Chapter 4
Distributions
Learning Objectives
Upon completion of this chapter, you will

Be able to apply the rules for cash distributions.

Be aware of the rules for property distributions.

Understand the ordering of distributions.
Introduction
In this chapter, we will discuss the following:

Cash distributions

Property distributions

Accumulated Adjustment Account (AAA)

Distributions during the Post-termination Transition Period

Effect on Stock Basis of Distributions
Distributions are payments of cash or property to shareholder based on stock ownership. S
corporation distributions are governed by IRC Section 1368. Distributions have no effect on the
current share of income that is taxable to shareholders. Whether or not a distribution is taxable
or not depends on whether the S corporation has any accumulated E & P from C years or as an S
corporation in preSSRA years.
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Earnings and Profits (E&P)
For taxable years beginning after 1982, an S corporation will not generate E&P. If a corporation
is formed and immediately elects S corporation status, it cannot have E&P as long as it remains
an S corporation and does not acquire a corporation carrying over E&P under Sec. 381. An S
corporation may have accumulated E&P attributable to any taxable years for which an S election
was not in effect, a taxable year from 1958-1982 for which an S election was in effect (e.g., taxexempt income, accelerated depreciation), or from certain corporate acquisitions which resulted
in a carryover of the acquired corporation’s E&P. If a corporation is an S corporation for its first
tax year beginning after 1996, its accumulated E & P is reduced by any pre-1983 E & P
accumulated while the corporation was an S corporation.
A C corporation generates E&P under Sec. 312. When the C corporation elects S status, the E&P
balance carries into the S corporation. E&P is designed to track the C corporation's income in a
way that reflects the corporation's economic (rather than taxable) income. For example, new
assets can be depreciated for tax purposes by using the modified accelerated cost recovery
system (MACRS), but for E&P purposes must be depreciated by using the alternative
depreciation system (ADS).
When considering E&P, we should remember that a distribution of E&P is a taxable dividend to
the recipient. If the S corporation does not have E&P or has negative E&P it cannot distribute a
taxable dividend.
Reduction of AE&P
When a C corporation with E&P becomes an S corporation, the amount of E&P is frozen. Once
S corporation status is effective, the E&P amount is reduced only by
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
Distributions of that E&P (taxable dividend distributions) [Section 1371(c)(3)],

Certain redemptions, reorganizations, liquidations, or corporate divisions [Section
1371(c)(2)], and

Tax paid at the corporate level because of business credit recapture [Section 1371(d)(3)].
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Example 4-1
C Inc., elects S status on January 1, when it has $100,000 of E&P. The company
passes through a $70,000 loss for the year ended December 31 and distributes $20,000
to its sole shareholder during the year. The $70,000 pass-through loss does not affect
E&P. Since the corporation has no undistributed S corporation earnings at the end of
the year, the $20,000 distribution reduces E&P, and is dividend income to the
shareholder. The balance in the corporation's E&P at December 31 is $80,000
($100,000 – $20,000).
To discuss distributions made by S corporations we will first divide the discussion between
distributions made by S corporations without E&P and S corporations with E&P.
Cash Distributions Made by S Corporations without E&P [Section
1368(b)]
If an S corporation has no AE&P at the end of its taxable year, the treatment of distributions
made by the corporation during the year is relatively simple. In that event, distributions are first
treated as a tax-free return of stock basis. The shareholder reports the distribution when
received. The shareholder’s basis in the stock, however, is computed at the close of the taxable
year in which the distributions are made [Section 1368(d)]. Stock basis is first adjusted for
income, but not losses, before the basis is reduced for distributions [Section 1368(d)(1)]. Basis
for distributions does not include a shareholder’s debt basis. Excess of distributions over stock
basis is gain from the sale of stock, thus capital gain.
Example 4-2
D owns all of the stock of an S corporation for which he has a basis of $20. This year
the corporation suffered on ordinary loss of $100 and distributed cash to D of $100. D
will reduce his basis for the distribution first. Thus, the distribution will reduce D’s basis
to zero. The additional $80 ($100 distribution – $20 basis) will be a capital gain for D.
Because D has a zero basis in the stock, the loss will be limited by Section 1366.
Cash Distributions Made by S Corporations with E&P [Sec. 1368(c)]
If an S corporation has E&P, the rules governing distributions become more complex. For tax
purposes an S corporation’s “retained earnings” account consists of the four tiers shown below.
Any distributions come out of the following accounts in the order shown:
1. Accumulation Adjustments Account (AAA)
2. Previously Taxed income (PTI; on Schedule L referred to as shareholders’ undistributed
taxable income previously taxed)
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3. Accumulated E&P
4. Other Adjustments Account (OAA)
Distributions are deemed to come first from the AAA account. These distributions are
considered a nontaxable return of basis. Any distribution that comes out of AAA that exceeds a
shareholder’s basis in its stock is a capital gain. AAA is an account that is adjusted in a manner
similar to basis adjustments with the following exceptions [Section 1368(e)(1)]. AAA is

