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S corp AAA invalid in subsequent S period

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Tax Hot Topics newsletterThe U.S. District Court for the District of Oregon held in Tomseth v. United States (No. 6:17-cv-02017-AA) that an S corporation’s accumulated adjustments account (AAA) is no longer available when it re-elects S corporation status after an intervening period as a C corporation. On a second issue, the court ruled that the IRS could not adjust the S corporation’s AAA to a negative amount to take into account what should have been a taxable distribution in 2005. Collection of tax was otherwise barred by the applicable statute of limitations.

The taxpayers in Tomseth were a married couple that owned three corporations that toggled back-and-forth between C corporation status and S corporation status over several decades. Each of the three corporations started as a C corporation, became an S corporation ( First S Period), reverted back to a C corporation, re-elected S corporation status (Second S Period) and the reverted again back to a C corporation.

The first issue considered by the court was whether each corporation’s AAA at the end of the Second S Period included AAA remaining at the end of the First S Period. Corporate distributions are generally treated in the following order: (1) tax free to the extent of AAA, (2) dividends to the extent of earnings and profits, (3) return of basis, and (4) gain from the sale or exchange of a capital asset.

In the case, the taxpayers claimed certain distributions were tax-free from AAA. The IRS disagreed, claiming that the distributions exceeded the AAA and should be dividends because the corporations overstated AAA by including AAA from the First S Period. The court ruled in favor of the IRS on this issue and held that leftover AAA from the First S Period does get carried forward and added to AAA in the Second S Period.

The court reasoned that Section 1368(e)(1) provides, “the term ‘accumulated adjustments account’ means an account of the S corporation which is adjusted for the S period,” and Section 1368(e)(2) provides, “the term ‘S period’ means the most recent continuous period during which the corporation has been an S corporation” (emphasis added). As a result, certain portions of distributions that the taxpayer claimed were tax free distributions from AAA were instead taxable dividends out of earnings and profits.

The second issue in the case stemmed from a distribution in 2005 that was erroneously treated by the taxpayers as tax-free from AAA instead of as a taxable dividend but for which the statute of limitations on the assessment of tax had expired. The IRS attempted to adjust AAA to a negative balance as of the 2005 distribution, which would cause later distributions that would otherwise be tax-free distributions from AAA to be taxable dividends.

The court disagreed with the IRS approach. It reasoned, in part, that the IRS attempt to impose a negative AAA balance on the corporation contradicted rules that prevent AAA from going negative (other than in certain limited circumstances that were not applicable). Thus, the IRS was barred from collecting tax related to a 2005 distribution by the statute of limitations and was also unable to adjust AAA in a way that would enable the IRS to collect additional tax in a future period when the statute of limitations remained open.

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Josh Brady
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Washington National Tax Office
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Bryan Keith
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Jack Stringfield
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