Business Entities · S corporations

Treatment of distributions

The default treatment is simple: a distribution comes out of money the shareholder has already been taxed on, so it is a recovery of basis and nothing more. The complexity arrives only where the corporation carries accumulated earnings and profits from an earlier life as a C corporation — and then the whole apparatus of the accumulated adjustments account exists to keep what has already been taxed once from being taxed again.

The rule

What the section covers. a distribution of property by an S corporation with respect to its stock to which, but for IRC § 1368(a), IRC § 301(c) would apply^TY2026 (IRC § 1368(a)). So subchapter S displaces IRC § 301(c) for an ordinary distribution, but only for one.

No accumulated earnings and profits. the distribution is not included in gross income to the extent it does not exceed the adjusted basis of the stock, and any excess is treated as gain from the sale or exchange of property^TY2026 (IRC § 1368(b)). There is no dividend, because there is nothing for a dividend to come out of.

With accumulated earnings and profits. where an S corporation has accumulated earnings and profits, a distribution is applied first against the accumulated adjustments account and treated as a return of basis then gain; then as a dividend to the extent of the accumulated earnings and profits; and any remainder is again treated as a return of basis then gain (IRC § 1368(c))^TY2026 (IRC § 1368(c)). Three tiers, in order: the accumulated adjustments account, treated as IRC § 1368(b) treats a distribution; then a dividend to the extent of the accumulated earnings and profits; then IRC § 1368(b) again.

The account. the accumulated adjustments account is an account of the S corporation adjusted for the S period in a manner similar to IRC § 1367, except that no adjustment is made for income exempt from tax and related expenses, the phrase "but not below zero" is disregarded so the account can go negative, and no adjustment is made for federal taxes attributable to a year in which the corporation was a C corporation (IRC § 1368(e)(1)(A))^TY2026 (IRC § 1368(e)(1)(A)), and the accumulated adjustments account is an account of the S corporation and is not apportioned among shareholders; on the first day of the first year for which the corporation is an S corporation the balance is zero^TY2026 (Reg. § 1.1368-2(a)(1)).

Timing. for a distribution made during a taxable year the adjusted basis of the stock is determined with regard to the increases provided in IRC § 1367(a)(1) for that year — the income adjustments come first, the distribution second, and the loss adjustments last^TY2026 (IRC § 1368(d)).

Where does the earnings and profits balance come from? Not from the S years. except for redemptions, liquidations, reorganizations and separations, for investment credit recapture, and for the portion of a distribution treated as a dividend under IRC § 1368(c)(2), no adjustment is made to the earnings and profits of an S corporation^TY2026 (IRC § 1371(c)). An S corporation that has never been a C corporation and has never acquired one in a reorganisation has no accumulated earnings and profits at all, and IRC § 1368(c) never applies to it.

Current figures

How it works in practice

Ask the earnings and profits question first. Everything turns on it. If the corporation has no accumulated earnings and profits, IRC § 1368(b) applies and the answer is a two-line calculation: basis first, gain on the excess. If it has them, IRC § 1368(c) applies and you need the account balance.

Then get the order of adjustments right. for a taxable year beginning on or after 18 August 1998 the account is increased first; then decreased for losses and non-deductible expenses without regard to any net negative adjustment; then decreased, but not below zero, by ordinary distributions; then decreased by any net negative adjustment; and finally adjusted for redemption distributions^TY2026 (Reg. § 1.1368-2(a)(5)). Four features of that sequence do the work. Income increases the account before losses reduce it. Losses reduce it before distributions do — but only to the extent they are not a net negative adjustment. Distributions may not take the account below zero. And the net negative adjustment, if any, is applied last, after the distributions have already been measured.

