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been distributed to the shareholders. The portion of a
distribution to a shareholder that does not exceed the AAA is a
nontaxable return of capital to the extent of the shareholder's
basis in S corporation stock. Sec. 1368(b) and (c)(1). The AAA
is increased for the S corporation's income and decreased for the
S corporation's losses and deductions and for nontaxable
distributions to shareholders. See secs. 1367 and 1368.
Distributions in excess of the AAA balance are treated in the
same manner as subchapter C dividend distributions. Accordingly,
to the extent of an S corporation's accumulated earnings and
profits from a prior C corporation, such shareholder
distributions are taxable as ordinary income.
In that regard, the controversy here focuses on the order in
which reductions are to be made to the AAA. If petitioners are
correct, then no part of the 1990 distributions to petitioner
would result in taxable ordinary income. If, however, respondent
is correct, a distribution in excess of the AAA would result in
taxable income and an income tax deficiency for petitioners.
At the beginning of 1990, MTI had an AAA balance of
$349,256. During 1990, MTI had an ordinary loss of $217,341 and
made distributions to petitioner of $323,399, both of which call
for negative adjustments to the AAA. Petitioners argue that in
determining the tax consequences of the distributions, the
distributions should be applied in reduction of the AAA balance
as of the beginning of 1990 (i.e., prior to the $217,341
reduction attributable to the annual operating loss). Under
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