S-Corporation with C-Corporation E&P
An S-Corporation with C-corporation E&P (earnings and profits) is allowed to make a AAA (accumulated adjustment account) Bypass Election per 26 U.S. Code Section 1368(e)(3). This bypass election results in distributions of the S-Corporation being treated as first coming out of C Corporation E&P, then out of AAA of the S-Corporation.
26 U.S. Code Section 1368(e)(3) allows an S-Corporation to elect to bypass the required order of distributing from AAA first for all distributions in a given tax year. All shareholders would have to agree to the election. Upon election, this would mean that the tax treatment of distributions would be first as dividends out of AEP (taxed as dividends at shareholders’ tax rate), then out of AAA (tax free distribution to extent of shareholders’ bases). Per 26 CFR 1.1368-1 “An S-corporation with AEP (accumulated earnings and profits) may elect under this paragraph (f)(2) for any taxable year to distribute earnings and profits first as provided in section 1368(e)(3). Except as provided in paragraph (f)(2)(ii) of this section, distributions made by an S corporation making this election are treated as made first from earnings and profits under section 1368(c)(2) and second from the AAA under section 1368(c)(1). Any remaining portion of the distribution is treated in the manner provided in section 1368(b). This election is effective for all distributions made during the year for which the election is made.”
If one made a Section 1368 election, a shareholder would not reduce the shareholder’s stock basis by taking a distribution first out of AAA (when distributing from AAA first), and thus preserve his or her basis to allow losses that may otherwise be disallowed. Given a 15% dividends tax rate, for example, for shareholders in the 25% tax rate bracket (e.g. 2017, married filing jointly, 25% tax rate on ordinary income of $75,900 to $153,100), it could be beneficial to preserve basis to allow other losses to pass through to the shareholder to offset ordinary income (income otherwise taxed at the ordinary income rate of 25%).