Distributions from your S Corporation are generally tax free to the extent that you have basis in your stock. However, when your C Corporation elected S status, all of its accumulated earnings and profits (E&P) were frozen. Any distributions you take from E&P accrued when your business was a C Corporation are taxed as a dividend.
Under current tax law, qualified dividends are taxed at a maximum rate of 15%. Starting in 2011, dividends will be taxed at the same rate as ordinary income. The top marginal rate on ordinary income for 2011 will be 39.6% (unless new legislation is passed extending the current lower rate). Given the expected increase to the tax rate on dividends, the cost of distributing your E&P may substantially increase.
Distributions are typically deemed to be made from accumulated E&P when they exceed the corporation’s accumulated adjustments account (AAA). A corporation’s AAA generally consists of its net income or loss for all S Corporation years less any distributions that were sourced from AAA. However, an S Corporation can elect, with the consent of all its shareholders, to distribute its earnings and profits before AAA.
If the corporation does not have sufficient cash on hand to distribute all of its E&P, it can eliminate E&P by distributing its own corporate notes, or by making a deemed dividend election. A deemed dividend is a hypothetical distribution of E&P to all shareholders that is treated as being immediately contributed back to the corporation. As a result, the stockholder pays tax on the deemed distribution and receives basis for the contribution. The additional created basis can be used by the taxpayer to take losses otherwise suspended by basis limitations, or offset gain on the ultimate sale of the S Corporation Stock.
With the expected increase in tax on dividends, we suggest that you consider distributing your E&P in 2010. There are many relevant considerations when deciding to distribute E&P. Please contact us to discuss if it will be advantageous for you to distribute your E&P in 2010.
Tax Department – Hill, Barth & King For more information about how these changes relate to your unique circumstances, please call our Fort Myers office at 239-482-5522.