In Tomseth, et al. v. United States, a federal district court granted partial summary judgment for the Government, concluding that the accumulated adjustments accounts of corporations with terminated S elections reset to zero after the expiration of the corporations' post-termination transition periods (PTTP). Thus, when the corporations re-elected S status, their beginning accumulated adjustments account (AAA) balances were zero. The Court also held that S corporation distributions made in a closed year that exceeded the corporation's AAA and were not included in shareholders' income did not create a negative AAA balance that must to be taken into account when the corporation re-elected S status.

Background

An S corporation that was previously a C corporation must maintain an AAA. The AAA generally approximates undistributed S corporation earnings and represents the amount that the corporation can distribute to its shareholders (generally tax-free) before the corporation's accumulated earnings and profits (AE&P) (generally taxable as dividends).

The AAA is defined as an account of the S corporation that is adjusted for the S period in a manner similar to a basis adjustment (with certain exceptions). The term "S period" is generally defined as the most recent continuous period during which the corporation has been an S corporation. Regulations provide that, on the first day of the first year for which the corporation is an S corporation, the AAA balance is zero.

Generally, distributions are sourced from the AAA only while the corporation is an S corporation. This general rule, however, has two exceptions. First, if a corporation's S election has terminated, any distribution of money by the corporation with respect to its stock during a PTTP is applied against and reduces the adjusted basis of the stock, to the extent that the amount of the distribution does not exceed the AAA. Second, if an "eligible terminated S corporation" within the meaning of IRC Section 481(d)(2) distributes money after the PTTP, the AAA is allocated to the distribution and the distribution is chargeable to AE&P in the same ratio as the amount of the AAA bears to the amount of AE&P.

A PTTP arises either when a corporation's S election terminates or after a termination when, under an audit, the IRS adjusts a subchapter S item of income, loss or deduction arising during the S period (and with respect to distributions, results in an increase in the corporation's AAA).

The Tomseth case

In this case, the taxpayers were individual shareholders in three S corporations that transitioned between S corporation and C corporation status several times. For the year at issue, the corporations were S corporations that made distributions that significantly exceeded the AAAs arising from their most recent periods as S corporations. In addition, one of the S corporations made distributions that exceeded its AAA during a prior S period, which the shareholders treated as non-taxable distributions. The year in which the distributions should have been included in the shareholders' taxable income was closed by the statute of limitations on assessment.

The taxpayers argued that, in determining an S corporation's AAA, the corporation's undistributed AAA from prior S periods should be taken into account. The Government argued that the AAA is determined only by reference to a corporation's most recent S period, and that a significant portion of the distributions received by the taxpayers were therefore taxable as dividends. Regarding the S corporation whose distributions exceeded its AAA in a closed year, the Government acknowledged that it was too late to assess the tax that should have been paid in the closed year but argued that the S corporation should be treated as having a negative beginning balance in its AAA upon reelecting S status in an amount equal to the distributions made in excess of the AAA in the closed year.

Taxpayers' arguments

In support of their position that a corporation's undistributed AAA from prior S periods should be taken into account in determining the S corporation's AAA, the taxpayers argued that IRC Section 1368(e) (providing that the AAA is adjusted for the S period, and defining the S period as the most recent continuous period during which the corporation has been an S corporation) does not require the AAA to be reset to zero at the start of a new S period; rather, it simply means that adjustments to the AAA are only permissible during an S period. The taxpayers also argued that the legislative history to the Subchapter S Revision Act of 1982 (SSRA) supported their position, citing language from a House Report stating that, "under the bill, shareholders of subchapter S corporations with accumulated earnings and profits will be assured of tax-free treatment with respect to distributions, regardless of when made." Finally, the taxpayers noted that newly enacted IRC Section 1371(f), which sources cash distributions from an eligible terminated S corporation after the PTTP to AAA, supports their position because a AAA that expires after the PTTP can't logically be available for distribution under IRC Section 1371(f).

