By: John S. Morlu II, CPA
Switching a business’s tax classification is not a decision to take lightly. Transitioning from an S corporation (S corp) to a C corporation (C corp) and then back to an S corp adds layers of complexity, especially regarding tax rules and the treatment of retained earnings. Understanding how the IRS views these transitions, particularly the impact on the Accumulated Adjustments Account (AAA), is crucial for making informed choices.
What Happens to the Accumulated Adjustments Account (AAA)?
The Accumulated Adjustments Account (AAA) is a key component of S corporation taxation. It tracks income that has been taxed at the shareholder level but not yet distributed. AAA allows S corporations to make distributions to shareholders tax-free, as long as those distributions don’t exceed the account’s balance.
When a business switches from an S corporation to a C corporation and then back to an S corporation, the IRS has clarified that the AAA does not survive beyond the post-termination transition period of the initial S corporation period.
IRS Guidance on AAA Reset
According to Chief Counsel Advice (CCA) 201446021:
- Definition of the “S Period”: Section 1368(e)(2) defines the “S period” as the most recent continuous period during which the corporation operated as an S corporation.
- AAA Reset: When the corporation re-elects S corporation status after being a C corporation, the IRS requires that the AAA be reset to zero. Any previous balance in the AAA from the earlier S period is wiped out.
This means that any retained earnings accumulated during the previous S period are treated as part of the C corporation’s earnings and profits (E&P) upon re-election of S status. Shareholders may face double taxation on distributions of these amounts during the new S period.
What Does This Mean for Business Owners?
1. Impact on Distributions:
During the new S period, distributions to shareholders will first come out of the new AAA. Once this account is exhausted, distributions are treated as coming from the corporation’s accumulated E&P, which could be taxable as dividends to shareholders.
2. Reset Timeline:
The AAA reset takes place at the end of the post-termination transition period (PTTP). This period typically lasts one year after the corporation’s S election terminates. After this time, the AAA is no longer available, even if the corporation returns to S status.
3. Risk of Double Taxation:
Retained earnings from the prior S period that convert into C corporation E&P may be taxed twice:
- Once at the corporate level during the C corporation period.
- Again as taxable dividends during the new S period.
Reasons Businesses Make the Switch
Switching between S and C status might seem unusual, but there are legitimate reasons why a business might go through these transitions:
1. Transitioning to C Corporation for Growth:
Businesses seeking to reinvest most of their profits or attract outside investors may convert to C corporation status to benefit from the flat 21% corporate tax rate and unlimited shareholder structure.
2. Returning to S Corporation for Tax Simplicity:
If the business later reduces its need for reinvestment or shareholders wish to avoid double taxation on distributions, re-electing S status can restore the benefits of single-level taxation.
Key Considerations When Switching Back to S Corporation
IRS Requirements for Re-Election
The IRS imposes strict rules on switching back to S status:
- A business that terminates its S election must wait five years before re-electing S corporation status, unless it obtains IRS consent.
- All shareholders must agree to the re-election, and the business must meet S corporation eligibility requirements, such as limiting the number and type of shareholders.
Tax Implications
1. C Corporation Earnings and Profits (E&P):
Any E&P from the intervening C corporation period carries over to the new S period. Distributions from these retained earnings will be taxed as dividends to shareholders.
2. Built-In Gains Tax (BIG):
If the business holds appreciated assets when it returns to S status, it may be subject to the Built-In Gains (BIG) Tax on asset sales for a period of five years following the S election.
3. Tax Complexity:
Transitioning back to an S corporation involves significant tax planning to manage distributions, avoid unnecessary tax liabilities, and comply with IRS requirements.
Strategies to Minimize Tax Impact
1. Plan Distributions Carefully:
Before re-electing S status, consider distributing C corporation E&P to shareholders during the C period, when it’s taxed as qualified dividends rather than being subject to double taxation.
2. Wait for the Five-Year Period to Expire:
If possible, delay the S re-election until after five years have passed since the termination of the previous S election. This reduces the risk of triggering the BIG tax on asset sales.
3. Track AAA and E&P Accurately:
Maintain clear records of the corporation’s AAA and E&P balances to ensure compliance and optimize tax planning during the transition.
4. Consult a Tax Professional:
Switching between S and C status, and especially switching back to S, involves complex tax rules. Work with a tax advisor to develop a strategy tailored to your business’s unique situation.
Final Thoughts
Switching from an S corporation to a C corporation and back again involves intricate tax rules, particularly regarding the treatment of the Accumulated Adjustments Account (AAA). While these transitions may be necessary for growth, investment, or tax benefits, they require careful planning to avoid double taxation and ensure compliance with IRS regulations.
Understanding the implications of the AAA reset and the impact on retained earnings is essential for making the right decision. As with any major business change, consulting with a qualified tax professional can help you navigate these transitions and minimize potential tax burdens.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
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