United States: IRS Memo Says S Corporation’s Accumulated Adjustment Account Begins At Zero

The IRS concluded in a Nov. 14 internal legal memorandum (ILM 201446021) that an S corporation's accumulated adjustment account (AAA) was zero on the first day of its effective S corporation election, notwithstanding the corporation's prior history as an S corporation.

In ILM 201446021, a C corporation initially made an election to be treated as an S corporation under Section 1361. At that time, the corporation had accumulated earnings and profits. After that election, the corporation generated annual profits and had a positive AAA balance, but then its majority shareholders revoked the election.

In a taxable year after the revocation, the corporation made another valid election to be treated as an S corporation. Thus, the corporation had converted from a C corporation to an S Corporation as the result of the initial election, from an S corporation to a C corporation as the result of the revocation, and finally, from a C corporation to an S corporation as the result of the second election.

An S corporation's AAA is an account that isn't apportioned among the shareholders. For an S corporation that has earnings and profits from a prior period as a C corporation, the AAA tracks the S corporation's ability to make tax-free distributions to its shareholders.

To the extent that an S corporation has a positive AAA and a distribution to the S corporation's shareholders doesn't exceed their basis in the stock, the S corporation can make tax-free distributions. However, for all S corporations, the balance of the AAA is zero on the first day of the first year for which the S corporation election is effective, according to Treas. Reg. Sec. 1.1368-2(e)(2).

The IRS concluded that the corporation's AAA was zero on the first day that the second election was effective under Treas. Reg. Sec. 1.1368-2(e)(2), notwithstanding that the corporation had a positive AAA immediately before the revocation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.