 Welcome to this session in which we'll discuss distribution to shareholders from S corporation. Well, what are we discussing here? Simply put, shareholders would receive distribution, maybe cash or property from corporation based on their ownership interest in the corporate stock. So simply put, the corporation generate a profit, revenues minus expenses, and at some point it's going to distribute some of that money or some sort of a property to the shareholders. The question is, how do we treat those distribution? Now it's very important to differentiate between shareholder distribution and salaries, because in an S corporation the owners can also be employees. So those are different, they are treated as salaries and wages, that's this is not what we are discussing. Bear in mind that S corporation income is not taxable when distributed. Why? Because remember an S corporation is a flow through entity, it means whether they distribute the money or not in the year that the S corporation generate the revenues minus the expenses and will get to the profit. And let's assume 100,000 minus 40,000 equal to 60,000, and now you're a 50, let's assume you're a 50% owner, you are responsible for $30,000 of that 60,000, you are responsible for paying taxes on that $30,000. Now whether you took that $30,000, whether that $30,000 is distributed or not, it's irrelevant. So simply put, when the company makes a profit, you are responsible for paying the taxes. Now when you take the money out, well this is what we have to discuss, it may or may not be taxable, this is what we need to discuss the rules. So this is what we are discussing here. There are two types of distribution we need to be aware of. One is called liquidating distribution and what is liquidating distribution? Hopefully you know what that is, it's when the company go out of business. Basically the receipts, shareholder won't have any ownership interest in the capital stock. Simply put you're going down to zero, the company is liquidating and there's non-liquidating where you don't liquidate. After this distribution, you exist and this is what we're going to be discussing here, we'll have a different discussion about liquidating distribution in a separate recording. Now in order to understand the distribution to shareholder from S corporation, we have to understand few terms that are unique or fairly new, some of them are unique or new to the S corporation. The first term is something called accumulated adjustment account all AAA, another account called other adjustment accounts OAA and accumulated earnings and profit. You should be familiar with this AEP from the C Corp. Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. Now I want to show you physically these accounts, where did they go on the tax return? So this way you just kind of see, it's good to see the physical effect of things. So they go under schedule M2 and the reason I have schedule M1, so you know what schedule M1 will revisit this later. It's reconciliation, which is of income, either income or loss per books with the return. We'll talk about this later on. It has its own fund story, but this is what we need to be aware of. The first one is AAA, accumulated adjustment account. Then we have AEP, then we have OAA. So those are the three accounts that we need to understand. And once we understand those accounts, it's easier to see how do they apply in our situation. Now there's also a new column, the schedule M2, which is, I don't believe this column existed when I was in practice a long time ago, which are shareholders, undistributable, taxable income, previously tax, which is basically the amount that you can take that is not distributable and was already taxed. So it doesn't have to be taxed again. This is basically no. We don't have to worry about this for our purposes. So guess what? I'm going to start with the third one, C. I'm going to start with accumulated earnings and profit. This account only exists if the corporation, if this S corporation was a C in the past and it has earnings. So when the corporation was a C corporation, remember initially we are a C, we might operate as a C for several years, then switch to an S or we may exist as a corporation and immediately be an S corporation. So AEP only exists. This account, you'll have any numbers here, only if the corporation was a C corporation in the past and that C corporation had earning, undistributed earning, you switch from C to an S. Therefore, you have to keep track of those accumulated earnings and profit because those are not taxed yet. So when you take them out, those are taxed. So this is AEP. So this is what AEP is. The second thing we're going to discuss is the AAA accumulated adjustment account. So what is accumulated adjustments account or AAA? This account represents the cumulative, undistributed earnings and profit during the years the corporation is operating as an S corporation. So the AAA account, I'm going to be calling it the AAA is specific to S corporation status. So when the S corporation starts day one or day zero, whatever you want to call it, day zero or day one, the AAA account is start with a zero balance. So the main purpose of using this AAA account is to ensure that the earnings of the S corporation are not taxed twice. Remember, when the S corporation generates revenues and incurred expenses, then they will come up with the profit. So let's assume the profit is 60,000. Well, this profit, whether it's distributed or not, let's assume you're a 50% owner, as I just mentioned, that 30,000, if you're a 50% owner, you're responsible for paying taxes, whether