Not increased by tax-exempt income (e.g., tax-exempt interest, life insurance proceeds –
such items become part of the OAA). Thus a distribution of such income could be treated
as a distribution of accumulated E&P if the AAA is insufficient.

Not decreased by deductions related to tax-exempt income (these reduce OAA).

This account may be negative.
AAA is a corporate-level account and is not affected by transfers of stock; shareholders who
obtain shares automatically obtain an interest in this account. In contrast, previously taxed
income (PTI) is not transferable, and nontaxable distributions of PTI cannot be made to a new
shareholder. Although rare, a shareholder’s share of the AAA may exceed the basis in his stock
(e.g., inherited low value stock, purchase at low value). Except as provided by regulations, AAA
is allocated pro rata among all distributions made during the year. Redemptions under Sections
302 and 303 reduce AAA proportionately as of the date of the redemption, whether AAA is
positive or negative [proposed regulation section 1.1368-2(d)(2)]. If an S corporation acquires
the assets of another S corporation in a tax-free reorganization where Section 381(a)(2) applies,
the AAA and AE&P accounts of the two S corporations are combined. Note that a negative AAA
of one S corporation can offset a positive AAA of another S corporation. [Proposed regulation
Section 1.1368-2(d)(2).]
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Accumulated Adjustments Account (AAA)
The AAA starts at zero on the first day of an S corporation's first taxable year beginning after
1982. Thereafter, it is increased and decreased each year by, with certain exceptions, the same
items that adjust basis, but not in the same order as basis is adjusted. If the total decreases exceed
the total increases, the excess is a “net negative adjustment” and the AAA itself is adjusted in a
different order. The AAA is adjusted by using the following steps:
The balance of AAA at the beginning of the taxable year is increased by

Nonseparately stated income;

Separately stated items of income and gain (except for tax-exempt income);

Excess of the shareholder's deductions for depletion (other than oil and gas) over the
shareholder's proportionate share of basis of the property subject to depletion; and

Certain business tax credit recapture.
AAA is decreased by

Nonseparately stated loss;

Separately stated items of loss or deduction (except for expenses related to tax-exempt
income);

Any expense of the corporation that is neither deductible in computing its taxable income
nor capitalizable (except AAA is not reduced by federal taxes attributable to a C
corporation year);

The amount of the shareholder's deduction for depletion of oil and gas property held by
the S corporation to the extent the deduction does not exceed the property's adjusted basis
allocated to the shareholder under Section 613A(c)(11)(B); and

Certain business tax credit recapture.
AAA Is Reduced by the Full Amount of Loss or Deduction
The AAA, like basis, is reduced by the entire amount of a loss or deduction, even though the
shareholder cannot use the deduction because of another provision such as the passive activity
loss rules or the at-risk rules [Reg. Sec. 1.1368-2(a)(3)(ii)]. Unlike basis, the AAA can be
negative. A negative AAA balance can be caused by S corporation losses and deductions, but not
by distributions [Sec. 1368(e)(1)(A); Reg. Sec.1.1368-2(a)(3)].
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It should be noted that some tax commentators have suggested that the insurance premium should
reduce AAA. Rev. Rul. 2008-42 was issued to clarify the treatment of key-person life insurance
proceeds and premiums on the accumulated adjustment account (AAA). Essentially the ruling held
that neither tax-exempt income (here, the death benefits paid on a life insurance policy) nor the
expense related to a tax-exempt income item (the insurance premiums paid) will affect the AAA
under Sec. 1368(e)(1)(A). Rather, these items should be reported in the Other Adjustments Account
(OAA).
Differences between Basis and AAA Adjustments
The AAA increases and decreases by the same items as basis does each year, except

Tax-exempt income increases basis, but does not increase the AAA.

