Many closely held businesses operate as S Corporation “pass-through” entities for federal income tax purposes. Some S Corps started out as C Corporations and converted to an S Corp.
Often, questions arise on the income taxation of distributions of cash or assets from S Corps to the shareholders of those S Corps personally. These S Corp shareholders will often need to use S Corp distributions to fund personal financial objectives. Among them: personally owned or trust-owned life insurance to finance personal protection, retirement income or estate planning objectives.
A specific sequence and protocol must be followed under IRC Section 1368 when S Corp cash and/or assets are distributed to S Corp shareholders. Each “tier” of distribution must be reduced to zero before moving into the next “tier” of distribution.
Here is the sequence of taxation that must be followed when these distributions take place. For simplicity, assume the S Corp shareholder owns 100 percent of the shares of the company. S Corps are “pass-through” tax entities wherein K-1 net profits are taxed to the S Corp shareholders personally on Schedule E of their Form 1040 U.S. Income Tax return.
Distribution Tier #1
All S Corp Net Profit (business income minus business expenses) for the current tax year is “passed-through” as K-1 ordinary income to the S Corp shareholder.
For tax year 2013 and beyond, ordinary income may be taxed at a top federal rate of 39.6 percent for high income S Corp owners. Plus, an additional 3.8 percent tax on “passive” interest and rental income as a result of the Affordable Care Act went into effect in 2013 for certain high earners. The combined marginal tax rate on ordinary income for high income S Corp owners could be as high as 43.4 percent.
Distribution Tier #2
All S Corp “Accumulated Adjustments Account” (AAA) is distributed tax free to the S Corp shareholder.
This AAA account is a tax accounting entry for all previously taxed K-1 income that has been left in the S Corp and was not distributed to the shareholder in prior tax years. Some professionals refer to this AAA account for S Corps as “previously taxed profits” or “previously taxed income.” This AAA tier of distribution is important to verify because it can provide a tax-free technique to fund personal insurance needs. The most recent Form 1120S U.S. Income Tax Return for an S Corp would be a good source to verify the AAA account.
Distribution Tier #3
All “locked-in” Retained Earnings from S Corps that previously had C Corp status are distributed as a non-deductible dividend distribution to the S Corp shareholder.
For tax year 2013 and beyond, qualified dividends are taxed at only a 15 to 20 percent federal rate. Plus, an additional 3.8 percent tax on “passive” dividend income as a result of the Affordable Care Act went into effect in 2013 for certain high income earners. The combined marginal tax rate on dividend income for high income S Corp owners could be as high as 23.8 percent.
To accelerate taxable dividend distributions from Tier #3 up to Tier #2, a tier “switch” under IRC Section 1368(e)(3) can be elected. Accordingly, S Corp owners can take advantage of this tier switch to unlock retained earnings from C Corp status and be taxed currently.Distribution Tier #4
All Cost Basis that the S Corp shareholder has in the shares of the company is distributed tax free to the S Corp shareholder.
This cost basis is the original capital with which the shareholder started the corporation plus any “paid-in capital” the shareholder added to the company over the years the company has been in operation.
Distribution Tier #5
Finally, any additional asset value beyond Tier #4 cost basis is distributed as capital gain to the S Corp shareholder.
For tax year 2013 and beyond, capital gains are taxed at a 15 to 20 percent federal rate. Plus, an additional 3.8 percent tax on “passive” capital gain income as a result of the Affordable Care Act for certain high earners. The combined marginal tax rate on capital gain income for high income S Corp owners could be as high as 23.8 percent.
Example of S Corp Tier 1 and Tier 2 Distributions to fund life insurance
Assume a 100 percent S Corp owner is 60 years old and is in the highest personal income tax bracket for 2014 (39.6 percent). The S Corp has $400,000 of Tier #1 pass-through K-1 profit in the current year and $500,000 of Tier #2 previously taxed Accumulated Adjustment Account (AAA). The client wishes to make a tax-free withdrawal from the AAA account to pay the taxes on the K-1 profit and use the full $400,000 of K-1 profit to fund personal financial needs using tax-favored financial products.
- Tier #1 K-1 Profit (Ordinary Income): $400,000 x 39.6 percent = $158,400 tax.
- Tier #2 AAA: $500,000 – $158,400 withdrawal for tax = $341,600 remaining AAA
The $400,000 K-1 profit distribution can be placed in a personal side fund where annual withdrawals can be made to fund annual premiums for a non-MEC personally owned life insurance policy. The policy could be a no-lapse guaranteed UL policy, a current assumption UL policy, an indexed UL policy or a whole life policy, depending on the retirement needs and risk tolerance of the S Corp owner.
Or the $400,000 K-1 profit distribution could be gifted using $400,000 of lifetime gift exemption to a no-lapse UL or no-lapse SUL policy owned by an Irrevocable Life Insurance Trust (ILIT) if estate tax-free death benefits are required based on the facts of the case.