Former S Corporation Distribution Rules

There has been a code section on the books for some time that allows a former S Corporation to make distributions out of their S Corporation Accumulated Adjustments Account (AAA) during what is called the post-termination transition period.  This is the period after the termination of a corporation’s election to be an S Corporation.  This rule was put in place to allow former S Corporations to make tax free distributions out of AAA for a period of one year after the termination of the S-election.  This was important because absent this rule there was no way to extract the basis from the S Corporation activity that is represented in the AAA account. Even if the entity eventually chose to make the S Corporation election at a future date, there is no clear-cut guidance that AAA remained available from the form S Corporation activity.  The post-termination transition period rules provide certainty that some AAA can be extracted on a tax-free basis if all the requirements of the code are met.

The Tax Cuts and Jobs Act (TCJA) added a new provision to this rule that allowed a longer period to make tax-free distributions out of AAA beyond one year.  The TCJA requires that these eligible post-termination period distributions be prorated between AAA and accumulated earnings and profits (AEP) based on the ratio of AAA to AEP.

One of the many questions that have been asked related to post-termination transition period distributions is how to treat redemptions of stock.  In a C Corporation context, redemptions of a shareholder’s stock generally result in either dividend treatment or capital gain treatment.  But in the context of a former S corporation which is in the post-termination transition period, it was not clear if the C corporation redemption rules applied or if a distribution out of AAA would be allowed.

Revenue Ruling 2019-13 clarified this issue and held that you can indeed treat the redemption as a distribution out of AAA.  This will give the distribution tax-free treatment to the extent there is AAA remaining from the S Corporation years, and you meet all of the other post-termination transition period requirements.

The rules on making post-termination transition period distributions and stock redemptions are complicated, and you should consult your tax advisors if you have any questions on these issues.