                 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
                                  ___________
Before BOWMAN and MURPHY, Circuit Judges, and KYLE,1 District
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 Court2 upholding the Commissioner’s
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),3 until October 31, 1988.          The
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




     1
      The Honorable Richard H. Kyle, United States District Judge
for the District of Minnesota, sitting by designation.
     2
      The Honorable David Laro, Judge, United States Tax Court.
     3
      Unless otherwise indicated, all references to the Internal
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-
construction contracts using the completed contract method of accounting.4
While




        4
      Under the completed contract method, the total income from
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-
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




     5
      The percentage of completion method of accounting requires
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-
corporate stock--whether or not the funds are actually distributed to the
shareholders.6        Instead of maintaining an earnings and profits account, an
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.7         See I.R.C. § 1368(c)(1).          The parties agreed in
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.8                As a result of the disparity
between the Company’s




        6
      For S corporations with no carried-over earnings and
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).
        7
      The accumulated adjustments account is a corporate level
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).
        8
      As a C corporation, the Company computed its taxable income
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-
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 carried-
over 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




      9
      An S corporation will have an earnings and profits account
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-
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




                                          -7-
divisives,10 see I.R.C. § 1371(c)(2); and (3) tax paid by an S corporation
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




     10
      The term “divisives” has not been defined under the
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-
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




                                        -9-
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




                                     -10-
