When a C corporation converts to an S corporation, it carries over its E&P. But to avoid double taxation, the Code creates an “accumulated adjustments account” (AAA). The AAA is a corporate account that tracks the S corporation’s undistributed, previously taxed income. § 1368(e).
Distributions from an S corporation with accumulated E&P are sourced in the following order (the “tier” system):
- Tier 1: From the AAA. These distributions are tax‑free to the shareholder, reducing stock basis. § 1368(c)(1).
- Tier 2: From accumulated E&P. These are taxable as dividends to the extent of E&P. § 1368(c)(2).
- Tier 3: From other sources (typically, the shareholder’s remaining basis). These are tax‑free (return of capital) until basis is exhausted, then capital gain. § 1368(c)(3).
The AAA is adjusted in the same way as shareholder basis, except that tax‑exempt income is not included, and the AAA can have a negative balance. Distributions cannot create or increase a deficit in the AAA.
The ordering of AAA adjustments is critical: first increases, then decreases without regard to net negative adjustments, then distributions, then net negative adjustments, then adjustments for redemptions. Reg. § 1.1368‑2(a)(5).
If the AAA is positive, distributions up to that amount are tax‑free. So if you’re converting from C to S, you want to build up the AAA as quickly as possible to allow tax‑free distributions. But watch out: too much accumulated E&P can trigger the § 1375 tax on passive investment income or even terminate the S election under § 1362(d)(3).
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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