you took the money or out, whether a distribution is made or not. So therefore, we need to keep track of how much profit you already paid taxes on. So we keep this in a AAA account. So it's very unique to the S corporation. So the following lead to an increase in AAA. So the AAA will start at zero. Then when the company makes a profit, it doesn't matter whether that profit is taxed or not, AAA is increased. Then we have what's called separately stated items and gain. And we don't include in that amount, in that amount tax exemptance, let's just hold on that. So let's assume we have 5,000 of those separately stated items and gains passed to the shareholder who's responsible for paying taxes for those. Then we have depletion and access of the basis and the property of any, which we're not going to assume there's any, you don't have to worry about this. Then we have certain things that could reduce the AAA account, such as the opposite, if we incur losses. So if the company rather than profit incur a loss, the shareholder will have to absorb some of that loss. Well, if you absorb losses, let's assume in a particular year you're allocated 10,000 of losses, the losses just like the opposite of the ordinary income, as far as the AAA account, they reduce your AAA. Well, separately stated losses and deduction, just the opposite of separately stated income and gains, let's assume there's 2,000 of those for any particular year, and non deductible expenses other than those related to tax exempt interest. Don't worry about this and we'll talk about that later. And any distribution to the extent of AAA available. So simply put, we're going to take the 30,000 and net them out to find out our AAA account, whatever that account is. So think of it this way, AAA account is similar to retained earnings, similar in concept. Notice it increases by income revenues and gains, it's reduced by losses and deductions. Now, again, we keep tax exempt interest, whether it's income or deduction out of the picture, you're going to see why in a moment. Now, the AAA, you need to know that it might reduce your corporate loss, sorry, the AAA may be reduced below zero. So it can be negative by corporate losses and deduction. So what could bring this below zero? Well, if you have corporate losses and deduction over the years, it could bring it down below zero. However, if you make any distribution, so this distribution here, if you make distribution, it cannot, it cannot bring it below zero. So, so first you have to figure out if the losses and the distribution brought it to zero, then any distribution, any distribution cannot bring it below zero, but losses and deductions simply put from the business itself, from operating the business, you could bring it down below zero. So that's the AAA account, the OAA account, what's the OAA account? Well, we saw, you saw it on schedule M2. The other adjustment account is an account that's designed to keep track of items that affect the basis, but not AAA. Remember, what did we talk about AAA? We kind of kept out, I kept saying tax exempt interest income, although it's income, it doesn't, it doesn't increase your AAA, tax exempt interest expense, it's a reduction, it doesn't affect your AAA. So what do we, where do we have this tax exempt interest and where do we have the tax exempt expense? We keep, keep, keep track of it separately because it affects your basis, but it doesn't affect your AAA account. Because remember, your tax exempt interest is not taxable, whether you are an S or a C, it's not taxable. So it doesn't need to be tracked in the AAA account. Okay, but if you did receive tax exempt interest, it's going to affect your basis. So to keep track of that, we keep track of it in the OAA account. So the following account will affect the OAA account, tax exempt interest income, and it's related expense. So tax exempt interest income would increase your OAA, well, will also increase your basis related expenses, which is tax exempt interest expense, interest expense that you incur to obtain that tax exempt interest income should reduce your basis, but not your AAA. Again, tax exempt life insurance proceeds, they're not taxable. And if you pay a premium to obtain that life insurance, that's the deduction, but it doesn't affect your AAA, it affect your stock basis. And also if you pay taxes on, on a crude S corporation year that related to a C corporation. So if you paid federal taxes for something that's related to a C corporation in the past, well, that's going to reduce your OAA because your ability to pay distribution is reduced. Now just know that this is what the OAA is. Now the important question is how is the tax treatment of the distribution? How do we treat that distribution? Well, this is where it's going to come very important, our knowledge of what we just learned. The tax treatment all depends of the origin of that distribution. Where is the distribution coming from? Well, if it's coming from the AAA account, and the first thing we see we look is, do they have a AAA account? And remember on schedule M2, we have that AAA. The first thing is it's AAA. Let me ask you this, is it taxable or not? Not taxable. So if it's coming from the AAA, it's not taxable. Why? Because the AAA keeps track of amount that you already accounted for and paid taxes on, although you did not get. So when they distribute the money, think of it this way. Let me give you another analogy. Let's assume you deposit it in the bank. I don't know. You have quite a bit of cash, a million dollars. Now the bank earned that for a year, you earned 10%. So you earned 100,000 dollars. Now this amount here, the bank would send you a statement at the end of the year that says you have to pay taxes on this amount. And let's assume you 20% taxes for simplicity. 