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The second issue is how the computation of Company's
earnings and profits was affected by its election under
subchapter S effective November 1, 1988. Absent the election,
Company would have continued to accrue income from its long-term
contracts for earnings and profits purposes on the basis of year-
end estimates of total contract costs. The earnings and profits
available for distribution to petitioners in 1989 would have been
determined on the basis of estimated costs to complete contracts
in progress on the last day of Company's 1989 taxable year. The
result is not the same under subchapter S.
The basic purpose of the earnings and profits account is to
keep track of the amount of corporate funds that have not yet
been taxed to shareholders. When a corporation elects
pass-through treatment under subchapter S, its net income earned
as an S corporation is taxed currently to the shareholders and
thereafter is generally distributed tax-free. Secs. 1366(a),
1368(b)(1), (c)(1). In accordance with the much more limited
role of earnings and profits in a pass-through system of
taxation, section 1371 provides, for taxable years after 1982,
that the accumulated earnings and profits that an S corporation
carries over from pre-election years when it was a C corporation,
generally are not adjusted for the taxable years during which the
election is in effect. Sec. 1371(c)(1); S. Rept 97-640, at 20
(1982), 1982-2 C.B. 718, 720 (accompanying Subchapter S Revision
Act of 1982, Pub. L. 97-354, 96 Stat. 1669). While exceptions
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