C corporations are generally subject to double taxation: once at the corporate level when income is earned, and again at the shareholder level when that income is distributed. In contrast, S corporations typically are not taxed at the corporate level. Instead, their income and deductions flow through to the shareholders when earned. Distributions from an S corporation are often tax-free to shareholders. However, the tax treatment of these distributions becomes more complex if the S corporation holds accumulated earnings and profits (E&P) from its history as a C corporation or from acquiring a C corporation.
An S corporation does not generate E&P on its own. It may have E&P only if it was previously a C corporation or acquired one. E&P earned during the C corporation period remain subject to double taxation—even if later held by an S corporation. These E&P are taxed at the corporate level when earned and again as dividends when distributed by the S corporation.
S corporations with accumulated E&P are required to maintain an Accumulated Adjustments Account (AAA). The AAA tracks previously taxed but undistributed S corporation earnings. These earnings, once taxed to shareholders when earned, may be distributed tax-free to the extent of the shareholder’s stock basis. The AAA is maintained at the corporate level and is not allocated among shareholders. It serves as a key factor in determining whether a distribution will be taxable. (See Treas. Reg. § 1.1368-2.)
If an S corporation holds E&P, any shareholder distribution could be characterized as:
- A reduction in the shareholder’s basis,
- A taxable dividend, or
- A gain on the sale or exchange of stock (IRC § 1368).
To determine the correct tax treatment, several elements must be analyzed: the amount of AAA, accumulated E&P, and the shareholder’s stock basis (adjusted under IRC § 1367(a)(2)).
S corporations are allowed to distribute AAA earnings before distributing E&P, regardless of when the income was earned. This ordering provides an opportunity to delay or avoid dividend treatment to the extent distributions are covered by AAA. The higher the AAA balance, the more likely distributions can be made tax-free. However, if the corporation distributes appreciated property, gain may be recognized under IRC § 311(b), even if the distribution is otherwise covered by AAA.
Generally, distributions from an S corporation with E&P are tax-free to the extent of the AAA (IRC § 1368(c)(1)). If the distribution does not exceed the AAA, it is treated as though made by an S corporation without E&P: the distribution first reduces basis, and any excess over basis is treated as gain. If the distribution exceeds the AAA, the excess is treated as a taxable dividend to the extent of E&P. Any portion exceeding both the AAA and E&P is again treated as a return of capital (reducing basis) and, to the extent it exceeds basis, is treated as gain.
An S corporation that wants to distribute E&P before exhausting the AAA may elect to do so under IRC § 1368(e)(3). This election can help the corporation avoid the passive income tax or termination of S status due to excessive passive income.
If an S corporation does not have any accumulated E&P, distributions are generally treated first as a return of capital (reducing the shareholder’s basis), and any amount exceeding basis is treated as gain (Treas. Reg. § 1.1368-1(c)). In this case, the AAA is technically not required, as there are no E&P to manage. However, maintaining the AAA can still be beneficial in case the corporation acquires E&P through a future reorganization or acquisition. Once all accumulated E&P are distributed, the S corporation is no longer required to track the AAA, though doing so may remain useful.
In summary, when an S corporation has accumulated E&P, the taxation of its distributions becomes more complex. Both corporate-level and shareholder-level attributes must be evaluated to determine the tax consequences. The rules are designed to preserve the distinction between distributions from S corporations and those from C corporations.