OUR THOUGHTS ON:

Accumulated Earnings and Profits Inside an S Corporation

Tax

By Dennis Loughran

Many of our corporate clients here at Schneider Downs are Subchapter S corporations, or more commonly called S corporations. S corporations are incorporated entities that give their shareholders liability protection with the added benefit of a single level of taxation at the shareholder level. The single level of taxation is the biggest difference between conducting business as an S corporation versus a C corporation, often referred to as regular corporations.

The earnings in an S corporation are “passed through” and taxed at the shareholder level. Once taxed to the S corporation shareholders, the earnings can be distributed tax-free by the S corporation to its shareholders. In contrast, a C corporation pays a corporate-level tax on its earnings, then, if the earnings are distributed to its shareholders, they also pay tax, since the distribution would then be considered a taxable dividend. The elimination of the double taxation of corporate earnings is why many C corporations, if certain eligibility requirements could be met, converted to S corporations. 

The possible expiration of the Bush tax cuts at the end of 2010 provides certain tax planning opportunities for current S corporations that were previously taxed as C corporations. Inside a C corporation, the earnings and profits are accounted for in an account called an Accumulated Earnings and Profits account, or AEP. Once a C corporation elects to convert to an S corporation, the AEP account is frozen, and any subsequent distributions deemed paid from AEP would be taxed as ordinary dividends to the S corporation shareholders, unlike the distribution of earnings of S corporation earnings, which are tax-free to S corporation shareholders. 

One of the Bush tax provisions set to expire on December 31, 2010 is taxation of qualified dividends which are currently taxed at a favorable 15% tax rate. Notwithstanding a last-minute reprieve, dividends after December 31, 2010 will be taxed at the ordinary individual income tax rates, which will be increasing with the top rate going from 35% to 39.6%. Thus, a potential tax planning opportunity is to elect to distribute the previous C corporation AEP before distributing the accumulated S corporation earnings. The obvious drawback to such a plan is that the shareholder will be accelerating the payment of tax on the AEP dividend, but will be paying at a 15% rate as opposed to potentially a 39.6% rate if AEP are withdrawn after 2010. One benefit of distributing AEP before the end of 2010 is that the S corporation earnings and profits that are tracked in an Accumulated Adjustments Account or AAA would be preserved for tax-free withdrawals in future years. 

Unlike the typical tax planning strategy of deferring income and accelerating deductions, 2010 may be the year to reverse that theory by accelerating income to take advantage of the lower tax rates that maybe expiring at the end of the year. The strategy of electing to distribute AEP from an S corporation should be explored on a case –by-case basis. 

It may seem unusual for accountants to discuss or recommend accelerating or taxing income, but 2010 is not a usual tax year. We will keep you posted as discussions of a possible extension of the Bush tax cuts heats up in Congress. 

Schneider Downs provides accountingtax, wealth management and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA and Columbus, OH. 

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.

Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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