three consecutive taxable years. The regulations provide three elections that are designed to facilitate an S corporation's distribution of its earnings and profits:
          1. An election to bypass the AAA and distribute earnings and profits first;
          1. An election to make a deemed dividend; and
          1. An election to bypass PTI.
      1. Election to Bypass AAA.
        1. Under § 1368(e)(3), a corporation with earnings and profits may elect to treat all distributions made during the taxable year as made first from earnings and profits.
        1. Reg. § 1.1368-1(f)(2) provides that if the election is made, distributions out of earnings and profits will be treated as first out of Sub C earnings and profits and then out of Sub S earnings and profits.
      1. Election to Make a Deemed Dividend.
        1. A corporation that wishes to distribute Sub C earnings and profits may lack sufficient liquid assets to make such a distribution. Reg. § 1.1368-1(f)(3) provides an election that permits a corporation that elects to bypass the AAA to distribute its Sub C earnings and profits through a deemed dividend.
        1. A deemed dividend is a hypothetical distribution that is treated as made by the corporation from its Sub C earnings and profits with respect to its stock on the last day of its taxable year to all shareholders holding stock on that day.
        1. The amount of the deemed dividend is limited to the excess of the corporation's Sub C earnings and profits on the first day of the corporation's taxable year over actual distributions of Sub C earnings and profits made during the taxable year.
        1. The deemed dividend is considered, for all purposes, a distribution by the corporation in money from Sub C earnings and profits, received by the shareholder on the last day of the corporation's taxable year, and immediately contributed by the shareholder as capital to the corporation on that day. (See definition of Consent Dividend under § 565(c)).
      1. Election to Bypass PTI.
        1. Under the general rules, if an S corporation with earnings and profits also has PTI with respect to one or more of its shareholders from a taxable year ending before the effective date of the "Subchapter S Revision Act of 1982," distributions made in excess of the AAA are treated as made out of PTI before they are treated as made out of earnings and profits. Thus, even if an S corporation makes the election to bypass the AAA, absent a special rule, the distribution would be treated as made first out of PTI and then out of earnings and profits. Reg. § 1.1368-1(f)(4) permits an S corporation to elect to treat distributions as not made from PTI.
      1. Time and Manner of Making Elections.
        1. A corporation makes an election to distribute earnings and profits, to make a deemed dividend distribution, or to forego previously taxed income by attaching a statement to a timely filed original or amended return required to be filed under § 6037 for that taxable year.
        1. The statement must state that the corporation is making an election under Reg. § 1.1368-1(f), identify the election, and be signed under penalties of perjury by an officer of the corporation on behalf of the corporation and by each shareholder of the corporation who receives a distribution during the taxable year (including a deemed dividend distribution).
        1. The election is irrevocable and is effective only for the taxable year for which it is made (Reg. § 1.1368-1(f)(5)).
      1. Election in Case of Disposition of Substantial Amounts of Stock.
        1. A shareholder who disposes of a substantial interest in the corporation before the end of the year cannot be certain of the tax consequences of the disposition or of the distributions made to the shareholder during the taxable year before that shareholder disposes of his or her stock. To alleviate this uncertainty, Reg. § 1.1368-1(g) provides that, if a shareholder disposes of 20% or more of the corporation's issued shares of stock in one or more transactions during any 30-day period during the taxable year of the corporation, the corporation may elect to treat the taxable year as if it consists of separate taxable years, the first of which ends on the date on which the shareholder disposes of 20% or more of the corporation's issued stock.
          1. A redemption treated as an exchange under § 302(a) or § 303(a) of 20% or more of the outstanding stock of the corporation from a shareholder in one or more transactions during any thirty day period during the corporation's taxable year also qualifies as a substantial disposition (Reg. § 1.1368-1(g)(2)(B)).
          1. An issuance of an amount of stock equal to or greater than 25% of the previously outstanding stock to one or more new shareholders during any thirty day period during the corporation's taxable year also qualifies as a substantial disposition (Reg. § 1.1368-1(g)(2)(C)).
        1. Under the election, the taxable year is treated as if it consists of separate years for purposes of allocating items of income and loss, making adjustments to the AAA, basis, and earnings and profits, and determining the tax effect of distributions.
        1. A corporation makes an election for a taxable year by attaching a statement to a timely filed original or amended return required to be filed under § 6037 for a taxable year (Reg. § 1.1368-1(g)(2)).
          1. The statement must state that the corporation is electing for the taxable year under Reg. § 1.1368-1(g)(2) to treat the taxable year as if it consisted of separate taxable years.
          1. The statement also must set forth the facts relating to the qualifying disposition (e.g., sale, gift, stock redemption, or issuance), and must be signed under penalties of perjury by an officer of the corporation on behalf of the corporation and by all shareholders who held stock in the corporation during the taxable year.
          1. A single election statement may be filed for all elections made for the taxable year.
          1. An election made in the case of a substantial disposition is irrevocable.