Modifying the Order of Distribution Rules for an S Corporation with AE&P

A distribution from an S corporation is generally treated as made from the corporation’s accumulated adjustments account (AAA) tax free to the extent of a shareholder’s basis. It is then treated as taken from any remaining balance of AAA and is taxed at capital gain rates. Next, it is treated as a tax-free reduction of previously taxed income (PTI), which consists of S corporation earnings from tax years beginning 1982 and earlier, and then as a taxable dividend to the extent of accumulated earnings and profits (AE&P). After AE&P is exhausted, any remaining distribution amount is treated as tax free to the extent of the shareholder’s basis, and the balance is treated as a capital gain.

Because of these ordering rules, any AE&P are essentially “trapped” in this group of undistributed earnings until AAA and PTI are fully depleted. There may be some cases in which it would be advantageous to distribute AE&P before AAA and/or PTI. Fortunately, the Code allows a taxpayer to elect to change these ordering rules and treat S corporation distributions as made out of AE&P first.

Elections

Three elections allow S corporations to distribute AE&P before AAA and/or PTI:

1. An election to distribute AE&P before AAA;
2. An election to make a deemed dividend; and
3. An election to forgo distributions of PTI. (See exhibit)

An S corporation can elect to modify the distribution order of AAA and AE&P. Specifically, the S corporation can elect under Sec. 1368(e)(3)(A) to treat distributions as being made from AE&P before reducing AAA.

In addition, an S corporation that lacks liquid assets to distribute AE&P can also elect to make a deemed dividend under Regs. Sec. 1.1368-1(f)(3), effectively bypassing AAA and reducing AE&P first by creating a hypothetical distribution. If this election is made, the first election described above will be considered to have been made.

Generally, an S corporation will want to distribute PTI as quickly as possible, because the ability to distribute PTI tax free is limited to those who were shareholders at the time it was earned. PTI cannot be distributed tax free to subsequent shareholders or after an S corporation election terminates. However, if the S corporation has PTI and wishes to bypass it in addition to AAA, the S corporation will have to make an election under Regs. Sec. 1.1368-1(f)(4). If it does not make this election but makes the first two, distri-butions will first reduce PTI tax free, then AE&P, and finally AAA.

Purpose

There are a few potential tax advantages associated with strategically accelerating AE&P distributions. For instance, if a shareholder has an NOL carryforward that is going to expire, these elections can essentially get AE&P out of the S corporation tax free to the extent of the NOL.

S corporations with AE&P and passive investment income (PII) (as defined in Sec. 1362(d)(3)) that exceed 25% of gross receipts are subject to a tax on excess net passive income of 35%. Similar to the built-in gains tax, this tax is paid by the S corporation and reported on the company’s income tax return. By making the preceding elections and distributing AE&P as a dividend (taxable at 15%), the S corporation and its shareholders will no longer be subject to this tax. Further, a corporation that has no AE&P cannot have its S election terminated due to excess PII.

Currently, qualified dividends are taxed at a preferential rate of 15% under Sec. 1(h); this rate is set to expire in 2010. Although these rates were originally set to expire after 2008 and were extended by the Tax Increase Prevention and Reconciliation Act of 2005, P. L. 109-222, there is a real possibility that this provision will not be renewed. Therefore, making these elections and distributing any AE&P before then will effectively eliminate the possibility of this income being taxed at ordinary rates.

Timing and Manner of Elections

For an S corporation to make these elections, it must attach a statement to the timely filed original or amended corporate return that identifies the elections and states that each shareholder consents to the elections. The elections need not be signed, because they will be considered to be verified by the taxpayer’s signature on Form 1120S. The elections, if made, are irrevocable and apply only to the year of the election. (See Regs. Sec. 1.1368-1(f)(5).)

From Daniel J. Burke, M. Acc., Aidman, Piser & Company, Tampa, FL

S Stock Call Options as a Second Class of Stock

S corporation can have only one class of stock; if a second class of stock exists, a corporation’s S election will terminate. The second-class-of-stock requirements are governed by the regulations under Sec. 1361, which states that generally call options, warrants, or similar instruments (collectively, “call options”) are treated as a second class of stock if the call options are substantially certain to be exercised and have a strike price substantially below the FMV of the underlying stock on the date that the call options are issued or transferred by an eligible shareholder to a person who is not an eligible shareholder. The regulations require retesting if and when the call options are first transferred to an ineligible shareholder. A call option is not considered to have a strike price substantially below FMV if the price at the time of exercise, under terms of instrument, cannot be substantially below the FMV of the underlying stock at the time of the exercise. It is important that the stock’s FMV be determined through a formal process, such as an independent appraisal.

