The IRS has published guidance (Revenue Ruling 2019-13) on certain tax consequences of a cash distribution made in redemption of a former S corporation's stock during a post-termination transition period (PTTP). The guidance provides that a cash distribution in redemption of stock during a PTTP that does not qualify for sale or exchange treatment reduces the corporation's accumulated adjustments account (AAA) (but not below zero) to extent of the redemption proceeds.

Background

Under Section 1371(e)(1), any distribution of money by a corporation with respect to its stock during a PTTP is applied against and reduces the adjusted basis of stock (i.e., is tax-free), to the extent that the amount of the distribution does not exceed the AAA. A PTTP is defined in Section 1377(b) as a specific period following the termination of a corporation's S election.

AAA is an account of an S corporation that is adjusted in a manner similar to basis in the stock of an S corporation for the S period. The "S period" is defined as the "most recent continuous period during which the corporation has been an S corporation." In Revenue Ruling 95-14, 1995-1 C.B. 169, the IRS ruled that the S corporation distribution rules under Section 1368 apply to a redemption distribution that does not qualify for sale or exchange treatment under Section 302 and is therefore treated as a distribution under Section 301.

Issue

The question at issue in the ruling was whether a former S corporation (now C corporation) should reduce its AAA under Section 1368 if, during the PTTP, the corporation distributed cash to redeem a shareholder's stock and this distribution was characterized as a distribution under Section 301.

Ruling

In Revenue Ruling 2019-13, the IRS ruled that if a former S corporation distributes cash during a PTTP in redemption of a shareholder's stock that does not qualify for sale or exchange treatment, but instead is treated as a distribution under Section 301, the corporation must reduce its AAA (but not below zero) by the amount of cash distributed.

Implications

Although not specifically identified as an issue in the Revenue Ruling, the Revenue Ruling does confirm that the special rules relating to cash distributions during a PTTP apply to a distribution in redemption of stock to which Section 301 applies.

The Revenue Ruling concludes, with no legal analysis, that a corporation's AAA must be reduced by a distribution of cash to which Section 301 applies during a PTTP. The conclusion is interesting because, as a technical matter, Section 1368 only provides for adjustments to AAA during the S period, which is defined as the corporation's most recent continuous period as an S corporation. Because a distribution made during a PTTP is not made during the corporation's S period (the corporation is a C corporation when the distribution is made), it is arguable that AAA should not be adjusted for distributions made during the PTTP. Although, as a policy matter, the IRS's position in the Revenue Ruling is likely correct, the technical basis for this conclusion is unclear. The IRS position expressed in this Revenue Ruling is consistent with observations the agency previously made in CCA 201446021, which addressed whether a corporation can have a balance in its AAA after the end of its PTTP.

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