Government's arguments

In support of its position, the Government cited IRS Chief Counsel Advice No. 201440621 (Nov. 14, 2014) and three tax treatises: Mertens Law of Federal Income Taxation (Thompson Reuters); Standard Federal Tax Reporter (CCH); and S Corporations: Federal Taxation (Thompson Reuters).

The Court's findings

The Court rejected the taxpayers' arguments that a corporation's AAA from prior S periods can be taken into account, finding that an AAA, as "an account of the S corporation," can only exist while an S corporation exists. Further, the Court found the word "continuous" in the definition of the S period as significant. Congress's decision to include that word, the Court noted, implies that the AAA is eliminated once an S period ends; "[o]therwise, Congress could have chosen to define an S-period as any period that a corporation operates as an [S corp] without regard to whether that period has been continuous." If an AAA survived the termination of a corporation's S election, the Court observed, there would be no point in having a PTTP.

While acknowledging that the SSRA legislative history cited by the taxpayers supported their position, the Court noted that the history could not resolve the statute's meaning, absent more evidence. The Court also dismissed the taxpayers' arguments based on IRC Section 1371(f), noting that IRC Section 1371(f) was an apparent "prophylactic measure against unwanted consequences of the Tax Cuts and Jobs Act for certain [S corps]. It is a narrow exception for certain [S corps] that were not prepared for the effect of the new legislation." Finally, the Court found the authorities cited by the Government compelling and the CCA "worthy of deference."

While holding against the taxpayers generally, the Court did hold in their favor in rejecting the Government's position that an S corporation's beginning AAA could be negative if, in a closed year, the S corporation made distributions in excess of its AAA and the shareholders did not include the excess distributions in their taxable income. The Government's argument was based primarily on the fact that IRC Section 6501 does not bar recalculations, despite barring tax assessments outside of the statute of limitations.

The Government then cited authorities under which it could adjust net operating losses and tax credit carryforwards available in open tax years, for adjustments to amounts in closed tax years. The Court did not find the Government's arguments compelling. While accepting the government's position on recalculations, it noted that an AAA could not be reduced below zero as a result of distributions and that the recalculation rules would not change this result. Even if the recalculation rules would allow an S corporation's AAA to be reduced below zero as a result of distributions, the Court noted, the rules resetting a corporation's AAA to zero at the beginning of a new S period would preclude a beginning negative balance in the AAA.

Implications

The decision in the Tomseth case highlights the importance of planning for a corporation's AAA in conjunction with the intended termination of the corporation's S election. Some planning ideas that could be considered include:

1.  Distributing the corporation's AAA in the form of notes to its shareholders before terminating the corporation's S election

2.  Distributing the AAA in cash during the PTTP

3.  Distributing the AAA in cash, for eligible terminated S corporations, during the period after the PTTP

4.  Implementing a "hybrid" structure, to preserve the AAA at the parent S corporation level, with some or all the subsidiary entities taxed as C corporations

The decision also calls into further question the IRS's position that a "suspense" account is created when an S corporation shareholder claims losses in excess of basis in a closed year, with positive adjustments to basis arising after that tax year first reducing the suspense account, as opposed to being available for tax-free distributions and/or to claim against losses and deductions. See FSA 200230030, TAM 200619021 and PLR 9304004. See also, LB&I Process Unit Knowledge Basis — S Corporations, "Losses Claimed in Excess of Basis" (Subsection 53.5.1.3), for the IRS's position.

Regardless of its position on the creation of suspense accounts, the IRS has taken measures to identify situations in which distributions and losses may cause basis issues before the statute closes. Beginning with the 2018 tax year, the instructions to Schedule E, Supplemental Income and Loss, require S corporation shareholders to attach a basis computation schedule to their US federal income tax return if they report a loss, receive a distribution, dispose of stock, or receive a loan repayment from an S corporation during the year. By enhancing the ability to identify in real time when there may be loss disallowances or gain recognition, situations in which the IRS asserts that a suspense account is created are less likely to arise.

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