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IRS Counsel’s Memorandum Could Have Important Implications for S Corporation Shareholders

13048311844_426bfa9bee_z.jpgThe Office of the Chief Counsel of the Internal Revenue Service (IRS) issued a memorandum late last year addressing a question about the rights of shareholders in a corporation that switched from subchapter S to subchapter C and then switched back to subchapter S. IRS Chief Counsel Memorandum (“IRS Memo”) No. 201446021 (Nov. 14, 2014) (PDF file). C corporations face “double taxation,” in which the corporation pays tax on its net income, and shareholders pay tax on the same money when they receive it as dividends. Under subchapter S of the Internal Revenue Code (IRC), 26 U.S.C. § 1361 et seq., qualifying corporations can elect to be taxed much like a partnership, meaning that shareholders pay taxes directly on a pro rata share of corporate profits. Losing subchapter S status can result in the loss of tax benefits, as demonstrated by the IRS memorandum.

Shareholders in S corporations are liable for taxes on their share of corporate income whether they receive dividends or not. The IRC provides a way for shareholders to obtain this money, on which they have already paid income tax, from the corporation without any additional tax liability. S corporations must maintain an “accumulated adjustments account” (AAA), which consists of corporate profits already taxed to shareholders but not distributed. 26 U.S.C. § 1368(e)(1), 26 C.F.R. § 1.1368-2. The AAA comes into existence with a balance of zero on the first day of a corporation’s first year as an S corporation.

If a corporation’s subchapter S election is revoked, a “post-termination transition period” (PTTP) begins on the date of revocation and ends after one year or on the due date of the tax return for the corporation’s last year as an S corporation, whichever is later. 26 U.S.C. § 1377(b). A corporation can distribute the balance of its AAA to its shareholders during the PTTP as though it still had subchapter S status. 26 U.S.C. § 1371(e). The question presented to the IRS was whether an AAA survives the transition from S to C, then back to S. The IRS concluded that it does not.

The taxpayer corporation discussed in the IRS memorandum originally chose taxation under subchapter C. At some point, after it had begun to turn a profit, it elected subchapter S taxation. Its majority shareholders revoked its subchapter S status, and it made distributions from the AAA, as permitted by § 1371(e). However, the corporation apparently did not have enough available cash, so when the PTTP ended, it still had a balance in its AAA. It made a new subchapter S election and asked the IRS for a ruling on whether it could still disburse funds from the AAA to the shareholders.

The IRS looked at the language of the statutes and regulations, as well as the legislative history of both subchapter S and the law that created the AAA. It concluded that the legislative intent appears to be that “the undistributed taxable income expire[s] at the end of any given S period.” IRS memo at 5. Therefore, the corporation’s AAA “reset to zero after the PTTP and remain[ed] zero into a subsequent S period.” Id. at 6.

If you have a business dispute involving a contract or another matter, a skilled commercial law lawyer can advise you of your rights and protect your interests. James G. Schwartz has represented businesses and business owners in the Bay Area since 1976. Contact us today online or at (925) 463-1073 to schedule a free and confidential consultation.

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Benefit Corporations Enable California Business Owners to Serve the Public Good, Pleasanton Business & Commercial Law Blog, August 15, 2014

Shareholder in S Corporation Must Pay Tax Despite Exclusion from Management, Pleasanton Business & Commercial Law Blog, June 16, 2014

New California LLC Statute Took Effect at the Beginning of 2014, Pleasanton Business & Commercial Law Blog, February 12, 2014

Photo credit: eFile989 [CC BY-SA 2.0], via Flickr.