8948 / How does tax reform modify the treatment of S corporation that convert to C corporations?

Under prior law, if an S corporation converted to a C corporation, distributions of cash by the C corporation to the shareholders during the post-termination transition period were tax-free to the extent of the amount in the company’s accumulated adjustment account. These distributions also reduced the shareholders’ basis in the company’s stock. The “post-termination transition period” was the one-year period after the S corporation election terminated.

The 2017 Tax Act provides that any accounting adjustments under IRC Section 481(a) that are required because of the revocation of the S corporation election of an “eligible terminated S corporation” (such as changing from the cash to accrual method of accounting) must be taken into account ratably during the six tax years beginning with the year of the change.^[1]

An “eligible terminated S corporation” is defined as any C corporation which (1) was an S corporation the day before the enactment of the 2017 Tax Act (i.e., December 22, 2017), (2) during the two-year period beginning on the date of enactment revokes its S corporation election under IRC Section 1362(a), and (3) where all of the owners of the S corporation on the date the election is revoked are the same owners (in identical proportions) as the owners on the date of the enactment of the 2017 Tax Act.^[2]

Under Revenue Procedure 2018-44, an eligible terminated S corporation is required to take a positive or negative Section 481(a) adjustment ratably over six years beginning with the year of change if the corporation (1) is required to change from the cash method to accrual method and (2) makes the accounting method change for the C corporation's first tax year. An eligible terminated S corporation is permitted (but not required) to take a positive or negative Section 481(a) adjustment ratably over six years beginning with the year of change if the eligible terminated S corporation (1) is permitted to continue using the cash method of accounting after termination of its S status, and (2) changes to the overall accrual method of accounting for the C corporation’s first tax year.

Under the new rules, if there is a distribution of cash by an eligible terminated S corporation, the accumulated adjustments account will be allocated to that distribution, and the distribution will be chargeable to accumulated earnings and profits, in the same ratio as the amount of the accumulated adjustments account bears to the amount the accumulated earnings and profits.^[3]

[1]. IRC Sec. 481(d)(1).

[2]. IRC Sec. 481(d)(2).

[3]. IRC Sec. 1371(f).