There are three main exceptions to the general rule under Sec. 1361:

1. Call options issued to a person actively and regularly engaged in the business of lending and issued in connection with a commercially reasonable loan to the S corporation (Regs. Sec. 1.1361-1(l)(4)(iii)(B)(1)). This exception applies if the call option is transferred with the loan or if a portion of the call option is transferred with a corresponding portion of the loan. If the call option is transferred without a corresponding portion of the loan, this exception no longer applies. Upon such a transfer, if, but for this exception, the call option would have been treated as a second class of stock as of its date of issue, the option is retested under the general rule.
2. Call options issued to employees or independent contractors (Regs. Sec. 1.1361-1(l)(4)(iii)(B)(2)). Call options issued to employees or independent contractors in connection with the performance of services do not constitute a second class of stock if the call options are not transferable and do not have a readily ascertainable FMV at the time the option is issued under Sec. 83. This exception extends beyond the termination of employee or independent contractor status and applies whether the services are provided to a corporation itself or to a corporation controlled by the issuing corporation.
3. Safe-harbor exception: The strike price is at least 90% of the FMV on the date the call option is issued (Regs. Sec. 1.1361-1(l)(4)(iii)(C)). A call option is not treated as a second class of stock if on the date the call option is issued, the strike price is at least 90% of the underlying stock’s FMV on that date. Failure of an option to meet this safe harbor does not automatically result in the option being treated as a second class of stock.

The following are examples from the regulations:

Example 1—Transfer of call option by eligible shareholder to ineligible shareholder: S Corp. has 10 shareholders. S issues call options to A, B, and C, individuals who are U.S. residents. A, B, and C are not shareholders, employees, or independent contractors of S. The options have a strike price of $40 and are issued on a date when the S stock’s FMV is also $40. A year later, P, a partnership, purchases A’s option. On the date of transfer, the S stock’s FMV is $80.

On the date the call option is issued, its strike price is not substantially below the S stock’s FMV. Thus, the initial issuance of the options does not create a second class of stock, because the option has a strike price of at least 90% of the stock’s FMV on that date. However, whether a call option is a second class of stock must be redetermined if the call option is later transferred by an eligible shareholder to a person who is not an eligible shareholder. In this case, A is an eligible S shareholder, but P is not. Accordingly, the option is retested on the date it is transferred to P. Because on that date the option’s strike price is 50% of the FMV, the strike price is substantially below the S stock’s FMV. The call option is therefore treated as a second class of stock as of the date it is transferred to P if, at that time, it is determined that the option is substantially certain to be exercised. That determination is made on the basis of all the facts and circumstances.

Example 2—Call option issued in connection with performance of services: E is a bona fide employee of S Corp. S issues E a call option in connection with E’s performance of services. At the time the call option is issued, it is not transferable and does not have a readily ascertainable FMV. However, it becomes transferable before it is exercised by E. While the option is not transferable, it is not treated as a second class of stock, regardless of its strike price. When the option becomes transferable, it could possibly be treated as a second class of stock if the call option is substantially certain to be exercised and has a strike price substantially below the underlying stock’s FMV on the date that the call option is issued or transferred by an eligible shareholder to a person who is not an eligible shareholder.

Conclusion

When determining whether call options, warrants, or similar instruments constitute a second class of stock, there are issues that must be considered, such as strike price, the stock’s FMV, and whether the stock option will be exercised. If a call option is certain to be exercised and the strike price is substantially below the underlying stock’s FMV, a second class of stock is created. When a call option is issued in connection with performance of services, and the stock is not transferable and does not have a readily ascertainable FMV, a second class of stock does not exist. When a call option has a strike price of at least 90% of the underlying stock’s FMV on that date, a second class of stock does not exist. It is also important to note that the stock’s FMV must be determined in a formal independent manner, such as by an independent appraisal. Therefore, an S corporation must carefully plan to ensure that the one-class-of-stock requirement is not violated on the issuance of call options.

From Jennings P. Pitts, CPA, Bennett Thrasher PC, Atlanta, GA