20% taxes, you paid $20,000 in taxes. That was year one. And you kept that money in the bank. In year three, you took this money out. Now you went to the bank and you withdrew your interest, 100,000. Do you have to pay taxes on that? No, you already paid the taxes. And the AAA account is similar in concept. You already accounted for that revenue, for that gain, and you pay taxes on it. When you take it out, if the distribution is considered coming from the AAA, and that's why you have to keep track of your AAA, then it's not taxable. Then if it's not coming from AAA, let's assume you were a C corporation in the past, we would look to see if you have any AEP. So the first thing, it's AAA not taxable. If the distribution is coming from the AEP accumulated earnings and profit, well, guess what? It's dividend. Why? Because it's supposed to be dividend when you had it as a C corporation. Then here, it's dividend. So that's easy. Once you, it's coming out of EMP, it's dividend. Once you deplete your AEMP, well, we would look at your other adjustment account. Remember other adjustment account, it might be different than AAA, because it has those tax exempt interest and life insurance proceeds. Well, if you have anything here, it will be considered from here. And again, this is not taxable, because that amount that's here, it's already not taxable right from the get-go. Then let's assume that's the case, then you used your OAA, then we would look at your basis. We would say, is the amount coming, is it considered a share coming out of your basis? If it's coming out of your basis, you should know, that's not taxable. Because if it's coming out of your basis, it means that it's a return of capital. The corporation is giving you back what you invested, you have a basis. Once the basis are depleted, are down to zero and they're still giving you money, then guess what? Whatever distribution and access to the basis is considered capital gain. Now they're giving you back money more than what you invested. It's like you invest in a company, $10,000 and they're giving you back 15. Well, 10,000 is your return of capital. The additional five is an access. Well, that's a capital gain. In general, a corporation that never operated as a C will have no EMP. If you've been an S all your life, there's no AEMP. Also, if you have no tax exempt interest or life insurance proceeds, this one don't exist. Simply put, it's going to be either non-taxable because it's either AAA or shareholder basis, which is also non-taxable. And if you go beyond your basis, it's capital gain. So it's very easy. So the distribution to shareholder from a corporation that never operated as a C corporation, well, distribution to the extent of the S corporation basis are return of capital. First of all, we said AAA not taxable because it's already been taxed. Your basis, if it go down to your basis, not taxable because that's your basis, they're giving you back your money. And if they gave you money way more than your basis above and beyond, then it's then it's capital gain. It's as simple as that. Let's take a look at a quick example to start to illustrate these concepts. So Zayna, a calendar S year corporation made a distribution of $20,000 in cash to its shareholder, Sam. Okay, let's take a look. Prior to the distribution, Sam basis in the stock amounted to 11,200 and the operation neither had an EMP nor AAA. So they don't have a AAA to start with. They don't have EMP was it was never a C corporation. So no EMP and they have no AAA from the past, basically brand new and just gave gave them 20,000. What's the appropriate tax treatment? Well, if they distributed $20,000, is it going to be taxable or not? Well, we find out whether there is a basis and if there is no basis, it's considered a capital gain. Given that the corporation has neither EMP nor AAA, the amount distributed is not taxable to the extent of the shareholder basis. And any distribution and access is considered a trap capital gain. So let's assume the basis is 11,000, sorry, the distribution is 20, the basis 11,200, assuming the basis 11,300. So of that $20,000, we say the first 11,000, 11,200 return of capital or return of your basis. And that's non taxable. And the remainder 8,800 is capital gain and your subject to capital gain tax, whatever your capital gain tax happened to be zero 15 or 20%. This is how it works. Now let's take a look at the rules of distribution when the S corporation operated as a C corporation before it became an S. It's a mouthful. So you were a S in the past, now you're a C, what happens? Once again, the rules are, I just went over the rules, let's go over them one more time. First, we assume the distribution is coming out of the AAA, assuming there are AAA. If that's the case, not taxable. But you have to understand, if you take the money out, now we're going to talk about the basis. So the AAA, now I'm going to be adding this concept here, not this concept, this important addition is it reduces your shareholder basis. So as you take the distribution out, you would reduce your AAA, but also AAA withdrawal reduces your basis in the S corporation. Once your AAA are depleted and you're still taking money out, we want to see if you have any A, E and P from prior life. Prior life mean when the corporation was a C. If that's the case, that amount is considered dividend income, and based on your dividend income, however, this