A sure way to make a client's day during tax season is to tell them that they accidentally made a taxable distribution from their S corporation. Normally S corporation distributions are non-taxable; they are treated as a tax-free payout of income that has been taxed on the owners' 1040s. But if the S corporation was once a C corporation, a distribution to shareholders can be a taxable dividend if the corporation has no accumulated S corporation income to distribute.
An S corporation's cumulative S corporation income is tracked in an "Accumulated Adjustments Account" ("AAA")on Schedule M-2 on page 4 of Form 1120-S. Distributions are treated as first coming out of AAA. If the the corporation was a C corporation at one time, the distributions are taxable distributions of C corporation "earnings and profits" if there is no AAA left.
AAA works like this:
- It's increased for S corporation taxable income items.
- It's decreased for taxable losses, and for expense items that pass through separately, like charitable contributions and the Section 179 deduction.
- It's decreased for permanently non-deductible expense items, like the non-deductible portion of meals and entertainment.
- It's reduced by distributions to shareholders.
AAA is not adjusted for tax-exempt income and related expense. These items increase shareholder basis when earned by an S corporation, but these increases are tracked as "other adjustments" to basis on Schedule M-2. This basis increase prevents the tax-exempt income from become taxable when a shareholder computes gain or loss on the sale or liquidation of their shares. Other adjustments can't be distributed unless all old C corporation earnings have been paid out as taxable dividends.
So where does life insurance fit in? Yesterday the IRS issued Rev. Rul. 2008-42, holding that non-deductible life insurance premiums do not reduce AAA, and that tax-free life insurance proceeds do not increase AAA. That means life insurance proceeds do not increase the amount that former C corporations can distribute tax-free. They instead go into the "other adjustments" to shareholder basis.
This is the proper result, and we have always filed our returns this way. But what is the proper treatment if the life insurance policy becomes taxable - for example, if the S corporation cashes out the policy for its surrender value, and the value exceeds cumulative premiums? I believe that the cumulative premiums and the surrender proceeds move out of "other adjustments" to AAA -- the premiums as expenses related to the production of taxable income (the surrender proceeds), and the proceeds themselves as taxable income. The IRS hasn't specifically addressed this issue, as far as I know.
UPDATE:: Roger McEowen has more.
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