Why are distributions limited to balance of AAA when Retained earnings are available?

[rbmuCPA]

Is this a technical problem within ProSeries? I have available retained earnings to put distributions against, but not enough in my AAA. Why does ProSeries automatically limit the distribution to the amount available in AAA and mark the rest as Distributions in excess of Retained Earnings on the M-2 worksheet? Is the only workaround an over ride on the M-2 worksheet?

[TaxMonkey · Accepted solution]

Why are your Retained Earnings greater than AAA?  Did they used to be a C-corp?

[sjrcpa]

It's the tax law.

[rbmuCPA]

It is my understanding that distributions are not directly limited by AAA, but distributions in excess of basis are treated as sales of stock and subject to capital gains. Distributions in excess of AAA, is a good indicator that distributions could be taxable, but not the indicator itself or any limiting factor.

The distribution itself is not limited in any way, only the tax treatment of the distribution is called into question. Section 1368 says, "If the amount of the distribution exceeds adjusted basis of the stock, such excess shall be treated as gain from the sale or exchange of property." No language disallowing the excess distribution, only the tax treatment of the excess distribution.

So why the limitation by ProSeries?

[sjrcpa]

Because ProSeries is following the law. Your understanding is correct, though.

[TaxMonkey]

Distributions cannot reduce AAA below zero.Treas Reg 1.1368-2(a)(3)(iii)

https://www.law.cornell.edu/cfr/text/26/1.1368-2

[sjrcpa]

Thanks.

[rbmuCPA]

I understand that distributions cannot reduce AAA below 0, but AAA and Retained earnings are not one in the same. Though they more than likely should closely mirror each other.

Distributions can be in excess of Retained Earnings and Retained Earnings can be less than 0, whether they should be from the perspective of how one runs their business is a different matter. If this was not the case then, the balance sheet for tax purposes and book purposes would be different.

Is this just an instance of accounting standards and tax law clashing and ProSeries is erring on the side of safety and preventing the balance sheet from showing a debit balance from distributions due to the limitation imposed on AAA?

[sjrcpa]

ProSeries is correct. And your understanding of distributions and retained earnings is also correct. I'm done here.

[TNR]

ProSeries does not handle this situation well. I used PrSystem FX at my previous firm and that software would do a reconciliation between AAA and RE that automatically handled distributions in excess of AAA (not in excess of basis). The following year if you had an increase in AAA, it would automatically decrease the timing difference. I've been overriding the distributions on the M-2/Retained Earnings worksheet in ProSeries for years, both in the years that the distributions exceed AAA and again in the years when net income exceeds current distributions to reverse the timing difference.

[Pgrady09]

Have you found any other solution to correct this?  It is very frustrating that proseries limits distributions to AAA (when there is sufficient stock basis). 

[Pgrady09]

Distributions are not limited to AAA. They are limited to stock basis in order to be tax free.  But proseries is limiting them to AAA without an override. 

[Pgrady09]

It is my understanding that distributions cannot reduce AAA to below zero, but they are not limited by AAA. AAA is only relevant to determine if a distribution is taxable as a dividend in the case the entity was formerly a C Corp and had accumulated E&P.

in the case that it has always been an S Corp the only relevant measure to determine the if the distribution is taxable is stock basis. 

[sjrcpa]

Correct. But you can't make AAA negative on the 1120S by distributions.

No one said distributions are limited by AAA. They can be anything the shareholders want. But there may be adverse tax consequences if they take too much..

[trvw181]

No, ProSeries has not fixed this issue. 

When I have distributions in excess of AAA, I still use overrides on the M-2/Retained Earnings Worksheet to reconcile RE to AAA. I also keep an Excel spreadsheet to help me keep track of the cumulative timing differences from one year to the next to make sure AAA is correct when the distributions in excess of AAA are restored.