The IRS recently released proposed regulations that would clarify, among other things, the proper treatment of certain distributions by certain former S corporations.
In response to changes made by the Tax Cuts and Jobs Act of 2017 (TCJA), some S-corporation financial services organizations revoked their S-corporation elections and converted back to C corporations. The TCJA created a mechanism for an “eligible terminated S corporation” (ETSC) to distribute its accumulated adjustment account (AAA) balance to shareholders tax-free after the standard one-year post-termination transition period (PTTP) following the effective date of the revocation, and the proposed regulations (REG-131071-18) explain how to apply these special distribution rules.
ETSCs and the TCJA
An ETSC is any C corporation that satisfies all of the following:
- Was an S corporation on Dec. 21, 2017
- Revoked its S-corporation election via a voluntary shareholder revocation during the two-year period beginning on Dec. 22, 2017
- Has the same shareholders, holding shares in the same proportion, on Dec. 22, 2017, and on the revocation date
Under IRC Section 1371(e), S corporations that terminate their election can distribute their positive AAA balances tax-free to shareholders to the extent of each recipient’s basis in the stock of the corporation – but only during the PTTP. If the entirety of the AAA balance isn’t distributed within the PTTP, the remainder cannot be distributed tax-free to shareholders. Any additional distributions after the PTTP are treated as coming from the C corporation’s current and accumulated earnings and profits (AE&P) and therefore are taxable as dividends.
The TCJA established IRC Section 1371(f), which provides that a distribution by an ETSC after the PTTP is treated as coming from the corporation’s AAA or AE&P in the same ratio as the amount of the AAA to the AE&P as of the date the S-corporation revocation became effective – a method referred to as “ETSC proration.” In other words, amounts that previously would have become permanently taxable as a dividend now can be distributed partially tax-free after the one-year PTTP window.
The proposed treatment of post-PTTP distributions
The proposed regulations specify the time at which amounts of AAA and AE&P are determined for purposes of the ETSC proration, clarify the AAA and AE&P ratios used to implement the ETSC proration, and describe in detail the method of characterizing qualified distributions.
The proposed regulations adopt the so-called “snapshot approach,” under which the AAA and AE&P ratios are determined only once, as of the beginning of the day for which the S-corporation revocation is effective, and distributions are allocated to AAA and AE&P based on those ratios until no AAA remains. Thus, a bank that has always been an S corporation – meaning it has no AE&P on the revocation date – will have an AAA ratio of 100%.
Examples
Some potential scenarios help illustrate how the proposed regulations would play out for ETSC financial services organizations.
1. A bank that had always been an S corporation qualifies as an ETSC with an effective termination date of Jan. 1, 2018. On that day, it has an AAA balance of $25 million and no AE&P balance. The bank distributes $15 million to shareholders on Feb. 1, 2018, within the PTTP. On Jan. 1, 2019, after the PTTP but during the ETSC period, it distributes another $10 million. Because the bank is an ETSC, AAA is allocated to a qualified distribution that is chargeable to AE&P in the same ratio that the amount of the AAA bears to the amount of AE&P. Thus, all distributions during the ETSC period are applied against the AAA balance existing after expiration of the PTTP, as follows:
