IRS proposes terminated S corp distribution regs

Tax Hot Topics newsletter The IRS issued proposed regulations (REG-131071-18) on Nov. 4, 2019, under Sections 1371 and 481 that provide rules relating to distributions of money by eligible terminated S corporations (ETSCs) after the corporation’s post-termination transition period (PTTP) has ended. They would also revise current regulations to extend the treatment of distributions of money during the PTTP under Section 1371(e) to all shareholders of the corporation, not just shareholders that were shareholders at the time the corporation’s election to be treated as an S corporation was terminated.

Generally, a distribution by a C corporation to its shareholders with respect to their stock is treated as a taxable dividend to the extent of the corporation’s earnings and profit (E&P) under Section 301(c). However, Section 1371(e) provides for an exception to that rule for C corporations that were previously treated as S corporations but have recently terminated their S election.

Section 1371(e) allows for shareholders of a C corporation that has terminated its S election to benefit from its former status as an S corporation with respect to distributions of money made during the corporation’s PTTP. A C corporation’s PTTP is generally the one-year period after the S election terminates, but can also arise after the one-year period if changes are made to one of the corporation’s S years as a result of an IRS audit.

During the PTTP, a distribution of money by the corporation is characterized as a distribution from the corporation’s accumulated adjustments account (AAA) to the extent that the corporation has AAA. The receipt of such distribution is tax-free to the extent of the recipient’s basis in the stock of the corporation, and if the corporation exhausts its AAA during the PTTP, then subsequent distributions are subject to treatment under Section 301. Absent Section 1371(e), all distributions from the corporation after it terminates its S election would be subject to treatment under Section 301.

Section 1371(f), enacted by the Tax Cuts and Jobs Act, extends the period during which a corporation can benefit from the AAA generated while that corporation was an S corporation. It permits a corporation to distribute money to which Section 301 would otherwise apply, to be sourced, in whole or in part, from AAA. Specifically, it provides that if an ETSC makes a qualified distribution after that corporation’s PTTP has ended, then the distribution is chargeable to the ETSC’s AAA and accumulated E&P (AE&P), in a ratio that the amount of the ETSC’s AAA bears to the amount of the ETSC’s AE&P.

The proposed regulations provide rules for implementing Section 1371(f) and amends Treas. Reg. Sec. 1.1377-2(b), the so-called “no-newcomer rule,” for Section 1371(e) distributions.

In order for a distribution to qualify for Section 1371(f) treatment, the corporation must qualify as an ETSC. To do so, the proposed regulations provide that it must satisfy three requirements:

  • It must have been an S corporation on Dec .21, 2017, the day before the TCJA was enacted
  • It must have revoked its S election during the two-year period beginning on Dec. 22, 2017.
  • The owners of the stock of the corporation on Dec. 22, 2017, must be the same owners (and in identical proportions) as the owners of the corporation on the date that the corporation made a revocation of its S election (the regulations provide for a limited amount of circumstances where stock transfers do not result in an ownership change for purposes of qualifying as an ETSC).

Intrinsic in these three requirements is the requirement that the corporation revoked its S election and that the S election was not terminated in any other way.

If a corporation qualifies as an ETSC and makes a distribution during its ETSC period, then that distribution is allocated between the ETSC’s AAA and its AE&P. A corporation’s ETSC period is defined as any taxable year, or portion thereof, beginning on the first day after the corporation’s PTTP and ending on the date on which the ETSC’s AAA balance is zero. If a PTTP arises due to audit after the ETSC period has already begun, the ETSC period stops until the audit PTTP ends and the ETSC period resumes at the end of the audit PTTP if the corporation’s AAA is greater than zero.

