S Corp Conversions: Watch out for Disappearing AAA

Small and medium-sized businesses can save quite a bit in taxes by using S corporations. But with these tax savings comes complexity.

This complexity comes from how S corporations flow through profit and have the profit taxed on the individual owner’s personal tax return. The rules for tracking this are, well, lacking. Accountants are often left to fill in the gaps by applying reason to get to a logical result, and perhaps erring on the side of less tax when the law is not clear.

The recent Tomseth v. United States, No. 6:17-cv-02017 (D. Or. 2019) court case provides an example of how rounded-down logic doesn’t always carry the day when it comes to tax law.

Facts & Procedural History

The taxpayers owned several successful tire stores. The companies started as C corporations and operated as C corporations for a period of time. Then they converted to S corporations, to C corporations, and finally back to S corporations.

This case focuses on the two periods during which the companies were S corporations.

Because they stores were profitable and they did not fully distribute their profits to the taxpayer owners when they were S corporations, the stores had positive Accumulated Adjustment Account (AAA) balances from these periods.

After converting to C corporations for the last time, the businesses made substantial distributions to the owners. The distributions were approximately the same as the AAA balances.

The taxpayers took the position that the distributions were not taxable to the owners as they were a return of the AAA balances.

As part of the IRS audit, the IRS argued that the AAA balance from the first S corp period did not continue once the companies converted to C corps and, as such, was not added to the AAA for the second period the entities were S corporations. This resulted in a large portion of the distribution being taxed as a dividend to the owners.

S Corporation Distributions

The S corporation is typically elected to limit employment taxes for the owners. It is also used in various tax planning strategies that freeze the value of property contributed to the corporations. Most recently, the Tax Cuts and Jobs Act added a few new planning opportunities involving S corporations.

But regardless of the reason for creating the S corp, one has to apply a set of rules to determine how the distributions are taxed to the owner. Very generally, the S corp profits earned in year 1 will flow through and be taxed to the owner in year 1. This is true even if the S corp does not distribute the profits to the owner in year 1. To ensure that the retained profits from year 1 are not taxed in year 2, 3, etc., the S corp tracks the amount in an AAA account. Thus, AAA is the amount the taxpayer can take in distributions free of income tax.

After this amount is used up, the taxpayer can also take amounts in excess of this for their tax basis. This allows the taxpayer to recoup their investment in the S corp before being taxed.

Amounts distributed to the owner in excess of AAA and tax basis are generally taxed as dividends to the owners. Dividends are generally taxed at ordinary tax rates.

The Disappearing S Corp AAA Balance

This brings us to the question in this case. If an S corp has a positive AAA balance and converts to an S corp, what happens to the AAA balance? Does the AAA balance still exist and the taxpayer can continue to use it if it later converts back to an S corp? One would think so.

The court considered the statutory language, policies, and even the reasoning from an IRS legal memorandum. Without going into the details, the court essentially concluded that there is no rule on point and, absent a rule, the IRS’s interpretation is to be accepted.

This absent-a-rule the IRS wins analysis is suspect, but for purposes of this post, the absence of the rule is the issue. There isn’t a rule here.

This case stands as a reminder that those converting from S corps should take steps to use up the AAA balances before or shortly after converting to C corps. This will help avoid the loss of a AAA balance should this court opinion stand.