Notice 2003-65: S Corp Distribution Tax Consequences

The Internal Revenue Service (IRS) issues guidance to alert taxpayers and their advisors to transactions with the potential for tax avoidance. In some cases, the IRS designates a specific arrangement as a “listed transaction.” This designation is significant, as it signals the IRS’s view that the transaction is a tax avoidance scheme and imposes strict disclosure requirements on both the participants and their advisors.

The primary function of this guidance is to shut down strategies used by some S corporations with significant accumulated earnings and profits to make distributions to shareholders that are improperly characterized as tax-free. By officially listing a transaction, the IRS puts taxpayers on notice that the claimed tax treatment is not permissible and that engaging in such a transaction without proper disclosure can lead to substantial penalties. The notice aims to ensure that distributions from S corporations that have a history as C corporations are taxed according to established rules.

Understanding S Corporation Distributions

An S corporation is a type of business structure that generally does not pay federal income tax at the corporate level. Instead, the company’s profits and losses are “passed through” to the shareholders, who then report this income or loss on their individual tax returns. The tax treatment of cash or property distributions made to shareholders can be complex, particularly for a corporation that previously operated as a C corporation.

For an S corporation that has always been an S corporation, distributions are generally non-taxable to the extent of a shareholder’s stock basis. The basis is a measure of the shareholder’s investment in the company, which increases with income passed through to them and decreases with distributions and losses. A distribution first reduces the shareholder’s stock basis, and once the basis is reduced to zero, any further distribution is typically taxed as a capital gain.

The rules become more intricate when an S corporation has accumulated earnings and profits (E&P) from years when it was a C corporation. E&P is a measure of a corporation’s economic ability to pay dividends to its shareholders. To handle this situation, the tax law establishes a specific three-tiered distribution system designed to ensure that the earnings generated while the company was a C corporation are taxed as dividends when distributed.

The first tier of a distribution is from the corporation’s Accumulated Adjustments Account (AAA). The AAA tracks the cumulative taxable income earned by the corporation during its time as an S corporation, reduced by prior distributions. Distributions from the AAA are tax-free to the shareholder and reduce their stock basis, which allows shareholders to receive the profits earned during the S corporation period without an additional layer of tax.

Once the AAA is depleted, the second tier of the distribution is considered to be from the S corporation’s accumulated E&P. Distributions from this layer are taxed to the shareholder as a dividend, subject to dividend tax rates. This ensures that the profits earned during the C corporation years, which were never taxed at the shareholder level, are taxed upon distribution. This dividend income does not reduce the shareholder’s stock basis.

If a distribution exceeds both the corporation’s AAA and its accumulated E&P, the third tier comes into play. This portion of the distribution is treated as a tax-free return of the shareholder’s remaining stock basis. After the shareholder’s basis is reduced to zero, any additional amount from the distribution is taxed as a capital gain.

An Example of a Prohibited Transaction

The IRS has targeted transactions structured to circumvent the standard S corporation distribution rules. One such arrangement was designed by promoters to allow shareholders of S corporations with substantial accumulated E&P to receive cash distributions while improperly avoiding the dividend tax that should apply. The transaction involved a series of steps that, while appearing to have a business purpose, were orchestrated to achieve an incorrect tax result.

Consider a hypothetical S corporation that has a significant amount of E&P from its prior life as a C corporation. The shareholders of this corporation have a relatively low basis in their stock and wish to receive a large cash distribution without triggering a taxable dividend. To avoid this outcome, the prohibited transaction introduces a financing element.

The core of the prohibited transaction involves the S corporation obtaining a loan from a financial institution. The loan proceeds are then used to fund a distribution to the shareholders. The participants in this transaction would then take the position that the distribution was not made from the corporation’s E&P. Instead, they would argue that because the distribution was made from borrowed funds, it should be treated as a non-dividend distribution that is applied against their stock basis.

This characterization is contrary to the intent of the tax law. The argument attempts to create a distinction based on the immediate source of the cash, suggesting that borrowed funds are not connected to the corporation’s E&P. However, the IRS’s position is that money is fungible, and the use of loan proceeds does not change the fundamental character of the distribution. The presence of E&P dictates the tax treatment of distributions, regardless of whether the cash distributed was generated from operations or from a loan.

Tax Consequences and Reporting Requirements

When the IRS identifies a transaction as a tax avoidance scheme, it will disregard the taxpayer’s characterization and apply the tax law as it should have been applied. For shareholders who participated in such a transaction, the IRS will re-characterize the distribution as a taxable dividend to the extent of the S corporation’s E&P. This means the shareholders will owe income tax on the distribution at the applicable dividend tax rates.

A shareholder who incorrectly treated the distribution as a tax-free return of basis will now face a tax liability, plus interest and potentially substantial penalties. The amount that was claimed as a reduction in stock basis will be reversed, and the distribution will be reclassified as dividend income on the shareholder’s tax return for the year the transaction occurred.

Because such an arrangement is a “listed transaction,” taxpayers who participated in it have specific reporting obligations. Participation must be disclosed to the IRS using Form 8886, Reportable Transaction Disclosure Statement. This form requires the taxpayer to provide detailed information about the transaction, including the name of the listed transaction, the tax year of participation, and the expected tax benefits.

The procedural steps for filing Form 8886 are precise. A completed copy of the form must be attached to the taxpayer’s income tax return for each year of participation. In addition, a separate copy of the form must be mailed to the IRS Office of Tax Shelter Analysis (OTSA). Failure to properly disclose a listed transaction can result in a penalty of $10,000 for individuals and $50,000 for all other taxpayers.

Obligations of Material Advisors

The reporting requirements for listed transactions extend beyond the taxpayers who participate in them. Accountants, attorneys, financial advisors, and other promoters who play a significant role in these transactions also have legal obligations. An individual or firm is considered a “material advisor” if they provide material aid, assistance, or advice regarding the transaction and receive a minimum level of compensation. For listed transactions, the compensation threshold is $10,000 for advice provided to an individual and $25,000 for advice provided to an entity.

A material advisor must disclose the transaction to the IRS by filing Form 8918, Material Advisor Disclosure Statement. This form must be filed with the IRS Office of Tax Shelter Analysis by the last day of the month that follows the end of the calendar quarter in which the advisor became a material advisor. The form requires the advisor to describe the reportable transaction and the expected tax treatment. The penalty for a material advisor who fails to file Form 8918 for a listed transaction is a flat $200,000.

In addition to filing Form 8918, material advisors have another obligation: they must maintain a list of all clients who participated in the reportable transaction. This list must be kept for seven years and must be furnished to the IRS within 20 business days of a written request. Failure to maintain this list or provide it to the IRS upon request carries its own penalty, which can be $10,000 for each day of non-compliance after the 20-day grace period.