When a corporation sells an item or asset, income is usually realized or recognized. The AAA, dividend, and return of capital are incorporated into an S-Corporation's income classification.
Income that is not liquidated for an S Corporation is typically classified based on its source and nature. Let's break it down:
- Income generated by the corporation's regular business operations is called Ordinary Business Income. It is transferred to shareholders and recorded on their personal tax returns.
- Passive income is made up of interest, dividends, and rental income. If passive income is greater than 25% of the corporation's gross receipts, it could result in additional taxes under IRC Section 1375. Capital gains are classified and passed through to shareholders when the corporation sells assets.
- Other income refers to income that is not directly related to business operations, such as investment income.
The corporation's Form 1120-S filing includes the shareholders' Schedule K-1, which reports each type of income separately.
What are the distinctions between AAA and E & P?
S Corporation taxation involves the distinction between the Accumulated Adjustments Account (AAA) and Earnings and Profits (E&P).
AAA (Accumulated Adjustments Account):
- AAA monitors income that has already been taxed to shareholders but hasn't been distributed yet.
- When the S election is made, it is unique to S Corporations and starts with zero.
- Shareholders generally receive tax-free distributions from AAA, provided they have sufficient stock basis.
E&P includes earnings and profits
- The concept of E&P has been carried forward from when the corporation was a C corporation.
- The retained earnings accrued during the years of C Corporation are what it represents.
- E&P distributions are regarded as dividends that are taxed to shareholders. A letter "E" represents gross sales whereas letter "P" represents profit after the expenses.
Distributions made by an S Corporation are typically applied in the following order:
- AAA offers tax-free dividends up to the stock basis. (Related to an S-Corporation)
- The dividends from E&P are taxed. (Related to a C-Corporation)
- The excess is considered a return of capital or capital gain. (Trigger to tax).
What is the distinction between Accumulated Adjustment Account (AAA) and Retained Earnings?
The Accumulated Adjustments Account (AAA) and Retained Earnings have different functions and are utilized in various settings, particularly for S Corporations. Let's take a look at the main differences between them:
- Monitors income that was previously taxed but has not yet been distributed in an S Corporation.
- This is exclusively for S corporations.
- Distributions from AAA are generally tax-free for shareholders as long as they have sufficient stock basis.
- Under the S Corporation rules in the U.S. tax code, it is governed.
Retained Earnings:
- Shows how much net income remains in the business after dividends or distributions.
- This applies to both C Corporations and S Corporations, but it is less relevant for S Corporations because they rely on AAA.
- Nature is a financial accounting concept that depicts profits held within the company.
- Dividends are usually taxed as dividends to shareholders when C Corporations distribute retained earnings. The importance of retained earnings in S Corporations is limited because of pass-through taxation.
- Rather than specific tax code rules, regulations are governed by general accounting principles.
- To sum up, AAA is solely focused on tax monitoring for S Corporations, while retained earnings are an accounting concept that is applicable to all businesses. When dealing with an S Corporation, the AAA takes precedence over retained earnings in the determination of distributions and their taxability.
Here is an example for the explanation:
- "P Inc" an S-Corporation is owned by "M" and "S".
- M and S they both share income and loss equally 50/50.
- In year one "P Inc" declared profit of $90,000 and $12,000 tax exempt income.
- Each owner M and S had basis in corpration $25,000.
- Beginning of the year corporation had E&P $30,000 from previously C-Corporation.
- M and S each received distribution of $80,000 on December 15, year 1.
Assumed AAA and OAA both are "Zero". What is the characterstic of Martin's distribution?
Total income Martin Received $80,000 in distribution which will be classified as follow:
- $45,000 AAA (90,000/2) (Distribution from S-Corporation Ordinary Income).
- $15,000 dividend from E & P (Distribution form previously C-Corporation).
- $20,000 from return of capital (Excess of income but not from the basis).
Total $80,000 ($45,000 + $15,000 + $20,000)
In a nutshell, "M" received in distribution $80,000 - $15,000 = $65,000 whiich reduced his basis by $45,000 - $25,000 - $6,000 leaving basis for M in Corporation $11,000 ($65,000 - $45,000 $25,000 - $6,000).
Note: $80,000 distribution is included $15,000 E&P which does not effect on basis.
- Basis Calculation: Basis $70,000 ($25,000 + $45,000)
- Tax exempt income $6,000 M's share which will increase basis to $76,000 ($70,000 + $6,000).
- The first $45,000 distriburion to "M" which is tax free anf leaving AAA to "Zero". And, his basis remains to $31,000 ($76,000 - $45,000).
- The next $15,000 distributed to "M" comes from "E & P" dividend income which does not reduce to basis.
- Next $6,000 distribution comes from the OAA is tax free which reduces basis to $25,000.
- Remaining $14,000 comes from stock basis tax free and reduced basis to $11,000.
