Anticipating that the reduction of the corporate tax rate to 21% would result in taxpayers eager to cast aside their S elections in favor of C corporation treatment, the Tax Cuts and Jobs Act (TCJA) included several provisions intended to smooth the transition. Perhaps none caused as much confusion as new Section 1371(f), which offered an extension on the time period in which an eligible terminated S corporation (ETSC) could make tax-free distributions from its accumulated adjustments account (AAA). Although the statute promised preferential treatment to ETSCs, uncertainty surrounding its mechanics made it difficult for taxpayers to accurately predict the time value considerations when calculating the potential tax savings of a switch from S to C status. Recently proposed regulations include a taxpayer-favorable approach to applying this provision, allowing ETSCs to accelerate tax-free distributions of AAA to their shareholders.
As was the case prior to the TCJA, any cash distribution with respect to stock during the S election post-termination transition period (generally, one year after revocation of the election) is tax-free to the extent it does not exceed AAA. Section 1371(f) also permits distributions of money by an ETSC after the post-termination transition period to be proportionally allocated between AAA and accumulated earnings and profits (AE&P). Although the statute does not place a time limit on this treatment, until now it was unclear (1) whether this ratio should be determined after distribution of current-year earnings and profits (E&P), and (2) whether current-year and AE&P were combined for this purpose, thereby diluting the allocation to tax-free AAA as the corporation accumulates additional E&P after revocation of S status. However, the proposed regulations adopt a “snapshot” approach: The ratio of AAA to AE&P is determined as of the date the S election revocation is effective and remains static as the AAA and AE&P are depleted. Therefore, ETSCs with both AAA and AE&P at the time of revocation can quickly distribute AAA, regardless of post-termination profits.
Time is running out for S corporations to qualify as ETSCs and take advantage of the TCJA transition relief. Because an ETSC must revoke its S election within two years after enactment of the TCJA, revocations effective on or after December 22, 2019 will not qualify. S corporations considering a change to C corporation status should contact their tax advisor to determine whether and how these proposed regulations could impact their decision to revoke.
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