# 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. -2- 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. Camero n appeal from a final decision of the Tax Court upholding the Co mmissioner’s 2 assessment of tax deficiencies based on dividend distributions from Camero n Con structionCompany made to the Broadaways and the Camerons during th e 1989 tax year. We affirm.

I.

This ca se was submitted to the Tax Court on the basis of a full y stipul ated record that provides the following salient facts. Th e Br oadaways and the Camerons are shareholders in Cameron Constructio n Company (t he Company) which operated and paid taxes as a Subchapter C corpor ation, see I.R.C. §§ 301-385 (1988), until October 31, 1988. Th e 3 Company has at all times been engaged in the roa d and highway construction business and has at all times calculated its tax able 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). -3- construction contracts using the comp leted 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.”). -4- operating as a C corporation, the Company was required to maintain a n earnin gs and profits account from which distributions to Compan y shareholders--including the Broadaways and the C amerons--would be taxed as dividends. See I.R.C. § 316(a). For purposes o f determining earnings and profits, the parties agree that the Company, eve n though it calculated its taxabl e income under the completed contract method of accounting, wa s required under I.R.C. § 312(n)(6) to account for its long-term constructio n 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) t o switch from Subchapter C status and to be taxed as
a S ubchapter S corporation, see I.R.C. §§ 1361-1379, effective upon th e clo se of the Company’s taxable year ended October 31, 1988. Unde r Subcha pter 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. -5- corporate stock--whet her or not the funds are actually distributed to the shareholders. Instead of maintaini ng an earnings and profits account, an 6 S corporation monitors its undistributed corporate earnings, those tha t have been taxed to the shareholders but not yet distributed, using a n accumulated adjustments account from which distributions to shareholders are genera lly tax-free. See I.R.C. § 1368(c)(1). The parties agreed in 7 their jointly filed stipulation of facts that the Company remaine d obligated to account for its earnings and profits in 1989 under th e pe rcentage of completion method of accounting, despite the Company’ s electionto switch to Subchapter S status. A number of long-ter m con structioncontracts begun while the Company was a C corporation wer e completed after it became an S corporation.
From November 1, 1988 through December 31, 1989, the Company in curred cost s on long-term contracts begun while it was a C corporation tha t exceeded the reasonable estimates the Company had used under the percentag e of completion method of accounting to calculate earnings and profits for its last taxable year as a C corporation. As a result of the disparit y 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). -6- reasonable cost estimates and its actual costs t o 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 corporation 9 reflects an artificially high balance. This artificially high earnings an d 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 earn ings 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 t o calcul ate earnings and profits on long-term contracts in progress o n 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 tha t for pu rposes of calculating the taxable amount of the dividen d distribution, the Com pany’s earnings and profits for its last year as a C corporation must be c omputed on the basis of estimates of the total costs of its long-term contracts made on October 31, 1988

### -7-

without retroactive adjustment to reflect actual, higher costs incurre d du ring the 1989 tax year. Accordingly, the court upheld the ta x deficiencies assessed by the Commissioner. The taxpayers appeal the Tax Court’s decision.

II.

We ha ve jurisdiction over appeals from final decisions of the Ta x Court, see I.R.C. § 7482(a) (1994), and we revie w the legal conclusions of the Tax Court de novo. See Chakales v. Commissioner , 79 F.3d 726, 728 (8t h Cir.), cert. denied , 117 S. Ct. 85 (1996). The taxpayers make severa l arguments to support their claim that the Tax Court erroneously concluded tha t the Company could not adjust its carried-over earnings and profit s accou nt 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.

Un der I.R.C. § 1371(c)(1), with limited exceptions, “no adjustmen t shall be made to the earnings and profits of an S corporation.” Thi s provision effectively suspends activity related to the earnings and profit s 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 unle ss one of a limited number of specific events occur that warran t adjustment to the acc ount. 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 fro m 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). -8- 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 co rporation acquires another corporationwith 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, 198 8 through D ecember 31, 1989. As a result, the Company’s October 31, 198 8
earn ings and profits account balance of $251,650.13 remained unchange d until the Company depleted the account by making the $300,000 dividen d distr ibutionto 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 thei r position. This subsection provides that “[i]n the case of an y transaction involving the application of subchapter C to any S corporation , proper adjustment to any accumulated earnings and profits of th e corporation shall be made.” However, the title of this subsection ,

“ Ad justments for redemptions, liquidations, reorganizations, divisives , etc. ,” belies this ar gument and specifically limits this exception to the enumerated situations where an S corporation und ergoes fundamental changes that w ould likely require adjustments to an accumulated earnings an d profi ts account. The plain language of § 1371(c)(2), coupled with th e general rule of § 1371(c)(1), precludes adjustments to the

### -9-

accumulated earnings and profits account of an S corporation except in the specific instances en umerated. An adjustment to the accumulated earnings and profits account of an S corporation to rectify ultimately inaccurate estim ates of the costs necessary to complete long-term constructio n contracts is not the sort of “transaction involving the application o f subchapter C” to which I.R.C. § 1371(c)(2) applies.
The taxpa yers argue that compliance with I.R.C. § 312(n)(6) (1988 & Sup p. I 1989), which requires computation of the Company’s earnings an d profit s using the percentage of completion method of accounting , necessitates adjustment to the earnings and prof its account to reflect the
reason able cost estimates to complete long-term contracts as ye t 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 treatmen t, the Company was required to track its earnings using a n ac cumulated adjustments account rather than the earnings and profit s acc ount 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 reason able estimates of these costs as of October 31, 1988, thes e 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 adjus t the Company’s carried-over earnings and profits account. The ta xpayers further argue that, as a matter of fairness, th e Company should be all owed to revise retroactively the cost estimates used
onOctober 31, 1988 to calculate earnings and profits for the Company’ s final year as a C cor poration to reflect more accurately the higher costs actually incurred during 1989 to complete the co ntracts. This argument is not unattractive, but given the terms of the governing Code provisions , whichwe already have discussed at some length, it cannot prevail. Once the

### -10-

Companyelected to be taxed under Subchapter S, the taxpayers thereafter
wer e prevented from taking advantage of the adjustments to earnings an d 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 a nd 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-ter m contra cts that cannot be recomputed retroactively after the Company ha s become an S corporation to account for unforeseen increases in actua l costs. This no-retroactive-recomputation rule is plainly established in the applicable statutory provisions, and represe nts a burden the taxpayers necessarilyassumed 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 aff irmed.

A true copy.

Attest:

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