Shareholders in three family-owned corporations owed income tax on $9.33 million left in an S corporation undistributed earnings account after the expiration of the transition period following a conversion to a C corporation.
Matthew and Diana Tomseth were shareholders in three family-owned Les Schwab tire corporations. Throughout their history, these companies toggled between operating as S corporation and C corporation status.
S corporations sometimes retain their earnings instead of distributing them to their shareholders. This is so even though the shareholders are taxed on those earnings. Tax code Section 1368(e) requires those taxed, but undistributed, earnings to be recorded in a separate “accumulated adjustments account” (AAA). Section 1371(e) allows for an S corporation’s AAA balance to be distributed tax-free, even after it becomes a C corporation, as long as the distribution takes place within a one-year post-termination transition period (PTTP).
It is particularly important for an ’S’ corporation with Subchapter C earnings and profits to have an accumulated adjustments account. Distributions by such an S corporation are treated as a return of capital (up to the basis of the stock with respect to which the distribution is made) but only to the extent that such a distribution does not exceed the accumulated adjustments account. Distributions by an S corporation without an accumulated adjustments account, but with Subchapter C earnings and profits, are “treated as a dividend” to the extent the distribution does not exceed such accumulated earnings and profits. See Section 1368(c).
What if the corporation does not distribute all of its AAA within the PTTP? Can it distribute the remaining AAA funds tax-free once the corporation reverts to an S corporation?
The Tomseths argued that the old AAA balance was “still accessible“ once the C corporation reverted to an S corporation. The Internal Revenue Service argued that ”PTTP expiration equals AAA expiration.“ Once the PTTP expires, the IRS contended, the old AAA earnings are no longer available for tax-free distribution, even if the corporation reverts to an S corporation. In that case, the IRS argued that ”the AAA balance resets to zero“ after a new S corporation election.
The Tomseths, in 2013, received $9.33 million in distributions from the corporations, which the IRS characterized as taxable dividends. The corporations were C corporations at the time of the distributions, and the distributions were well within the PTTP. In previous years, however, they had twice operated as S corporations and calculated their AAA funds at the beginning of their most recent S-election as the sum of the AAA balances during these two S-periods.
The Tomseths argued that any AAA funds that were not distributed to shareholders during the previous PTTPs were still distributable on a tax-free basis if a corporation becomes an S corporation sometime in the future. They argued that their interpretation of the AAA and PTTP provisions was supported by the relevant statutory texts. A federal trial court disagreed. (Tomseth v. United States, No. 6:17-cv-02017 (D. Or. 9/27/19).
Statutory Text Favors IRS’s Interpretation
The Tomseths argued that the plain language of Section 1368(e) does not require AAA to be reset to zero at the start of a new S-period. The Tomseths’ “textual analysis is unconvincing,“ the court said. Section 1368(e)(1) provides: “In general, except as otherwise provided…the term, accumulated adjustments account, means an account of the S corporation which is adjusted for the S period in a manner similar to the adjustments under Section 1367…. Section 1368(e)(2) provides that: The term, S period, means the most recent continuous period during which the corporation has been an S corporation...” (emphasis added).
Section 1368(e)(1), therefore, defines AAA as an account “of the S corporation,” which is adjusted for the S period. The phrase ‘of the S corporation’ implies that the AAA can only exist while there is an S corporation, i.e., a AAA does not continue to exist (except during the PTTP) after the S corporation becomes a C corporation. This is, the court reasoned, “the only interpretation that gives effect to the phrase, of the S corporation,” and precludes allowing the Tomseths to carry over AAA from previous S periods.
Additionally, the court noted, Section 1368(e)(2) defines an S period as “the most recent continuous period” during which the corporation was an S corporation. The existence of the word, continuous, “is significant.” Congress’s decision to include the word implies that once an S period ends, the AAA’s tax-free status should also end. In short, “it makes more sense to interpret Section 1368(e) as only allowing a AAA balance to exist during the corporation’s most recent sojourn through subchapter S.”
The IRS’s position was also supported by the companion PTTP provisions. Section 1377(b) defines PTTP: The term, post-termination transition period, means 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 one year after such last day, or (ii) the last day for filing the return for such last year as an S corporation. Section 1371(e) provides: Any distribution of money by a corporation with respect to its stock during a post-termination transition period shall be applied against and reduce the adjusted basis of the stock, to the extent that the amount of the distribution does not exceed the AAA within the meaning of Section 1368(e).
The court asked the following cogent question—“why have a PTTP—a designated period for tax-free distributions—if not to serve as an expiration date for distributing AAA funds tax-free?“ It seems, the court reasoned, ”more sensible to interpret the PTTP to simply allow for a reasonable time for the corporation to distribute its AAA to shareholders.“ The existence of the PTTP, then, signifies that Congress intended for it to be the exclusive time for distributing AAA funds when an S corporation elects to become a C corporation. The PTTP created a one-year timeframe for distributing AAA funds after an S corporation becomes a C corporation. It makes eminent sense to interpret this ”as the only time when an S corporation can distribute its AAA funds tax-free.“
Tax Treatises Support IRS’s Position
The IRS cited several “treatises” in support of its interpretation: (1) Mertens Law of Federal Income Taxation, (2) the Standard Federal Tax Reporter, and (3) S Corporations: Federal Taxation. The court found their consistency in supporting the IRS’s interpretation “to be persuasive.”
Mertens states that “the purpose of the AAA is to provide a mechanism for S corporations to make tax-free distributions of their already taxed income from their most recent sojourn through subchapter S.” It further explains that these funds can only be distributed tax-free during a limited period of time, and that the PTTP functions as that limited period.
The Standard Federal Tax Reporter is similarly supportive of the U.S.’s interpretation. That treatise states that: “If the AAA is not exhausted by the end of the PTTP, it disappears.” The fact, the court noted, that all treatises agree on this issue is persuasive evidence that the IRS’s interpretation “is likely correct.”
Finally, the court said, CCA 201446021, Nov. 14, 2014, was also persuasive.“ That document points out that the very existence of a PTTP implies that a corporation cannot make any further tax-free distributions from the AAA once the PTTP expires, i.e., the undistributed AAA does not carry over to the C corporation’s next stint as an S corporation. Thus, the court had no choice but to grant the IRS’s motion for summary judgment.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.