United States Court of Appeals

FOR THE EIGHTH CIRCUIT

___________

No. 96-2154

___________

John P. Broadaway; Teena G. *

Broadaway, *

*

Appellants, *

* Appeals from the 

v. * United States Tax Court

*

Commissioner of Internal *

Revenue, *

*

Appellee. *

___________

No. 96-2155

___________

John M. Cameron; Caroline D. *

Cameron, *

*

Appellants, *

*

v. *

*

Commissioner of Internal *

Revenue, *

*

Appellee. *

___________

 Submitted: January 16, 1997

 Filed: April 16, 1997

___________
The Honorable Richard H. Kyle, United States District Judge 1

for the District of Minnesota, sitting by designation.

The Honorable David Laro, Judge, United States Tax Court. 2

Unless otherwise indicated, all references to the Internal 3

Revenue Code are to the 1988 edition of Title 26 of the United

States Code, as amended effective through December 31, 1989,

which is applicable to the tax years in dispute. We have

disregarded amendments effective after December 31, 1989.

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Before BOWMAN and MURPHY, Circuit Judges, and KYLE, District 1

Judge.

BOWMAN, Circuit Judge.

John P. and Teena G. Broadaway and John M. and Caroline D. Cameron

appeal from a final decision of the Tax Court upholding the Commissioner’s 2

assessment of tax deficiencies based on dividend distributions from Cameron

Construction Company made to the Broadaways and the Camerons during the

1989 tax year. We affirm.

I.

This case was submitted to the Tax Court on the basis of a fully

stipulated record that provides the following salient facts. The

Broadaways and the Camerons are shareholders in Cameron Construction

Company (the Company) which operated and paid taxes as a Subchapter C

corporation, see I.R.C. §§ 301-385 (1988), until October 31, 1988. The

3

Company has at all times been engaged in the road and highway construction

business and has at all times calculated its taxable income from long-term
Under the completed contract method, the total income from 4

a contract is recognized, and the total costs of performance are

deducted, in the taxable year in which the contract is completed. 

See Treas. Reg. § 1.451-3(d)(1) (as amended in 1985). While

income from most long-term construction contracts must be

reported using the percentage of completion method, see I.R.C. §

460(a), (b) (Supp. I 1989), the Code provides an exception for

construction contracts estimated to be completed within two

years. This exception applies only to taxpayers whose average

annual gross receipts for the three preceding taxable years do

not exceed ten million dollars. See I.R.C. 

§ 460(e)(1)(B).

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construction contracts using the completed contract method of accounting.4

While 
The percentage of completion method of accounting requires 5

that the Company account for income from long-term contracts each

taxable year as the work progresses. The amount of income

accrued for each taxable year is that proportion of the expected

total contract income that the amount of costs incurred through

the end of the taxable year bears to the total expected costs,

reduced by cumulative amounts of contract income that were

reported for previous years. See I.R.C. § 460(b) (Supp. I 1989);

Berger Eng’g Co. v. Commissioner, 20 T.C.M. (CCH) 1518, 1522

(1961) (“The object of the percentage of completion method is to

provide a means of reporting income in a steady flow as work on

the contract advances toward completion.”).

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operating as a C corporation, the Company was required to maintain an

earnings and profits account from which distributions to Company

shareholders--including the Broadaways and the Camerons--would be taxed as

dividends. See I.R.C. § 316(a). For purposes of determining earnings and

profits, the parties agree that the Company, even though it calculated its

taxable income under the completed contract method of accounting, was

required under I.R.C. § 312(n)(6) to account for its long-term construction

contracts under the percentage of completion method of accounting. 

5

The dispute in this case flows from the Company’s election pursuant

to I.R.C. § 1362(a) to switch from Subchapter C status and to be taxed as

a Subchapter S corporation, see I.R.C. §§ 1361-1379, effective upon the

close of the Company’s taxable year ended October 31, 1988. Under

Subchapter S, the Company does not pay corporate-level income taxes.

Instead, the Company’s income is taxed directly to its shareholders based

on their ownership of 
For S corporations with no carried-over earnings and 6

profits, any distribution to a shareholder is treated first as a

nontaxable return of capital to the extent of the shareholder’s

stock basis, and second, to the extent the distribution exceeds

the shareholder’s stock basis, as a capital gain. See I.R.C.

§ 1368(b).

