What happens to retained earnings after conversion from c corp to s corp.
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Here comes OAA
Retained earnings continues to ebb and flow as usual for financial purposes, but something dramatic happens for tax purposes.
At the point of such a conversion, the existing retained earnings have never been distributed as dividends, and the resulting double-taxation has not occurred. That's OK - it doesn't have to. However, at that point, the retained earnings must be sequestered. There is a section on the 1120-S called "Accumulated Adjustment Account" and a portion of this is "Other" Adjustment Account which contains these sequestered earnings. So long as the sequestered earnings are never invaded, they never become taxable as dividends, but they continue to be reported, always lurking in the shadows in this "Other Adjustment Account."
If these "old" earnings are ever invaded, they become taxable at dividends. The best illustration is an example: Assume C corp converts to an S corp and at the time the existing Retained Earnings are $100,000. They are reported in the OAA unless something happens.
Assume all the "new" earnings since the conversion are exhausted, and one year the corporation earns $70,000 but distributes $90,000. The sequestered "old" earnings are now invaded to the extent of $20,000. At the end of that year, the recipients must report $20,000 as dividends, and the "Other Adjustment Account" is reduced to $80,000.
If the corporation chooses to do so, they may invade the earnings FIRST and be done with it forever instead of having to carry OAA going forward. If this happens, all the earnings are taxable as dividends upon distribution. After the "old" retained earnings are extinguished, the S corp may go forward with no dividend treatment. If you have the Tax Book, check out page 10 of the S corp chapter in the small business section.
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