S Corp Distributions, Loans, and the AAA Ordering Rules

S corp distributions are governed by § 1368 with a specific ordering depending on whether the corporation has accumulated earnings and profits (AE&P) from prior C-corp years. AAA tracking under § 1368(e) is the operative bookkeeping.

The ordering — § 1368(b) (no AE&P)

1. Distribution reduces the shareholder’s adjusted basis in the S corp stock; excess of distribution over stock basis is capital gain under § 1368(b)(2).
2. Negative basis is not allowed; loss suspension under § 1366(d)(2) kicks in if basis is exhausted before pass-through losses are absorbed.

The ordering — § 1368(c) (with AE&P)

1. Distribution treated as coming from AAA to the extent thereof; tax-free up to stock basis; capital gain to extent it exceeds basis.
2. Next from AE&P; taxable as dividend under § 301(c)(1), qualified dividend if eligible under § 1(h)(11).
3. Next from OAA (other adjustments account — tax-exempt income net of related expense) and previously taxed income (PTI) from pre-1983 S years; tax-free.
4. Remaining is return of capital reducing remaining basis, then capital gain.

AAA mechanics — § 1.1368-2

AAA starts at zero on the first S year. Annual adjustments: (i) increased by separately and non-separately stated items of income other than tax-exempt income; (ii) decreased by separately and non-separately stated items of loss and deduction other than expenses related to tax-exempt income and federal taxes; (iii) decreased by non-dividend distributions to the extent of positive AAA.

AAA can go negative due to losses but cannot be reduced below zero by distributions. AAA is not allocated per shareholder; it is a corporate-level account. Distributions are pro rata to shareholders based on stock ownership.

Bypass election — § 1368(e)(3)

The corporation may elect to treat distributions as made first from AE&P (skipping AAA). Election requires shareholder consent on a year-by-year basis. Reasons to elect:

• Reduce AE&P before passive investment income termination risk under § 1362(d)(3).
• QBI optimization: dividends from AE&P are not QBI but distributions of S corp income subject to AAA are; pre-distribution AE&P management can shape downstream QBI.
• Reduce future § 1375 excess net passive income tax exposure.

OAA & PTI

OAA tracks tax-exempt income net of related non-deductible expenses; distributed tax-free in step 3 of the ordering. PTI (previously taxed income) is a vestige of pre-1983 S corps; rare in current practice.

Shareholder debt

Under § 1366(d)(1)(B), shareholder debt basis can absorb pass-through losses after stock basis is exhausted. The debt must be bona fide indebtedness running directly from the shareholder to the corp (not a guarantee on third-party debt; not a back-to-back through a related entity, post-§ 1.1366-2).

Repayment of a debt with reduced basis triggers gain under § 1367(b)(2)(B): portion of repayment in excess of remaining loan basis is recognized as gain (ordinary if loan is open-account, capital if evidenced by a note).

Bona fide debt characterization factors: written note, market-rate interest at AFR or higher, fixed repayment schedule, actual repayment history, debtor capacity to repay, capitalization adequacy.

Loans from corp to shareholder

Loans from the S corp to the shareholder must satisfy the same bona fide debt criteria. Below-market loans are subject to § 7872 imputed interest. Loans without market terms, repayment schedules, or repayment in practice are recharacterized as either distributions (taxable to the extent exceeding basis) or constructive dividends (if AE&P available) or unreported wages (with payroll tax and penalty exposure).

Common recharacterization vehicles: shareholder “loan accounts” that grow without repayment; loans without notes; loans where the “repayment” is offset by year-end bonuses.

Distribution timing and short-year issues

Distributions are taken into account on the date paid. Pro rata distributions within a year are required to maintain single-class-of-stock status. Disproportionate timing can create issues even if total annual amounts are pro rata; document closely.

On termination of the election (voluntary revocation or involuntary), the post-termination transition period (PTTP) under § 1377(b) permits continued tax-free distribution from AAA for approximately one year after termination. Useful for clean wind-down.