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IRS: S Corp's AAA Resets to Zero Following Post-Termination Transition Period.
(Parker Tax Publishing November 23, 2014)

The IRS's Office of Chief Counsel has advised that the AAA balance of a corporation that terminated its S status was reset to zero when its post-termination transition period (PTTP) ended, and thus remained zero when the corporation re-elected S status after an intervening C corporation period. CCA 201446021 (11/14/14).

Facts

The taxpayer was incorporated as a C corporation and operated as such until it made its first election to be treated as an S corporation. At that time, the taxpayer had accumulated earnings and profits (E&P) and after its S election, continued to generate annual profits.

When its majority shareholders later revoked its S election, the taxpayer had a positive balance in its accumulated adjustments account (AAA). During the post-termination transition period (PTTP), the taxpayer distributed a portion of its AAA to its shareholders pursuant to Code Sec. 1371(e), but left a positive balance at the end of the PTTP.

OBSERVATION: An S corporation's AAA is an account of the S corporation not apportioned among the shareholders. For S corporations with E&P from a prior period as a C corporation or a merger with a C corporation, the AAA tracks the corporation's ability to make tax-free distributions to shareholders. To the extent a corporation has a positive AAA, and the distribution does not exceed a shareholder's basis in the stock, the S corporation can make tax-free distributions to that shareholder.

After an intervening C corporation period, the taxpayer made another S election, and continues to operate as an S corporation today. The taxpayer represents that it converted from C to S to C and back to S to take advantage of individual and corporation tax rates available at the time of each conversion.

The taxpayer requested a ruling regarding whether its AAA balance from its first S period survived the period between the end of the PTTP and the time it once again became an S Corporation.

Analysis

Code Sec. 1368(e)(1) provides that an AAA is adjusted for the S period in a manner similar to the adjustments under Code Sec. 1367 and that no adjustment will be made for federal taxes attributable to any tax year in which the corporation was a C corporation. Code Sec. 1368(e)(2) defines the term "S period" as the most recent continuous period during which the corporation has been an S corporation. Reg. Sec. 1.1368-2(a)(1) provides that on the first day of the first year for which the corporation is an S corporation, the balance of the AAA is zero.

The Chief Counsel's Office advised that an S Corporation's AAA is reset to zero after the PTTP and remains zero into a subsequent S period. The Chief Counsel's Office noted that legislative history did not include a detailed definition of "S period," nor did it indicate whether Congress intended an AAA to survive a break in S status, but there was reason to believe that undistributed taxable income expires at the end of any given S period.

The Chief Counsel's Office recognized an argument could be made that, when read together, Code Secs. 1368(e)(1) and (2) merely provide that the corporation's AAA will not be adjusted during any period that the corporation is not an S corporation. However, the Chief Counsel's Office reasoned this interpretation was too narrow because if AAA survives the PTTP, but may not be adjusted during the C corporation period under Code Sec. 1368(e), certain events, such as redemptions, occurring while the taxpayer is a C corporation may economically require adjustments forbidden by the statute, leading to distortions.

The Chief Counsel's Office ultimately concluded that the plain language of the statute states that the AAA will reset to zero when the PTTP ends. Code Sec. 1368(e)(2) defines the "S period" as the most recent continuous period during which the corporation has been an S corporation and Code Sec. 1.1368-2(a)(1) states that on the first day of the first year for which the corporation is an S corporation, the balance of the AAA is zero. Additionally, because the statute specifically grants a PTTP, it implies that the PTTP is the only time the corporation may draw down its AAA by making distributions after termination of S corporation status.

For a discussion of PTTP, see Parker Tax ¶34,580. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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