S Corporations with Prior C Corporation E&P

Because of the advantageous treatment afforded S
corporation distributions, there is tremendous motivation for a C corporation
with substantial E&P to convert to an S corporation prior to making a
distribution, so that the distribution will be treated as a tax-free return of
shareholder stock basis rather than a taxable dividend.

Recognizing this potential loophole, the statute
provides that a C corporation’s accumulated E&P survives the S election and
remains with the S corporation. Should this E&P be subsequently distributed
— even during an S corporation year — the distribution will be taxed as a
dividend to the recipient shareholders as if it had been made while the business
was a C corporation.

Until December 31, 2012, dividends received by
non-corporate shareholders from domestic and qualified foreign corporations are
taxed at a maximum 15-percent rate. (This expiration date was extended for two
years by the 2010 Tax Relief Act.) Accordingly, S corporations with C
corporation E&P may wish to consider making an actual or a deemed dividend
distribution of this E&P, which would be taxed to its shareholders at the
present maximum 15-percent dividend rate.