2020 has been a difficult year for many businesses and Congress has enacted measures to help taxpayers increase deductible losses, potentially carryback those losses, deduct additional interest expense, and accelerate depreciation deductions via the CARES Act.
Another very realistic prospect is that 2020 tax rates are the lowest taxpayers may experience for at least the near future. It is unclear how much longer the tax cuts implemented by the Tax Cuts and Jobs Act will continue to be available as well as the preferential rates on qualified dividends and long-term capital gains.
Taking both circumstances into consideration, 2020 may be an opportune time to take advantage of a deemed dividend distribution election if a taxpayer’s business is organized as an S corporation and has accumulated earnings and profits.
Accumulated Earnings and Profits (AEP):
AEP is the historical profits (adjusted for various tax items) that have yet to be paid out of a C corporation as dividends. If that C corporation makes an election to be taxed as an S corporation, that AEP is frozen within the S corporation at the election’s effective date. The S corporation will then begin tracking its earnings in its “accumulated adjustment account” or AAA. S corporations can make distributions out of AAA without them being taxed as dividends to the shareholders. However, if the S corporation makes a distribution in excess of AAA and it has AEP, the distribution is a dividend taxable to the shareholders. In essence, the distributions come from the old C corporation earnings. The rules are designed this way under §1368 and the associated regulations to prevent those old earnings from escaping double taxation under the C corporation rules. Also, under the normal ordering rules distributions always come out of AAA first, before eroding AEP. Normally, taxpayers would want to avoid this from happening so double taxation will not trigger on the cash distributed to them from their S corporations.
Another concept that is critical in this discussion is the shareholder basis. Unless an S corporation shareholder has a stock or debt basis in the entity, losses that pass through to the shareholder can not be deducted. Shareholders get basis by cash paid for the purchase of the stock, additional cash put into the entity, the income for the tax year earned, or cash directly loaned to the S corporation from the shareholder. Basis goes down by non-dividend distributions and losses incurred by the S corporation. So, if an S corporation is in a position in 2020 where losses incurred in operations exceed shareholder stock or debt basis, the losses could be limited in deductibility. This could then limit the ability to offset other income in 2020 (like wages) or utilize the very favorable net operating loss carryback rules via the CARES Act. These items can lead to refunds of precious cash for working capital in these difficult times.
Distribution of a Deemed Dividend Election:
So, what can be done to help a taxpayer in this situation?
- Increase stock basis to be able to deduct operational losses without a capital injection
- Decrease the AEP of the entity to avoid future double taxation
- Utilize the currently low Federal tax rates on dividends.
The taxpayer can make an election to distribute a deemed dividend under Reg. 1.1368-1(f)(3). If the taxpayer elects to do so, an election is attached to a timely filed tax return stating that distributions will come out of AEP first, instead of AAA, and will then be immediately contributed by the shareholders back into the S corporation to increase stock basis.
Let us walk through an example to illustrate how this works in a practical manner.
Assume ABC Company, Inc., an S corporation owned 100% by Shareholder A, incurs losses in 2020 of $100,000. Shareholder A materially participates in the business and is not considered passive. Like many closely-held businesses, Shareholder A takes distributions equal to income for most years and has a stock basis of $-0- at the beginning of 2020. However, Shareholder A has AEP in the S corporation of $125,000 from the periods before the S election (when ABC Company was a C corporation). Assume Shareholder A has no other taxable income or losses for 2020.
If the taxpayer chooses to do so, ABC will attach an election to its timely filed return for 2020, as well as a consent by the shareholders to make a deemed distribution of the AEP. The consequences of doing this are as follows:
- ABC Company, Inc. has paid a taxable dividend to Shareholder A which will be taxed on Shareholder A’s personal tax return as a qualified dividend and be taxable at 15% assuming there is no other income on the return triggering the 20% rate or the Medicare Surtax.
- Shareholder A is treated as contributing back the $125,000 immediately to ABC Company, Inc. which increase Shareholder A’s stock basis to $125,000. No cash or assets had to be paid out or distributed to achieve this.
- Since there is now $125,000 of basis, Shareholder A can now deduct the full $100,000 operating loss. This deduction also shelters $100,000 of the dividend income so only $25,000 is subject to tax.
- Now, ABC Company, Inc. no longer has AEP for future taxation, the deemed contribution back has freed up the losses and sheltered most of the dividend, and Shareholder A has taken advantage of the historically low Federal taxes rates on the dividend.
As 2020 comes to a close and financial result are determined, the opportunity to make this election should be kept in mind to fully take advantage of the tax rates in place and maximize deductible losses. Please consult your HBK tax professionals to discuss your specific situation and if this opportunity applies.