Understand what the net negative adjustment protects. the account at the close of the taxable year is determined without regard to any net negative adjustment, being the excess of the reductions for the year other than for distributions over the increases for the year^TY2026 (IRC § 1368(e)(1)(C)). Without it, a bad year would shrink the account before a mid-year distribution was tested against it, and a distribution the shareholder had every reason to believe came out of previously taxed income would be recharacterised as a dividend at the end of the year. The rule holds the account up for the purpose of measuring the year’s distributions, and then lets it fall.

Distinguish the two directions the account can move. the account may be decreased below zero by losses, deductions and non-deductible expenses, but a distribution may not take it below zero^TY2026 (Reg. § 1.1368-2(a)(3)(ii), (iii)). Losses can drive it negative; distributions cannot. That asymmetry is deliberate and is a common trap.

Prorate where the distributions exceed the account. except as provided in regulations, where the distributions during the taxable year exceed the accumulated adjustments account at the close of the year, the balance of the account is allocated among the distributions in proportion to their respective sizes^TY2026 (IRC § 1368(c), flush text). Not first-in-time — proportionately by size, across the year.

Note that the account is the corporation’s, not the shareholder’s. the accumulated adjustments account is an account of the S corporation and is not apportioned among shareholders; on the first day of the first year for which the corporation is an S corporation the balance is zero^TY2026 (Reg. § 1.1368-2(a)(1)). Stock basis is per shareholder and per share; the account is a single corporate figure. A new shareholder who buys in shares the existing account. That is why basis and the account, which move in step at the start of an S corporation’s life, drift apart over time and are never interchangeable.

Three elections can rearrange the ordering. an S corporation may modify the ordering by electing to distribute earnings and profits first, to make a deemed dividend, or to forego previously taxed income; the election is made by a statement attached to a timely filed original or amended Form 1120-S stating that each shareholder consents^TY2026 (Reg. § 1.1368-1(f)(1), (f)(5)(iii)). The most useful is the election to distribute earnings first: an S corporation may, with the consent of all affected shareholders — meaning any shareholder to whom a distribution is made during the year — elect to have IRC § 1368(c)(1) not apply to all distributions made during that year, so that distributions come first out of earnings and profits^TY2026 (IRC § 1368(e)(3)). It sounds perverse to volunteer for dividend treatment, but a corporation close to the passive investment income limits of IRC § 1362(d)(3) may prefer to clear its accumulated earnings and profits deliberately rather than lose the election. The deemed dividend does the same thing without moving cash: the amount may not exceed the subchapter C earnings and profits on the last day of the taxable year reduced by actual distributions of those earnings during the year, and is treated as distributed in money in proportion to stock ownership, received by the shareholders, and immediately contributed back by them, all on the last day of the year^TY2026 (Reg. § 1.1368-1(f)(3)).

After the election ends, the account still matters for a while. a distribution of money by a corporation with respect to its stock during a post-termination transition period is applied against and reduces the adjusted basis of the stock, to the extent it does not exceed the accumulated adjustments account — with an election available to have earnings distributed first (IRC § 1371(e))^TY2026 (IRC § 1371(e)). The period is defined by IRC § 1377(b), and only a distribution of money qualifies — property distributed in the post-termination transition period is an ordinary C corporation distribution under IRC § 301.

How this has changed

The architecture of IRC § 1368 has been stable since the Subchapter S Revision Act of 1982, and the net negative adjustment rule that does most of the work in the second scenario was added by Pub. L. 104-188 § 1309(b) in 1996, effective for taxable years beginning after 31 December 1996. The current ordering of adjustments to the account in Reg. § 1.1368-2(a)(5) applies to taxable years beginning on or after 18 August 1998; the regulation retains the earlier ordering at Reg. § 1.1368-2(a)(4) for years beginning before 1 January 1997, which is now of historical interest only.

Two pieces of the regulation are best read as archaeology rather than law in practice. Reg. § 1.1368-1(d)(2) and the election in Reg. § 1.1368-1(f)(4) both address previously taxed income, defined by reference to IRC § 1375(d)(2) “as in effect prior to its amendment by the Subchapter S Revision Act of 1982.” A corporation can only hold such an account if it was an electing small business corporation before 1983. Nothing about the current statute creates it, and no new corporation can acquire it — but the regulation still gives it priority over the accumulated adjustments account, so it appears in the ordering rules a reader may otherwise find complete.

