As you know, S corporations are taxed like partnerships. Such that their income deductions and credits flow through to shareholders annually when earned, rather than when distributed. However, it is still incredibly common for s corporations to distribute cash and other property to shareholders. In this lesson, you will learn about the special rules S corporations face when accounting for both operating and liquidating distributions. Each type of distribution is examined in a separate part. After learning the concepts, you will apply them to Sunchaser Shakery. Recall from taxation of business entities one, their earnings and profits or E&P as is known in practice, refers to a C corporation's ability to pay dividends to its shareholders, without encroaching on its capital. Although the term has been used in tax law since at least 1916, Congress is yet to provide a precise definition in the code. Thus, many experts view E&P as a concept similar to that of retained earnings in financial accounting, but computed using tax law instead of generally accepted accounting principles. In other words, E&P captures a C corporation accumulated prior and current capital. Notice that it does not refer to taxable income, net profit or any other performance metric. It is purely a tax concept. E&P is important because it defines the tax treatment of C corporation distributions. Our current topic adventures for sub chapter S corporations. The tax effects of operating distributions for S corporations shareholders, depend on whether the S Corporation formerly existed as a C corporation. If so, The primary tax concern is whether the S corporation possesses accumulated E&P at the time of the distribution, from its prior C corporation life. Let's first examine the case where an S corporation has no prior C corporation accumulated E&P. An S corporation will have no prior C corporation accumulated E&P, if it is operated as an S corporation since inception. Keep in mind, that it is also possible for a C corporation to convert to a S corporation without any accumulated E&P. In either case, as long as no C corporation accumulated E&P exist at the time of a distribution, the tax treatment mimics the partnership rules. Specifically, as corporation distributions to shareholders are nontaxable to the extent of the shareholder stock bases, which is measured after applying income or loss allocations for the current tax year. If a distribution exceeds a shareholder stock basis, the shareholder recognizes a capital gain to the extent of the excess distribution amount. Now let's consider the case where an S Corporation has Prior C corporation accumulated E&P. The rules for this situation are more complex because they prevent shareholders from simply avoiding the double taxation of C corporation dividends by electing Sub chapter S status, and distributing any accumulated E&P tax free. Along these lines, S corporations with prior C corporation accumulated E&P must maintain and accumulated adjustments account or AAA. To determine the tax treatment of S corporation distributions, the AAA reflects the cumulative income or losses for the period the corporation has operated as an S corporation, not a C corporation. The AAA is computed as follows; beginning balance plus separately stated income and gain items; other than tax exempt entries, plus ordinary income, less separately stated deduction and loss items, less ordinary loss, less non-deductible expenses that are not capital expenditures, less any distributions out of AAA. Unlike stock basis, the AAA can be negative. However, a distribution out of the AAA cannot cause the AAA to go below zero or become more negative. Also note that AAA is a corporate level account, not a shareholder level account. Accordingly, S corporation distributions are considered paid from three sources in a specific order. One; the AAA to the extent of a positive balance, two; any C corporation accumulated E&P, and three: the shareholder stock bases. S Corporation distributions from the first source, the AAA, are treated like distributions. When the S corporation does not have prior C corporation accumulated E&P. In other words, these distributions are nontaxable to the extent of the shareholder stock bases. However, when a distribution is made from the second source, C corporation accumulated E&P, it is taxable as a dividend to shareholders. This tax treatment is the main reason for these rules. That is to ensure that C corporation dividends do not escape double taxation after a Sub chapter S election has been made. After C corporation accumulated E&P is fully distributed, distributions are once again nontaxable to the extent of the shareholder stock bases. Finally, once the shareholders basis is reduced to zero, any remaining distributions trigger capital gains treatment. Note that it is possible for an S corporation to elect to have a distribution treated as if it were made from accumulated E&P, rather than from the AAA. This bypass election is used to eliminate a small accumulated E&P ballots. In sum, the tax treatment of an operating distribution from an S corporation depends on the S corporation's history. If no prior C corporation accumulated the E&P exists, then distributions are nontaxable to the extent of the shareholders stock bases. Capital gain results for any excess amount. If however, prior C corporation accumulated E&P does exist, the triple A in the ordering rules define the tax consequences. Ultimately, these rules aim to ensure that C corporation dividends do not escape double taxation. There is one final tax issue for operating distributions worth discussing. What happens if an S corporation distributes appreciated property to shareholders? Unlike partnerships, but similar to C corporations, S corporations recognize gain as though they sold appreciated distributed property at fair market value prior to the distribution. Shareholders receiving the distribution recognize their share of the dimmed gain and increase stock basis accordingly. For purposes of determining whether the distribution itself is taxable to the shareholder, the amount of the property distribution is the fair market value of the property received, less any debt assumed by the shareholder. Shareholders take a fair market value basis in the appreciated property distributed. Finally, note that S corporations do not recognize losses on distributions of depreciated value property.