distribution, the amount that we see it's dividend from A, E and P don't affect your stock basis, because this is coming from the C corporation. The only reason you're paying dividend income on it, because the C was transferred into an S, and now you are taking the money out, we're going to go back to your original formation and tax you based on that. So it doesn't affect your basis for the S corporation. So notice dividend income, yes, affect your basis, no. Once we depleted the accumulated earnings in profit, we would look at the OAA. Again, we'd look at the OAA, and OAA are not taxable, but the OAA reduce your basis. They would reduce your basis. Okay, because when you brought them in, they were money, actual money that you brought in. Now, what's going to happen when you're taking them out? They're supposed to reduce your basis. Four, any distribution and access of, you know, we depleted the AAA, we depleted A, E and P, we depleted OAA. Any basis that you have left, if you have left, distribution, as long as you have basis, it's return of capital, which is not taxable. It's called basically they're giving you back your money. Once they give you money and access of AAA, AEMP, OAA, and an access of your basis, well, that's considered capital gain. And the best way to illustrate this is to work an example. So once the stock basis is reduced to zero, any additional distribution is treated as gain from the sale or the exchange of the stock. Let's take a look at the summary first, and this is a good summary. If the distribution is considered coming from the AAA, it's non-taxable, but it does decrease your basis. If the distribution is coming from the AEMP, which is you were a C corporation in the past, well, the amount is taxable as dividend income, but it doesn't impact your basis because the C corporation has nothing to do with your S basis today. If the distribution is coming from OAA, well, it's also non-taxable, notice it just, the OAA is very similar, not very similar, it's the same treatment as AAA. If now the distribution is considered shareholder basis coming from your basis because those three don't exist, you have none of them, then the amount is non-taxable and it does decrease your basis. If they keep giving you money way above your basis, it means your basis is now zero, but they keep giving you distribution, then it's taxable as a capital gain and your basis are zero. You cannot bring your basis down below zero with those these distribution because here we're assuming basis equal to zero and that's why it's an access on basis. Let's take a look at an example. At the end of the current year, Khloe, a shareholder of the Smith Inc., an S corporation, received a distribution of a parcel of land with a fair value of 72. The corporation had accumulated EMP of 17,000, it means at some point in the past, this was a C corporation, the AAA account is 20,000. In addition, the closed stock basis is 31. Determine the amount of the distribution that's taxable to Khloe. Now, it's very important, let's do this. I'm going to keep track of the basis, keep track of the AAA account. The basis we're starting at 31,000 and the AAA is 20,000. AAA is 20,000 and what else do we have? AEP is 17. Now, we're going to start. The distribution comes first out of the AAA account. Well, how much do we have in the AAA? 20,000. Therefore, we have 72 in total, 72,000 minus 20,000. That's going to go against the AAA and it's going to bring the AAA down to zero. The AAA, we're done with the AAA. Would that affect your basis? Of course it will. So, reducing your AAA will affect your basis. Now, your basis are 11,000. Let me use my calculator. We have 72,000 in distribution in total and we used up 20,000. What's left is 72 minus 20. What's left is 52,000. Now, do we have AEP? Of course we do. We have 17,000 in AEP. So, of this 52,000, it's going to go to AEP. This is basically the second level. It's going to reduce your AEP by 17,000, bring AEP down to zero. Would that affect your basis? No. The second distribution don't affect your basis. You still have 11,000 of basis and the distribution here is considered dividend, which is taxable, but doesn't affect your basis. AEP is from a different life. Now, the remaining, which is 52 minus 17, equal to 35. Now, we still have 35,000. What do we do? Well, we still have basis of 11,000. So, of the 35,000, 11,000, it's going to be considered return of basis. Not return of basis, return of capital. So, negative 11,000. Your base is now to zero and this is not taxable. Notice your triple A is down to zero. AEP down to zero. Your base is down to zero. What's left is what? 35 minus 11 is 24. This additional 24,000 is considered what? It's considered capital gain. So, to summarize, out of the total amount, 41,000 is taxable to Chloe. Why? Well, you got 20,000 of, I'm sorry, not 20,000. You have 17,000 from the AEP that's taxable and you have that access, that access that's left once the basis were depleted and that's 41,000 and that's the amount that's taxable. Well, guess what? The remainder is non-taxable. The remainder is non-taxable. What should you do now? Go to Farhat Lectures and look at additional MCQs through false multiple choice questions that's going to help you understand this topic. This topic is extremely important. The triple A account, the AEMP, OAA, those are tested, heavily tested distribution from an S corporation to a shareholder. So, get comfortable with them. How do you get comfortable with them? Look at additional resources. Farhat Lectures can help you. I'm always here to help you. Good luck, study hard and of course, stay safe.