Blake Christian

AAA, PTI and E&P

Deciphering the alphabet soup of corporate dividend distributions.

August 28, 2008
by Blake Christian, CPA/MBT

In the U.S, shareholders can be subject to an almost infinite variety of taxability on distributions received from a corporation. The tax results can range from tax-free return to return of capital, capital gains, the current favorable federal 15 percent dividend rates on "qualified dividends" (generally dividends received from a domestic C Corps) or the highest ordinary rates — depending on the specific facts.

With the current low tax rates applied to qualified dividends received on or before December 31, 2010, and the possibility of these rates being increased sooner under an Obama presidency, it is critically important for both C and S corporations (and their shareholders) to understand the ordering rules and tax ramifications of corporate distributions fully — before they are made.

General Definitions

The controlling definitions, which impact the tax treatment for C and S Corp shareholders include:

  • "Earnings & Profits" (E&P — a modified taxable income concept for cumulative C Corp net profits since 1913, determined under IRC Section 312),
  • "Accumulated Adjustments Account" (AAA —similar concept to E&P applicable to net earnings since becoming an S Corp — IRC Section 1368(e)),
  • "Previously Taxed Income" (PTI — applicable to pre-1983 S Corps — IRC Section 1368) and
  • Tax Basis (IRC Sections 301/307 and 1367, for C and S Corps, respectively).

C Corp Dividends

In general, distributions from a C corporation's will fall into one of the following tax classifications:

  • "Qualifying" dividends — to the extent of "Accumulated Earnings & Profits" (AE&P) — (currently taxed at 15 percent for individual shareholders),
  • "Non-qualifying" dividends — to the extent of AE&P,
  • "Return of capital" — non-liquidating distributions in excess of AE&P and up to each shareholder's personal tax basis in the corporate shares (tax-free, but reduces stock basis),
  • "Liquidating distributions" — amounts in excess of AE&P and tax basis in shares (generally taxed at capital gain rates).

Dividends Eligible for Corporate Dividends Received Deduction (DRD)

In general, dividends received by a corporate stockholder from an affiliated domestic corporation will be able to exclude 100 percent of such dividends received (on the theory the profits have already been subject to corporate-level taxation). To the extent the recipient owns at least 20 percent of the corporate payor's stock, the dividend is generally eligible for an 80 percent DRD and most other domestic dividends are eligible for a 70 percent DRD.

The characterization of distributions from a C Corp will be generally determined at the end of the tax year, rather than at the point when the distribution is actually made.

Depending on the tax position of the dividend recipient, a corporate shareholder may prefer to receive distributions characterized as capital gains in a year in which they have expiring capital loss carryovers, or ordinary dividends in a year in which the recipient has a tax loss. A taxpayer in a high tax bracket, or with capital losses, will generally prefer to receive either a return of capital or capital gain income.

Foreign dividends received by U.S. Corporations or individuals will often have foreign taxes withheld at source — generally ranging from five percent to 30 percent. These withheld taxes can generally be claimed as either a tax credit or a tax deduction at the election of the recipient.

To the extent the distribution is made in the form of property, rather than cash, the taxability is generally measured by the fair market value of the property distributed. Such values may be reduced to the extent the property is encumbered with debt. For example if real estate valued at $500,000, with a mortgage of $200,000 is distributed to a shareholder in a year when the AE&P is $1,000,000, the dividend amount would be $300,000 ($500,000 FMV less $200,000 mortgage).

IRC Section 311(b) will also generally trigger corporate-level gain to the extent the FMV of the property exceeds the distributing corporation's tax basis in the property.

S Corporation Distributions

The concepts for S Corps differ from those applicable to C Corps, except with respect to S Corps with C Corp lineage.

IRC Section 1379(c) lays out the ordering rules for determining the taxability of S Corp distributions:

  • AAA (effectively represents previously reported taxable income and basis in S Corp shares),
  • Previously Tax Income (PTI) — only applies to pre-1983 S Corps,
  • AE&P — only applies to S Corps that were previously C Corps, with undistributed E&P at time of S conversion,
  • Non-Taxable Distributions — amounts distributed in excess of the aforementioned distributions, up to remaining shareholder stock basis,
  • Capital Gain Distributions — for amounts related to actual or deemed stock dispositions.

The rules for taxability of S Corp distributions get more complex when the distributing corporation was an S Corp prior to 1983 and had PTI, and/or was previously a C Corp, with AE&P at the time of converting to an S Corp. IRC Sec. 1379(c) provides the distribution ordering rules.

Planning Techniques

Obviously closely-held businesses have much more control than publicly-traded companies in formulating customized distribution policies. The added advantage in a closely-held corporate setting is that the aggregate tax consequences to the smaller shareholder group are more easily determined.

Distributions of C and S Corp AE&P as qualified dividends (taxable at 15% or less vs. 35%) may be advisable prior to 2011, and possibly before 2009 if Obama is elected President, since he continues to threaten reversal of the Bush tax cuts and across-the-board tax hikes for taxpayers "making more than $250,000." Accelerating taxable dividends may also allow more investment interest expense to be used, or income offsets by expiring Net Operating Losses or credits.

S Corps — which were previously C Corps — that currently have AE&P have three options under the Regulations to elect to change the general ordering rules.

  • Under IRC Sec. 1368(e)(3) a year-by-year election allows the distributing S Corp to treat a distribution as coming first from AE&P, then from AAA. This is referred to as a "bypass" election and the form of the election is a plain-paper statement attached to the Form 1120S.
  • Under Treas. Reg. Sec. 1.1368-1(f)(2)(ii) and (4) the S Corp can also make a secondary election to treat the second tier of dividends as PTI. In addition to making these ordering elections, Form 5452 (Corporate Report of Non-dividend Distributions) should be filed in any year in which distributions exceed AAA and AE&P.
  • To the extent the corporation is cash-strapped, they may make dividend distributions in the form of property or notes payable to the shareholders. Care must be taken to avoid an IRS attack as a second class of stock. IRC Sec. 1361(c)(5) and related regulations provide "straight debt" guidelines. Rather than distributing property or notes, the cash-poor corporation can make a "deemed dividend election" pursuant to Treas. Reg. 1.1368-1(f)(3). See Treas. Reg. Sec. 1.1368-1(f)(5) for specific details to be included in the election.

The beauty of most of these dividend strategies and elections is that they can be finalized after year-end, but be effective for the prior tax year.

Liquidating distributions, C Corp Personal Holding Companies and Personal Service Companies have additional issues and complexities that are beyond the scope of this article.


Dividend distribution strategies for C Corps and particularly S Corps, allow some of the most flexible planning in the tax code. A prudent CFO and the company's shareholders can achieve very positive after-tax results with some advanced planning, or careful analysis even after year-end.

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Blake Christian, CPA/MBT, is a Tax Partner in the Long Beach Office of Holthouse, Carlin & Van Trigt, LLP and is Co-Founder of NTCG, LLC. He can be reach at (562) 216-1800. Additional information is available at www.hcvt.com.