The accumulated adjustments account is a corporate level 7

account that begins with a zero balance and is adjusted to

reflect the net earnings of the corporation. The account is

adjusted upward by the amount of the corporation’s income and is

decreased by the amount of any losses and by return-of-capital

distributions to shareholders. See I.R.C. § 1368(e)(1)(A). 

As a C corporation, the Company computed its taxable income 8

based on a fiscal year ending October 31. As an S corporation,

the Company was required to compute its taxable income on a

calendar year basis. See I.R.C. § 1378. The Company’s first tax

year as an S corporation was a short year beginning on November

1, 1988 and ending on December 31, 1988. See id.

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corporate stock--whether or not the funds are actually distributed to the

shareholders. Instead of maintaining an earnings and profits account, an 6

S corporation monitors its undistributed corporate earnings, those that

have been taxed to the shareholders but not yet distributed, using an

accumulated adjustments account from which distributions to shareholders

are generally tax-free. See I.R.C. § 1368(c)(1). The parties agreed in 7

their jointly filed stipulation of facts that the Company remained

obligated to account for its earnings and profits in 1989 under the

percentage of completion method of accounting, despite the Company’s

election to switch to Subchapter S status. A number of long-term

construction contracts begun while the Company was a C corporation were

completed after it became an S corporation. 

From November 1, 1988 through December 31, 1989, the Company incurred

costs on long-term contracts begun while it was a C corporation that

exceeded the reasonable estimates the Company had used under the percentage

of completion method of accounting to calculate earnings and profits for

its last taxable year as a C corporation. As a result of the disparity

8

between the Company’s 
An S corporation will have an earnings and profits account 9

derived only from one or more of the following sources: (1) its

prior existence as a C corporation, (2) earnings prior to 1983,

when earnings and profits concepts were still applicable to S

corporations; or (3) the acquisition of another C corporation

with an earnings and profits account balance. See Boris I.

Bittker & James J. Eustice, Federal Income Taxation of

Corporations and Shareholders ¶ 6.08[1] (6th ed. 1994).

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reasonable cost estimates and its actual costs to complete these long-term

contracts, the taxpayers argue that the accumulated earnings and profits

account carried over from the Company’s existence as a C corporation9

reflects an artificially high balance. This artificially high earnings and

profits balance, they contend, ultimately resulted in the Commissioner’s

improper characterization of a $300,000 distribution to the taxpayers as

a taxable dividend to the extent of the balance in the Company’s carriedover earnings and profits account. The parties stipulate that the balance

in the Company’s earnings and profits account as of October 31, 1988--the

end of the Company’s last year as a C corporation--was $251,650.13. The

taxpayers argue that the Company should be allowed to adjust this amount

by retroactively revising the reasonable cost estimates that it used to

calculate earnings and profits on long-term contracts in progress on

October 31, 1988 to reflect the actual, higher costs eventually incurred

during its 1989 tax year. 

The Tax Court rejected the taxpayers’ arguments and concluded that

for purposes of calculating the taxable amount of the dividend

distribution, the Company’s earnings and profits for its last year as a C

corporation must be computed on the basis of estimates of the total costs

of its long-term contracts made on October 31, 1988 
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without retroactive adjustment to reflect actual, higher costs incurred

during the 1989 tax year. Accordingly, the court upheld the tax

deficiencies assessed by the Commissioner. The taxpayers appeal the Tax

Court’s decision. 

II.

We have jurisdiction over appeals from final decisions of the Tax

Court, see I.R.C. § 7482(a) (1994), and we review the legal conclusions of

the Tax Court de novo. See Chakales v. Commissioner, 79 F.3d 726, 728 (8th

Cir.), cert. denied, 117 S. Ct. 85 (1996). The taxpayers make several

arguments to support their claim that the Tax Court erroneously concluded

that the Company could not adjust its carried-over earnings and profits

account to reflect events occurring after the Company became an S

corporation. We agree with the Tax Court that the Internal Revenue Code

does not permit such adjustments to be made. 

Under I.R.C. § 1371(c)(1), with limited exceptions, “no adjustment

shall be made to the earnings and profits of an S corporation.” This

provision effectively suspends activity related to the earnings and profits

account, and the account balance carried over to an S corporation from its

previous existence as a C corporation remains unchanged from year to year

unless one of a limited number of specific events occur that warrant

adjustment to the account. The carried-over earnings and profits account

can be decreased under the Code only to reflect (1) dividend distributions

to shareholders to the extent made out of accumulated earnings and profits,

see I.R.C. §§ 1371(c)(3), 1368(c)(2); (2) distributions resulting from

redemptions, liquidations, reorganizations, or 
The term “divisives” has not been defined under the 10

Internal Revenue Code. It presumably refers to corporate

separations such as spin-offs, split-offs, and split-ups. See

Boris I. Bittker and James J. Eustice, Federal Income Taxation of

Corporations and Shareholders ¶ 6.08 (6th ed. 1994).