If an ETSC makes a distribution during its ETSC period, then the percent of the distribution sourced from AAA is the ratio of the historical AAA to the sum of the historical AAA and historical AE&P (the AAA ratio), and the percent of the distribution sourced from AE&P is the ratio of the historical AE&P to the sum of the historical AAA and historical AE&P (the AE&P ratio). Adopting what the proposed regulations call the Snapshot Approach, an ETSC determines its AAA ratio and AE&P ratio only once and all distributions will be allocated to AAA and AE&P based on these ratios until either the corporation has no remaining AAA or no AE&P. If, after a distribution, the ETSC’s AE&P is reduced to zero and the ETSC’s AAA is greater than zero, then the AAA ratio is adjusted to 100%.

Under the Snapshot Approach, the AAA ratio and the AE&P ratio are determined using the amounts of AAA and AE&P that the ETSC has on the day that it revokes its S election. Therefore if a corporation has always been an S corporation prior to becoming a C corporation, and thus has no historic AE&P on that date, then the AAA ratio will be 100%.

Generally, the amount of a distribution that is sourced from AAA will be the product of the distribution and the AAA ratio, but only to the extent of the ETSC’s AAA immediately before the distribution. The amount sourced from AE&P is similarly calculated, but using the AE&P ratio and only to the extent of the ETSC’s AE&P. Both the AAA and AE&P are reduced after a distribution in the amount that the distribution was sourced from each respectively. If there is any excess distribution due to the fact that the ETSC’s AE&P was reduced to zero in the distribution, then the excess distribution will be treated as a separate distribution to which Section 1371(f) applies, but with the adjusted AAA ratio that is now 100%. If there is any excess distribution due to the fact that the ETSC’s AAA was reduced to zero in the distribution, then the excess distribution is treated as a non-qualified distribution and the general rules of Section 301 apply to the excess distribution. Note that by being a non-qualified distribution, this excess distribution does not automatically come out of AE&P. Section 301 applies to this portion of the distribution and therefore rules addressing distributions out of current E&P now apply.

In addition to promulgating rules implementing Section 1371(f), the proposed regulations also propose an amendment to the existing regulations for distributions under Section 1371(e). Under the current regulations, Treas. Reg. Sec. 1.1377-2(b) imposes an additional rule for distributions to qualify for the special treatment under Section 1371(e). Specifically, the last sentence provides, “[t]he special treatment under Section 1371(e)(1) of distributions of money by a corporation with respect to its stock during the post-termination transition period is available only to those shareholders who were shareholders in the S corporation at the time of the termination” (the no-newcomer rule).

In the preamble to the proposed regulations, the IRS specifically addresses the possibility of including a no-newcomer rule for Section 1371(f) and explicitly outlines several reasons why they believe adding a no-newcomer rule would not be appropriate. Therefore, they note in the preamble, that a no-newcomer rule was not going to be added to the regulations under Section 1371(f) and thus distributions would still qualify under Section 1371(f) even if the shareholders receiving the distributions were not shareholders of the S corporation before it revoked its S election.

Given that it was not adding a no-newcomer rule for distributions under Section 1371(f), the IRS reasoned that there should not be a no-newcomer rule for distributions under Section 1371(e). Thus the proposed regulations also propose to amend Treas. Reg. Sec. 1.1377-2(b) to remove the no-newcomer rule for Section 1371(e) distributions. If finalized, the proposed amendment would extend Section 1371(e) treatment of distributions to all shareholders and not just shareholders that were shareholders at the time the S election was terminated.

These regulations are currently issued in proposed form (not currently applicable) and are proposed to apply to taxable years beginning after the date the regulations are published as final regulations. However, the proposed regulations, if finalized in their current form, will provide corporations with the option to apply the final rules in their entirety to taxable years that began on or before the date of publication for any year to which the period described in Section 6511(a), regarding period of limitations to file a refund claim, has not expired.

Josh Brady
National Managing Principal
Washington National Tax Office
T +1 202 521 1563

Bryan Keith
Managing Director
Washington National Tax Office
T +1 202 861 4116

Jack Stringfield
Senior Associate
Washington National Tax Office
T +1 202 521 1518

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