An S corporation with earnings and profits can make a taxable dividend distribution by making an bypass election. True False
The correct answer and explanation is:
Answer: True
Explanation:
An S corporation typically does not pay tax at the corporate level. Instead, income, losses, deductions, and credits pass through to the shareholders, who report these items on their individual tax returns. However, certain distributions from an S corporation can be taxable to the shareholders, depending on the corporation’s Accumulated Adjustments Account (AAA), earnings and profits (E&P), and other accounts.
Key Concepts:
- Earnings and Profits (E&P): This is a corporate-level measure of economic ability to pay dividends, similar to retained earnings for C corporations. An S corporation can have accumulated E&P from when it was a C corporation or from certain income items.
- Accumulated Adjustments Account (AAA): This is an account that tracks the S corporation’s cumulative income that has been taxed to shareholders but not yet distributed. Distributions to shareholders out of the AAA are generally tax-free to the extent of the shareholder’s basis.
- Bypass Election: The AAA bypass election allows an S corporation to bypass the AAA for a particular distribution and treat it as coming out of accumulated E&P instead. This can result in a taxable dividend to the shareholders even though the distribution is from an S corporation.
How the AAA Bypass Election Creates a Taxable Dividend:
If an S corporation has accumulated E&P from prior C corporation years and also maintains an AAA, distributions are generally treated as coming out of the AAA first (which are non-taxable to shareholders to the extent of basis), then out of accumulated E&P (which can be taxable dividends), and then as return of basis or capital gain.
However, the corporation can elect to bypass the AAA for a specific distribution. By doing so:
- The distribution is treated as coming directly out of the corporation’s accumulated E&P.
- The distribution is then treated as a taxable dividend to the shareholders (to the extent of E&P).
- This election is made under IRC Section 1368(f)(1) and is sometimes strategically used to classify distributions as taxable dividends to shareholders.
Why Make an AAA Bypass Election?
- Tax Planning: Shareholders might prefer a dividend treatment for some reason, such as qualifying for preferential dividend tax rates.
- Clarity: It clarifies the character of the distribution for tax reporting.
- Corporate History: S corporations with significant E&P from prior C corporation years might want to distinguish taxable dividends from tax-free distributions.
Summary:
- An S corporation with earnings and profits can make a taxable dividend distribution.
- Normally, distributions come out of the AAA first and are tax-free.
- By making an AAA bypass election, the distribution bypasses the AAA and is treated as a dividend from accumulated E&P.
- Thus, the statement is True.