Expenses relating to tax-exempt income reduce basis, but do not decrease the AAA.

Federal taxes relating to a C corporation year reduce basis, but do not decrease the AAA.

The order that increases and decreases are applied to basis and AAA differ.

Losses and deductions (but not distributions) can reduce the AAA below zero. Basis can
never have a negative balance.
Calculation of AAA, AE&P, and Basis Illustrated
The calculation of AAA, AE&P, and basis and the resulting tax effect on distributions is
illustrated in the following examples.
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Example 4-3
A corporation that became an S corporation on January 1, of the current year, when it had $15,000
of AE&P. The sole shareholder, had basis in his stock of $10,000 on that date. For the taxable year
ended December 31, the company showed the following items:
Nonseparately stated income
Tax-exempt interest
Long-term capital gain
Charitable contributions
Disallowed portion of M&E
Expenses relating to tax-exempt income
Distributions
$45,000
1,000
2,000
1,200
500
100
12,000
To determine the taxability of the distribution, you must first compute the AAA and AE&P balances
at December 31.
Balances, beginning of year
Nonseparately stated income
Long-term capital gain
Balances, before reductions
Charitable contributions
Disallowed 50% of M&E
Balances, before distributions
Distributions nontaxable
Balances, end of year
AAA
$0
45,000
2,000
47,000
(1,200)
(500)
45,300
(12,000)
$33,300
AE&P
$12,500
12,500
12,500
$12,500
Next, stock basis is calculated as follows:
Basis, beginning of year
Nonseparately stated income
Tax-exempt interest
Long-term capital gain
Basis, before distributions and other reductions
Distributions
Basis, before other reductions
Charitable contributions
Disallowed 50% of M&E
Expenses relating to tax-exempt income
Basis, end of year
Basis
$10,000
45,000
1,000
2,000
58,000
(12,000)
46,000
(1,200)
500
(100)
$45,200
The $12,000 distribution reduces both the AAA and stock basis, and is consequently a nontaxable
return of capital. Because the distribution does not exceed the amount in AAA, the AE&P does not
change.
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Example 4-4
Walt has been the sole stockholder of an S corporation for five years. At the beginning
of the current calendar taxable year, Walt's basis in his stock is $52,000, and the
corporation shows an AAA balance of $38,000, and an AE&P balance of $22,000.
During the year, he receives a $55,000 distribution. At the end of the current year, the
corporation passes through nonseparately stated income of $7,000 and a capital loss
of $2,000.
The AAA and AE&P balances at December 31 are calculated as follows:
Balances, beginning of year
Nonseparately stated income
Balances, before reductions
Long-term capital loss
Balances, before distributions
Distributions to extent of AAA
Distributions to extent of AE&P
Balances, end of year
AAA
$38,000
7,000
45,000
(2,000)
43,000
(43,000)
$0
AE&P
$22,000
22,000
22,000
(12,000)
10,000
Next, stock basis is calculated, as follows:
Basis, beginning of year
Nonseparately stated income
Basis, before distributions and other reductions
Distributions to extent of AAA
Basis, before other reductions
Long-term capital loss to extent of basis
Basis, end of year
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Basis
$52,000
7,000
59,000
(43,000)
16,000
(2,000)
$14,000
Distributions from Previously Taxed Income (PTI)
Distributions are deemed to come secondly from previously taxed income (PTI) during S years
prior to 1983. These distributions are nontaxable to the extent of the shareholder’s basis. Before
1983, the S corporation income upon which the shareholder had paid tax, but which had not been
distributed, was called Previously Taxed Income, or PTI. For tax years beginning after 1982, S
corporations do not generate PTI, but the AAA represents a variation on the same theme; income
that has been previously taxed to the shareholder can be distributed free of further tax. But what
if the S corporation carried PTI into a post-1982 year? It could – and in many cases did – happen.
Unfortunately, the Code is something less than enlightening when it addresses the problem of
how to distribute these items, because it seems to ignore the fact that there can be a distribution
tier composed of PTI. If the corporation has no AE&P, there is no problem. PTI has already
increased the basis of the stock. Distributions from an S corporation with no AE&P apply first as
a nontaxable return of capital, to the extent of stock basis, so PTI will automatically be a tax-free
reduction in basis when distributed. Distributions in excess of stock basis create a capital gain.
