Unless you elect different treatment, for shareholder income tax purposes S corporation distributions are applied in the following order:
1. To reduce the Accumulated Adjustment Account (AAA) determined without regard to any net negative adjustment for the tax year but not below zero.
According to IRC 1368 if distributions during the tax year exceed the AAA at the close of the tax year determined without regard to any net negative adjustment for the tax year the AAA is allocated pro rata to each distribution made during the tax year.
2. If applicable – as in pre 1983 – to reduce shareholders’ Previously Taxed Income (PTI) account for any IRC section 1375(d) distributions associated with tax imposed when passive investment income of the corporation has accumulated earnings and profits in excess of 25 percent of gross receipts.
A distribution from the PTI account is tax free to the extent of a shareholder’s basis in his or her stock in the corporation. This is rarely seen any more as there are few S Corps with pre 1983 PTI remaining.
3. To reduce accumulated earnings and profits (E&P).
According to IRC 1361(a)(2), the S corporation generally speaking has accumulated E&P only if it has not distributed E&P accumulated in prior years when the S corporation was a C corporation generally speaking.
The only adjustments that can be made to the accumulated E&P of an S corporation are for:
(a) dividend distributions;
(b) redemption, liquidation, reorganization, etc; and
(c) investment credit recapture tax liabilities under IRC 1371(c)+(d)(3).
4. To reduce the other adjustments account (OAA).
5. To reduce any remaining shareholders’ equity accounts.
These ordering rules can be changed with one of the following elections:
1. Election to distribute accumulated E&P first.
According to IRC 1368(e)(3)(B) if the corporation has accumulated E&P and wants to distribute from this account before making distributions from the AAA, and all affected shareholders consent, it may irrevocably elect to do so for a specified tax year.
2. Election to make a deemed dividend.
According to IRC 1368(e)(3)(B) a corporation may irrevocably elect to distribute all or part of its accumulated E&P through a deemed dividend with the consent of all its affected shareholders for a specified tax period. Under this election, the corporation will be treated as also having made the election to distribute accumulated E&P first.
Remember the amount of the deemed dividend cannot exceed the accumulated Earnings & Profits (E&P) at the end of the tax year and the E&P at year end is first reduced by any actual distributions of accumulated E&P made during the tax year.
Treat a deemed dividend as a distribution to the shareholders that is received by the shareholders and immediately contributed back to the corporation on the last day of the tax year.
3. Election to forego Previously Taxed Income (PTI)
Again according to IRC 1368(e)(3)(B) if a corporation wants to forego distributions of PTI, it may irrevocably elect to do so for a given tax period with the consent of all affected shareholders.
Three important points about the election statement
1. You must attach the statement to a timely filed original or amended IRS Form 1120S for the tax year for which the election is made.
2. You must identify the election being made AND state that each shareholder consents to the election.
3. A deemed dividend election must include the amount of the deemed dividend distributed to each shareholder in the statement.