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divisives, see I.R.C. § 1371(c)(2); and (3) tax paid by an S corporation 10

as a result of recapture of investment credit taken when the corporation

was a C corporation, see I.R.C. § 1371(d)(3). In addition, the earnings

and profits account can be increased if the S corporation acquires another

corporation with an earnings and profits account balance. See I.R.C. §

381(c)(2) (1988 & Supp. I 1989).

None of the triggering events that would permit the Company to reduce

its earnings and profits account balance occurred from October 31, 1988

through December 31, 1989. As a result, the Company’s October 31, 1988

earnings and profits account balance of $251,650.13 remained unchanged

until the Company depleted the account by making the $300,000 dividend

distribution to the taxpayers in 1989. See I.R.C. §§ 1371(c)(3);

1368(c)(2).

The taxpayers argue that the language of I.R.C. § 1371(c)(2) supports

their position. This subsection provides that “[i]n the case of any

transaction involving the application of subchapter C to any S corporation,

proper adjustment to any accumulated earnings and profits of the

corporation shall be made.” However, the title of this subsection,

“Adjustments for redemptions, liquidations, reorganizations, divisives,

etc.,” belies this argument and specifically limits this exception to the

enumerated situations where an S corporation undergoes fundamental changes

that would likely require adjustments to an accumulated earnings and

profits account. The plain language of § 1371(c)(2), coupled with the

general rule of § 1371(c)(1), precludes adjustments to the 
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accumulated earnings and profits account of an S corporation except in the

specific instances enumerated. An adjustment to the accumulated earnings

and profits account of an S corporation to rectify ultimately inaccurate

estimates of the costs necessary to complete long-term construction

contracts is not the sort of “transaction involving the application of

subchapter C” to which I.R.C. § 1371(c)(2) applies. 

The taxpayers argue that compliance with I.R.C. § 312(n)(6) (1988 &

Supp. I 1989), which requires computation of the Company’s earnings and

profits using the percentage of completion method of accounting,

necessitates adjustment to the earnings and profits account to reflect the

reasonable cost estimates to complete long-term contracts as yet

uncompleted at the close of tax year 1989. This argument is without merit.

Once the Company elected to switch from Subchapter C to Subchapter S

treatment, the Company was required to track its earnings using an

accumulated adjustments account rather than the earnings and profits

account utilized while the Company was a C corporation. See I.R.C. §

1368(e)(1)(A). When the Company incurred costs during 1989 that exceeded

its reasonable estimates of these costs as of October 31, 1988, these

additional costs were attributable to the Company’s operations as an S

corporation and, by virtue of I.R.C. § 1371(c)(1), cannot be used to adjust

the Company’s carried-over earnings and profits account. 

The taxpayers further argue that, as a matter of fairness, the

Company should be allowed to revise retroactively the cost estimates used

on October 31, 1988 to calculate earnings and profits for the Company’s

final year as a C corporation to reflect more accurately the higher costs

actually incurred during 1989 to complete the contracts. This argument is

not unattractive, but given the terms of the governing Code provisions,

which we already have discussed at some length, it cannot prevail. Once

the 
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Company elected to be taxed under Subchapter S, the taxpayers thereafter

were prevented from taking advantage of the adjustments to earnings and

profits normally available under Subchapter C. Consequently, there can be

no reduction in the taxable portion of the dividend distribution made in

1989. The earnings and profits account balance calculated on October 31,

1988, the close of the Company’s last year as a C corporation, was based

on contemporaneous, reasonable estimates of costs to complete long-term

contracts that cannot be recomputed retroactively after the Company has

become an S corporation to account for unforeseen increases in actual

costs. This no-retroactive-recomputation rule is plainly established in

the applicable statutory provisions, and represents a burden the taxpayers

necessarily assumed in order to gain the benefits of being taxed as an S

corporation instead of as a C corporation.

V.

For the foregoing reasons, the decision of the Tax Court is affirmed.

A true copy.

Attest:

 CLERK, U. S. COURT OF APPEALS, EIGHTH CIRCUIT