Other Distributions
Distributions in excess of AAA and PTI are considered to come from accumulated E&P and are
taxable as dividends.
The last level of distributions comes from the Other Adjustments Account (OAA). The Code
adopts no express rules for the treatment of those items which do not affect the AAA; tax-exempt
income and related expenses. The IRS in its instructions requires that taxpayers maintain a
special Other Adjustments Account presumably to account for these items. The S corporation
tax return, Form 1120S, states that tax-exempt income should increase the Other Adjustments
Account (OAA), and expenses directly related to tax-exempt income should reduce OAA. The
OAA is not in the Code and is used to record pass-through items that do not adjust AAA.
According to the IRS instructions, distributions are out the OAA after accumulated E&P are
exhausted and are nontaxable. As with distributions from AAA and PTI, distributions in excess
of stock basis will create a capital gain.
Any further distributions are a nontaxable return of basis. Amounts in excess of basis are treated
as gains from the sale of stock and are taxed as capital gain.
Section 1368(e) Election
An S corporation may make an annual election (i.e., for one year only) with the consent of all
affected shareholders to bypass the PTI and/or AAA in determining the taxation of all
distributions made during the taxable year [Sec. 1368(e)(3)].
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Distribution Order
1
2
3
4
No. Election
AAA
PTI
AE&P
OAA
Sec. 1368(e)(3)
Bypass Election
AE&P
AAA
PTI
OAA
PTTP Election
AAA
AE&P
PTI
OAA
Note. The bypass election is not sufficient if PTI is present. Sec. 1379(c) preserves the old
distribution order where there is PTI present. Thus, an election under Sec. 1368(e)(3) placed PTI
first in the order of distribution. (Proposed Regulations Sec. 1.1368-1(f)(2)(ii).) An additional
election under old Sec. 1375 will permit distribution of AE&P first where both AAA and PTI are
present. See Regulations Sec. 1-1375-4(c) and Proposed Regulations Sec. 1.1368-1(f)(4).
A corporation that elects to bypass AAA may also elect to make a deemed dividend of all of its
AE&P (proposed regulation section 1.1368-1(f)(3)).
An S corporation with AE&P has more problems to cope with than one without AE&P.
Accumulated earnings and profits can cause difficulties for S corporations with excess net
passive income. In this case the corporation may be subject to a tax on the excess net passive
income and more importantly, the S election will terminate if the corporation has excess net
passive income for three consecutive years. Also, distributions are more complicated and can
include dividend income if there is AE&P.
The bypass election is typically used to purge the corporation of its AE&P in order to avoid the
passive investment income or the termination of its S election for having excess passive
investment income.
Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, dividends received by an
individual shareholder from domestic and qualified foreign corporations generally are taxed at
the same rates that apply to long-term capital gains [Sec. 1(h)(11)]. This treatment applies for
both regular and alternative minimum tax purposes. The Tax Increase Prevention and
Reconciliation Act of 2005 extended this treatment for another two years. The dividend rate is
effective for tax years beginning after 2002 and before 2011.
Now that the maximum tax rate on dividend income is 15%, some existing S corporations may
want to make the election under Section 1368(d)(3) and distribute their AE&P to shareholders as
soon as possible. Also, under some circumstances, because of losses or other considerations,
receipt of the taxable dividend may not cause a tax burden on the shareholders, making it an
opportune time to distribute AE&P to them.
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Example 4-5
Alvin owns all of the shares of Alco, an S corporation. Alco has the following account
balances:
Accumulated Adjustments Account
Previously Taxed Income
Accumulated Earnings and Profits
$30,000
$20,000
$20,000
Alco has had excess passive income for the past two years and anticipates excess net
passive income in again this year. Alvin plans to withdraw $30,000 from the corporation
this year.
Without the election allowed by Section 1368(d)(3), the distribution will be a nontaxable
distribution that comes from the AAA account. However, because of the problem with
excess net passive income, the corporation should consider making the elections under
Section 1368(d)(3) and Section 1375 to make the distribution out of AE&P first. In that
