Recently, the IRS released Rev Proc 2018-44, a Revenue Procedure that deals with the conversion of S corporations to C corporations under the Tax Cuts and Jobs Act (TCJA).
Embedded in the Rev Proc are situations in which, after a conversion, companies can change their accounting method and receive automatic permission. Further, the document sets the rules whereby the new C corporation can distribute monies in its accumulated adjustments account (AAA), which is tax free to the shareholders, without those amounts being counted as dividends paid by the corporation.
The TCJA makes two modifications to existing laws for a C corporation that was an S corporation on Dec. 21, 2017, and revokes its S corporation election after that date but before Dec. 22, 2019, and has the same owners of stock in identical proportions on the date of revocation and on Dec. 22, 2017.
The following modifications apply to these entities:
The period for including net adjustments that are needed to prevent amounts from being duplicated or omitted as a result of an accounting method change and attributable to the revocation of the S corporation election is changed to six years. This applies to net adjustments that decrease taxable income as well as those that increase it.
Distributions of cash following the post-termination transition period are treated as coming out of the corporation’s AAA and E&P proportionally.
To begin with, the Rev Proc says an S corporation that converts to a C corporation can change their overall method of accounting either from cash to accrual or vice versa. However, this conversion is subject to IRC § 481.
Section 481, as it applies to this Rev Proc, specifies that on the original C corporation return, the new accounting method has to be elected, and it requires the corporation to take into account the negative or positive adjustment over a period of six years.
The second part of the Rev Proc, and perhaps the most alluring, is that if the S corporation that converted to a C corporation had previously taxed earnings, the shareholder is permitted to take the monies, create an AAA account and not pay double taxation on the distribution.
An AAA account is used to track the undistributed earnings of an S corporation that have been taxed to shareholders previously. Distributions from here are tax-free.
Essentially, the AAA is the cumulative total of undistributed nonseparately and separately stated items for S corporation taxable years beginning after 1982. Thus, it parallels the calculation of C corporation accumulated earnings and profits (AEP). This applies to all S corporations, but it is most important to those that have been C corporations. The AAA provides a mechanism to ensure that the earnings of the former are taxed to shareholders only once.
The caveat in the Rev Proc is that all amounts in the AAA account must be distributed by 2019. This is tailor-made for those companies that converted to a C corporation but may have undistributed, previously taxed income.
The conversion should not be taken lightly, but this Rev Proc is another incentive for certain corporations to consider it.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...