REVENUE RULE 95-14

1995-6 I.R.B. 29.

REDEMPTION OF S CORPORATION STOCK CHARACTERIZED AS A DISTRIBUTION

Published: February 6, 1995

Section 1367. - Adjustments to Basis of Stock of Shareholders, etc.

Section 1368. - Distributions, 26 CFR 1.1368-2: Accumulated adjustments account (AAA).

(See Also §§301, 302, 303, 317, 318, 1367, 1371.)

If an S corporation shareholder receives proceeds in a redemption characterized as a distribution under s 301, is the redemption treated as a distribution that reduces the corporation's accumulated adjustments account?

Redemption of S corporation stock characterized as a distribution. When an S corporation shareholder receives proceeds in a redemption that is characterized as a distribution under section 301 of the Code, the redemption is treated as a distribution for purposes of section 1368 that reduces the corporation's accumulated adjustments account.

ISSUE

If an S corporation shareholder receives proceeds in a redemption that is characterized as a distribution under s 301 of the Internal Revenue Code, is the redemption treated as a distribution for purposes of s 1368 that reduces the corporation's accumulated adjustments account?

FACTS

A, and A's child B, together own all of the stock of X, a corporation that files returns for a calendar year. X has a valid S election in effect, X redeems for cash a portion of A's stock at fair market value. There are no facts present that cause the redemption to be treated as a sale or exchange under s 302(a) or s 303(a)--X makes no other distributions during the taxable year.

At the end of the year, A has a basis in X stock in excess of the amount of the distribution made by X during the year. In addition, X has an accumulated adjustments account (AAA) in excess of that distribution. X also has subchapter C earnings and profits.

LAW AND ANALYSIS

Section 1371(a)(1) provides that except as otherwise provided in the Code, and except to the extent inconsistent with subchapter S, subchapter C applies to an S corporation and its shareholders.

Under the rules of subchapter C, a redemption is treated either as a sale or exchange under s 302(a) or s 303(a), or as a distribution of property to which s 301 applies. See s 302(d). Because the redemption of A's stock is not treated as a sale or exchange under s 302(a) or s 303(a), the redemption is treated, under s 302(d), as a distribution of property to which s 301 applies.

Section 301(a) provides that a distribution of property (as defined in s 317(a)) by a corporation to a shareholder with respect to its stock is treated in the manner provided in s 301(c).

Section 301(c) provides that, in the case of a distribution to which s 301(a) applies: (1) the portion of the distribution that is a dividend (as defined in s 316) is included in gross income; and (2) the portion of the distribution that is not a dividend is applied against and reduces the adjusted basis of the stock. The portion of the distribution that is not a dividend, to the extent that it exceeds the adjusted basis of the stock, is treated as gain from the sale or exchange of property.

Section 1368(a) provides that a distribution of property made by an S corporation with respect to its stock to which (but for s 1368(a)) s 301(c) would apply is treated in the manner provided in s 1368(b) or (c), whichever applies.

Section 1368(b) provides that, in the case of a distribution described in s 1368(a) by an S corporation that has no accumulated earnings and profits, the distribution is not included in gross income to the extent that it does not exceed the adjusted basis of the stock. If the amount of the distribution exceeds the adjusted basis of the stock, the excess is treated as gain from the sale or exchange of property.

Section 1368(c) provides that, in the case of a distribution described in s 1368(a) by an S corporation that has accumulated earnings and profits: (1) that portion of the distribution that does not exceed AAA is treated in the manner provided by s 1368(b); (2) that portion of the distribution that remains after the application of s 1368(c)(1) is treated as a dividend to the extent it does not exceed the accumulated earnings and profits of the S corporation; and (3) any portion of the distribution remaining after the application of s 1368(c)(2) is treated in the manner provided by s 1368(b).

Section 1368(e)(1) provides that the term "accumulated adjustments account" means an account of the S corporation that has adjustments for the S period similar to the adjustments under s 1367 (except that no adjustment is made for income (and related expenses) that is exempt from tax under the Code, and the phrase "but not below zero" is disregarded in s 1367(b)(2)(A)), and no adjustment is made for federal taxes attributable to any taxable year in which the corporation was a C corporation.

An S corporation's AAA tracks the amount of undistributed income that has been taxed to the shareholders, similar to the manner in which earnings and profits generally track a C corporation's undistributed income (whether or not taxable). AAA is the mechanism that allows previously taxed but undistributed income to be distributed tax-free to S corporation shareholders. It is an account of the S corporation and is not apportioned among shareholders. Section 1.1368-2(a).

Section 1368(c)(1)(B) provides a special rule to determine the adjustment to AAA in the case of a redemption that is treated as an exchange. In the case of any redemption that is treated as an exchange under s 302(a) or s 303(a), the adjustment to AAA is an amount that bears the same ratio to the balance in the account as the number of shares redeemed bears to the number of shares of stock in the corporation immediately before the redemption. Section 1368(e) does not provide a specific rule for adjusting AAA in the case of a redemption treated as a s 301 distribution.

Because X has subchapter C earnings and profits, distributions are treated in the manner provided in s 1368(c). A has an adjusted basis in X stock in excess of the amount of the distribution made by X during the year and X has AAA in excess of the amount of that distribution. Thus, under s 1368(c)(1), the distribution is not included in A's income.

Section 1368(e)(1)(A) provides that AAA is adjusted in a manner similar to the adjustments under s 1367. Section 1367(a)(2)(A) requires an S corporation shareholder to decrease basis in S stock for distributions by the corporation that were not includible in the shareholder's income because of s 1368. Section 1.1368-2(a)(3)(iii) provides that AAA is decreased (but not below zero) by any portion of a distribution to which s 1368(b) or s 1368(c)(1) applies. Because, under these facts, s 1368(b) and s 1368(c)(1) apply to the entire distribution, X's AAA is reduced by the full amount of X's distribution in redemption of A's stock. The provision of s 1368(e)(1) that refers to redemptions does not apply on these facts because this is not a redemption that is treated as an exchange under s 302(a) or s 303(a).

HOLDING

When an S corporation shareholder receives proceeds in a redemption that is characterized as a distribution under s 301, the entire redemption is treated as a distribution for purposes of s 1368 that reduces the corporation's AAA.

DRAFTING INFORMATION

The principal author of this revenue ruling is Brad K. Saunders of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling contact Armando Gomez at (202) 622- 3050 (not a toll-free call).