case the first $20,000 would come from AE&P with the remaining $10,000 coming from
AAA. If these elections were made it would cost Alvin $3,000 ($20,000 × 15%) because
the $20,000 from AE&P would be a taxable dividend. However, the benefits of
eliminating the AE&P (i.e., eliminating the excess net passive income tax and being
allowed to retain its S status) should outweigh the cost.
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Property Distributions
The effect on the shareholder of a distribution of property should be the same as a cash
distribution. The amount of distribution is the fair market value of the property at the time of the
distribution. The shareholder’s basis in the property received will be the property’s fair market
value.
The S corporation must recognize all income (but not loss) as if the distributed property was sold
to the shareholder [Sec. 1363(d)]. The corporation's gain on property distributed to a shareholder
may be ordinary income if the property is depreciable by the shareholder who receives it. As
stated earlier, the corporation treats the distribution as if it had sold the property to the
shareholder. Under Sec. 1239, gain on a sale of property is ordinary if the property is sold to a
related party (as defined in Sec. 267), and is depreciable in the hands of the transferee. A
shareholder is a related party for these purposes if the shareholder directly or indirectly owns
more than 50% of the stock [Sec. 267(b)].
This sale may be subject to the built-in-gains tax if the corporation converted from C to S within
the last ten years and the property was owned at the time of the conversion. The gain recognized
passes through pro rata to each shareholder as ordinary income or capital gain, as appropriate.
The recipient shareholder increases stock basis by the shareholder's pro rata share of the gain,
through the normal pass-through process, and then reduces stock basis by the fair market value
of the property distributed.
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Example 4-6
J formed R Corporation in 1975. The corporation operated as a C corporation from
1975 until 1986 when it elected to be taxed as an S corporation. At the beginning of
2009, J found himself overextended and needing cash. As a result, the corporation
distributed $100,000 to him. The corporation’s balance in its AAA account at the
beginning of 2009 was $140,000 and J’s basis in his stock was $100,000. The
corporation’s records for 2009 reveal the following information:
Sales
Cost of goods sold
Miscellaneous operating expenses (including deductible M&E)
Salary to B
Nondeductible portion of entertainment
Tax-exempt interest income
Expenses related to tax-exempt interest income
Capital gain
Capital loss
Charitable contribution
$300,000
(120,000)
(50,000)
(40,000)
$90,000
(4,000)
13,000
(3,000)
7,000
(2,000)
(5,000)
$96,000
On December 31, the corporation has accumulated earnings and profits from C years
of $100,000.
The AAA and AE&P balances at December 31 are calculated as follows:
Balances, beginning of year
Nonseparately stated income
Capital gain net of capital loss
Balances, before reductions
Charitable contribution
Nondeductible M&E
Balances, before distributions
Distributions to extent of AAA
Distributions to extent of AE&P
Balances, end of year
AAA
$140,000
90,000
5,000
235,000
(5,000)
(4,000)
226,000
(100,000)
$126,000
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AE&P
$100,000
100,000
100,000
(0)
$100,000
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Next, stock basis is calculated, as follows:
Basis, beginning of year
Nonseparately stated income
Capital gain net of capital loss
Tax-exempt income
Basis, before distributions and other reductions
Distributions to extent of AAA
Basis, before other reductions
Charitable contribution
Nondeductible M&E
Expenses related to tax-exempt income
Basis, end of year
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Basis
$100,000
90,000
5,000
13,000
208,000
(100,000)
108,000
(5,000)
(4,000)
(3,000)
$96,000
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Example 4-7
If we use the same facts as in Example 4-6, except the corporation distributed $240,000
the effect would be as follows.
The AAA and AE&P balances at December 31 are calculated as follows:
Balances, beginning of year
Nonseparately stated income
Capital gain net of capital loss
Balances, before reductions
Charitable contribution
Nondeductible M&E
Balances, before distributions
Distributions to extent of AAA
Distributions to extent of AE&P
Balances, end of year
AAA
$140,000
90,000
5,000
235,000
(5,000)
(4,000)
226,000
(226,000)
$126,000
AE&P
$100,000
100,000
100,000
(14,000)
$86,000
Next, stock basis is calculated, as follows:
Basis, beginning of year
Nonseparately stated income
Capital gain net of capital loss
Tax-exempt income
Basis, before distributions and other reductions
Distributions to extent of basis
Basis, before other reductions
Charitable contribution
Nondeductible M&E
Expenses related to tax-exempt income
Basis, end of year
Basis
$100,000
90,000
5,000
13,000
208,000
(208,000)
0
(0)
(0)
(0)
$0
In this case the amount of the distribution that comes from AAA $226,000 exceeds J’s
basis by $18,000. This amount would be a capital gain to J. In addition, J would have a
taxable dividend of $14,000.
J would not be allowed to deduct his share of charitable contributions in 2006 but would be
allowed to carry them over to 2010. The other excess noncapital, nondeductible expenses
evaporate as a result of the application of the carryover of disallowance rules under Reg.
Sec. 1.1366-2(a)(2) which makes no mention of noncapital, nondeductible expenses. This
negative impact could be changed by J making an election under Reg. Sec. 1.1367-1(g) to
reduce his basis by deductible items before reducing his basis by noncapital,
nondeductible expenses. In that case, the noncapital, nondeductible expenses specifically
would carry over to 2010.
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Example 4-8
J and K each own 50% of the stock of X Corporation, which they formed in 1978 as a
C corporation. In 1981, the corporation elected to be an S corporation. At the beginning
of the current year, the corporation’s records reveal the following:
Accumulated adjustments account
Previously taxed income
Accumulated E&P
$100,000
$40,000
$30,000
J and K have bases in their stock as of the beginning of the current year of $100,000
and $80,000 respectively. The corporation reported ordinary income of $30,000 during
the current year. During the current year, the corporation distributed land (FMV
$100,000, basis $60,000) to J and cash of $100,000 to K. The land was held by the
corporation for several years as an investment.
In this case the AAA, PTI AE&P are split equally.
The AAA, PTI and AE&P balances at December 31 are calculated as follows:
J
Balances, beginning of year
Nonseparately stated income
Capital gain
Balances, before distribution
Distributions to extent of AAA
Distributions to extent of PTI
Balances, end of year
AAA
$50,000
15,000
20,000
85,000
(85,000)
$0
PTI
$20,000
AE&P
$50,000
20,000
50,000
(15,000)
$5,000
$50,000
Next, stock basis is calculated, as follows:
Basis, beginning of year
Nonseparately stated income
Capital gain
Basis, before distributions and other reductions
Distributions to extent of AAA & PTI
Basis, before other reductions
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Basis
$100,000
15,000
20,000
135,000
(100,000)
35,000
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K
Balances, beginning of year
Nonseparately stated income
Capital gain
Balances, before distribution
Distributions to extent of AAA
Distributions to extent of PTI
Balances, end of year
AAA
$50,000
15,000
20,000
85,000
(85,000)
$0
PTI
$20,000
AE&P
$50,000
20,000
50,000
(15,000)
$5,000
$50,000
Next, stock basis is calculated, as follows:
Basis, beginning of year
Nonseparately stated income
Capital gain
Basis, before distributions and other reductions
Distributions to extent of AAA & PTI
Basis, before other reductions
Basis
$80,000
15,000
20,000
115,000
(100,000)
15,000
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Example 4-9
Father K and son L own all of the stock of X, a calendar year S corporation. K owns
70% of the stock, while L owns the remaining 30%. L received all of his stock from his
father as a gift in 1984. At that time, the balance of previously taxed income from pre1983 years was $1,400. At the beginning of the year, the corporation’s records reveal
the following:
Accumulated adjustments account
Previously taxed income
Accumulated E&P
$13,000
$1,400
$6,000
The corporation records also show the following:
Net ordinary income
Tax-exempt income
$12,000
$4,000
K’s basis in the stock at the beginning of the year was $12,000. L’s basis was $3,000
at the beginning of the year. During the year, the corporation distributed $30,000,
$21,000 to K and $9,000 to L.
In this case the AAA and the AE&P are split between K and L based on their
ownership percentages but the PTI applies only to K because L did not own the stock
at the time the PTI was generated.
The AAA, PTI, and AE&P balances at December 31 are calculated as follows:
K
Balances, beginning of year
Nonseparately stated income
Tax-exempt income
Balances, before distribution
Distributions to extent of AAA
Distributions to extent of PTI
Distributions to extent of AE&P
Balances, end of year
