Redemptions Taxed as Distributions Under §301 During Post-Transition Termination Period First Reduce AAA

If a former S corporation makes a distribution to redeem shares that is treated as equivalent to a dividend and, therefore, taxed under IRC §301 during its post-transition termination period, how is that taxed?  In Revenue Ruling 2019-13 the IRS answers that question which likely has not been keeping most of America awake at night awaiting an answer.

The relatively short ruling looks at whether that distribution first reduces the accumulated adjustment account (AAA) and the taxpayer’s basis in the stock or, rather, is treated as first coming out of earnings and profits. 

The post-termination transition period is a time frame following the termination of a corporation’s S election when its distributions are treated as coming first of S corporation AAA and only after that is exhausted as coming out of earnings and profits.[1]  There are three such periods defined in IRC §1377(b)(1):

(1) In general

For purposes of this subchapter, the term “post-termination transition period” means—

(A) the period beginning on the day after the last day of the corporation’s last taxable year as an S corporation and ending on the later of—

(i) the day which is 1 year after such last day, or

(ii) the due date for filing the return for such last year as an S corporation (including extensions),

(B) the 120-day period beginning on the date of any determination pursuant to an audit of the taxpayer which follows the termination of the corporation’s election and which adjusts a subchapter S item of income, loss, or deduction of the corporation arising during the S period (as defined in section 1368(e)(2)), and

(C) the 120-day period beginning on the date of a determination that the corporation’s election under section 1362(a) had terminated for a previous taxable year.

The ruling provides the following fact pattern to be considered:

X is a corporation that once was a C corporation and later elected to be an S corporation under § 1362(a) of the Code. X’s S election terminated under § 1362(d), such that it is now a C corporation. A, an individual, owns all 100 shares of the outstanding stock of X. X is a calendar-year taxpayer. At the time of its conversion to an S corporation, X had accumulated earnings and profits (E&P) of $600x and no current E&P. At the time of the termination of its S election, X’s AAA was $800x and its accumulated E&P was still $600x. During X’s post-termination transition period, X redeems 50 of A’s 100 shares of X stock for $1,000x. X makes no other distributions during the post-termination transition period. Pursuant to § 302(d) of the Code, the redemption is characterized as a distribution subject to § 301. For the taxable period that includes the redemption, X has current E&P of $400x.

The ruling holds that this distribution first reduces AAA and the shareholder’s basis in stock until the distribution has reached the level of the AAA ($800x).  The remainder of the distribution ($200x) is taxed as a dividend under IRC §301(c)(1).

[1] IRC §§1371(e), $1377(b)