Is the amount of allowable S Corp Dividends tied to retained earnings?

[Guest SDS]

Fairly small 70% ESOP owned "S" Corp made dividend of over $500,000, some of which was used to reduce their repurchase liability within the ESOP. However, the dividend was well within the amount of retained earnings since becoming an S Corp.

Has anyone else heard that S Corp dividends must be less than retained earnings since becoming S Corp or am I the only one?

[Guest Larry Goldberg]

The distribution from the S corporation is not limited to its retained earnings. However, a distribution in excess of such amount may not constitute "earnings" available to a leveraged ESOP to make a payment on its loan.

By your reference to retained earnings while an S corporation, I assume you are referring to the S corporation's "accumulated adjustments account" (called the AAA) which is essentially the account that tracks a corporation's earnings (current and accumulated) while it is an S corporation. S corporation distributions would generally be treated as first coming from the AAA. If an S corporation makes a distribution in excess of its AAA balance, the excess would be considered a dividend to the extent the S corporation was previously a C corporation and has accumulated earnings and profits from its C corporation years.

If the distribution exceeds the AAA balance and the accumulated earnings and profits (if any), this excess is treated as a tax-free return of basis to the extent of any remaining basis the shareholder has in his stock. To the extent the distribution exceeds basis, the excess is treated as a capital gain transaction.

Since the ESOP is tax-exempt, it is not subject to tax on the distribution. However, the capital gain portion of the distribution looks more like a sale of stock than a dividend for tax purposes. Therefore, the excess amount may not be available to a leveraged ESOP to make a payment on a loan.

In a recent Private Letter Ruling (dated July 2, 1999), the IRS held that dividends on unallocated shares (in the ESOP's loan suspense account) may be used by the ESOP to make loan payments, so long as the dividends are paid out of earnings and profits accumulated while the company was a C corporation or out of the S corporation's AAA. It would appear that the IRS would treat any excess as a return of basis or capital gains transaction, and not as "earnings" on the suspense account shares.

For a recent IRS PLR involving a C corporation that paid a dividend in excess of its earnings and profits, in which the ESOP did not use the excess distribution on suspense account shares to repay its loan, see PLR 199933040 (5/18/99).

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[This message has been edited by Larry Goldberg (edited 12-29-1999).]