The one live change to watch is not in this section at all. Because IRC § 1368(c)(2) treats a tier-two distribution as a dividend, the shareholder’s rate on it, and the treatment of that dividend for the net investment income tax, are set on the individual side of the Code and move with it. IRC § 1368 itself is silent on rate.

Exam focus

The single most productive question to ask is whether the corporation has accumulated earnings and profits. If the facts do not put a C corporation somewhere in its history, the answer is a short IRC § 1368(b) calculation and every dividend-flavoured answer choice is a distractor.

Where the facts do supply accumulated earnings and profits, expect the three tiers in order and expect one of the two ordering refinements to be the point: the net negative adjustment, which holds the account up while the year’s distributions are measured, or the proration of the account across distributions rather than a first-in-time stacking.

Learn the asymmetry — losses take the account negative, distributions stop at zero — and learn that the account belongs to the corporation while basis belongs to the shareholder. A large share of wrong answers comes from treating the two as one number.

Finally, keep IRC § 1371(e) in view. The post-termination transition period lets a former S corporation distribute the account against basis, but only in money, and only within the period IRC § 1377(b) defines.

Check yourself

1. An S corporation with no accumulated earnings and profits distributes $90,000 to a shareholder whose basis, after the year’s income adjustments, is $65,000. What does she report?

Answer: $65,000 is not included in gross income, because IRC § 1368(b)(1) applies it against basis. The $25,000 excess is treated as gain from the sale or exchange of property under IRC § 1368(b)(2), and her basis is zero. No part is a dividend — there are no accumulated earnings and profits for a dividend to come out of.

2. A corporation has $50,000 of accumulated earnings and profits, an account balance of $30,000, and distributes $100,000. The shareholder’s basis is $200,000. How is the $100,000 characterised?

Answer: $30,000 is treated under IRC § 1368(b) — here a tax-free reduction of basis, since basis exceeds it. The next $50,000 is a dividend under IRC § 1368(c)(2). The remaining $20,000 is again treated under IRC § 1368(b), reducing basis further. Her basis ends at $150,000 and she reports a $50,000 dividend.

3. In a year with no income, an S corporation has a $40,000 ordinary loss and distributes $25,000. Its account stood at $25,000 at the start of the year. What is the balance at the close?

Answer: Negative $40,000. Under Reg. § 1.1368-2(a)(5) the $40,000 loss is a net negative adjustment and is not taken into account before the distribution is measured, so the $25,000 distribution is charged against the $25,000 account and reduces it to zero. The net negative adjustment is then applied, taking the account to negative $40,000.

4. Why might an S corporation with a large accumulated earnings and profits balance elect under IRC § 1368(e)(3) to distribute earnings first?

Answer: To clear the balance deliberately. Accumulated earnings and profits are one of the two conditions for the passive investment income tax and for termination of the election on that ground, so a corporation with substantial passive receipts may prefer a controlled dividend now to an involuntary termination later. an S corporation may, with the consent of all affected shareholders — meaning any shareholder to whom a distribution is made during the year — elect to have IRC § 1368(c)(1) not apply to all distributions made during that year, so that distributions come first out of earnings and profits^TY2026

5. An S election terminates on 31 December. In March of the following year the corporation distributes appreciated land to its former shareholders. Does IRC § 1371(e) apply?

Answer: No. a distribution of money by a corporation with respect to its stock during a post-termination transition period is applied against and reduces the adjusted basis of the stock, to the extent it does not exceed the accumulated adjustments account — with an election available to have earnings distributed first (IRC § 1371(e))^TY2026 — the relief is confined to a distribution of money. A distribution of land in the post-termination transition period is an ordinary corporate distribution governed by IRC § 301.