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AAA
$9,100
8,400
17,500
(17,500)
PTI
$1,400
1,400
AE&P
$4,200
OAA
4,200
2,800
2,800
(2,100)
$2,100
$2,800
(1,400)
$0
$0
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Next, stock basis is calculated, as follows:
Basis, beginning of year
Nonseparately stated income
Tax-exempt income
Basis, before distributions and other reductions
Distributions to extent of AAA & PTI
Basis, end of year
L
Balances, beginning of year
Nonseparately stated income
Tax-exempt income
Balances, before distribution
Distributions to extent of AAA
Distributions to extent of PTI
Distributions to extent of AE&P
Balances, end of year
AAA
$3,900
3,600
Basis
$12,000
8,400
2,800
23,200
(18,900)
4,300
PTI
7,500
(7,500)
$0
$0
AE&P
$1,800
OAA
1,800
1,200
1,200
(1,500)
$300
$1,200
Next, stock basis is calculated, as follows:
Basis, beginning of year
Nonseparately stated income
Tax-exempt income
Basis, before distributions and other reductions
Distributions to extent of AAA & PTI
Basis, end of year
Basis
$3,000
3,600
1,200
7,800
(7,500)
300
In this situation K would receive a nontaxable distribution from AAA and PTI of $18,900
and a taxable dividend of $2,100 while L would receive a nontaxable distribution of $7,500
and have a taxable dividend of $1,500.
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Post-termination Transition Period
A break for the taxpayer is provided by Sec. 1371(e). It states that cash distributions during the
post-termination transition period (PTTP) are to be applied against stock basis to the extent of
the Accumulated Adjustment Account. In effect, these provisions provide an escape hatch. They
give the corporation some time to distribute its AAA (which has already been taxed) as a tax-free
return of capital in the event the election is revoked or involuntarily terminated.
Rather than having distributions during the post-termination transition period treated as coming
out of AAA, the corporation can elect to apply such distributions against AE&P. In that case, the
distributions would be dividend income to the shareholder recipients [(Sections 1371(e)(2),
1377(b)(2); Reg. Sec. 18.1371-1]. Also, unused losses and deductions can be taken by the
shareholder at the end of the post-termination period, provided the shareholder has sufficient
stock basis (and subject to other limitations, such as the passive loss and at-risk rules). Further,
an S corporation's unused at-risk losses carry over into the PTTP. The shareholder can deduct the
at-risk losses at the end of the PTTP to the extent stock basis and at-risk basis are increased by
capital contributions during the PTTP.
The PTTP rules were amended by the Working Families Tax Relief Act of 2004 (WFTRA),
effective retroactively to tax years beginning after 1996. WFTRA Section 407(a) focuses solely
on the 120-day audit-related PTTP. Under new Sec. 1377(b)(3), suspended losses do not carry
over to the 120-day, audit-related PTTP. Essentially, if adjustment to S taxable income increases
shareholder basis, any suspended losses can be deducted only on prior shareholder tax years. In
addition, cash distributions during the 120-day, audit-related PTTP are deemed to come from
AAA only to the extent of any increase in AAA due to the audit adjustments.
As a reminder the PTTP begins on day after last day as S corporation and ends the later of (1)
one year after termination, (2) the due date (including extended date) of final S return or (3)120
days after a final determination (e.g., court decision) that S election was terminated.
Example 4-10
Calendar S corporation terminates on 3-2-09. The last day as an S corporation is 3-109. The PTTP begins 3-2-09 and ends on 3-15-102: the later of 3-1-10 (one year after
termination) or 3-15-10 (due date of return assuming no extension was obtained).
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Summary

Income that has been taxed to the shareholder can be distributed with no further tax
effect.

If an S corporation does not have AE&P, distributions are


–
Nontaxable return of capital to extent of basis, and
–
Capital gain, if in excess of basis.
If the S corporation has AE&P and PTI, the distributions are made in the following order:
–
AAA
–
PTI
–
AE&P
–
OAA
Distributions that come from AE&P are taxable as dividends. Distributions that come
from AAA and PTI are nontaxable return of capital to extent of basis and capital gain
thereafter.
For self study participants only, the CPE Standards require the inclusion of review
questions that provide periodic learning feedback. Please go to the review section at
the end of the course to access the review questions for this chapter.
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