Tom Talks Taxes - March 11, 2022
The S corporation accumulated adjustments account (AAA) explained
Editor’s note: This article was modified post-publication to remove capital stock references.
The accumulated adjustments account (AAA) is a special S corporation account that exists only for tax purposes. It is not apportioned among shareholders.
Its sole purpose is to differentiate between undistributed accumulated net income during the S corporation period versus accumulated earnings and profits (AE&P) from a prior C corporation period. If a S corporation has AE&P from a prior C corporation period, then distributions are first treated as S corporation distributions (tax-free to the extent of stock basis) to the extent of the AAA balance. Once the AAA is reduced to $0, distributions then come from AE&P as taxable dividends to the shareholder.
A S corporation with no AE&P is not required to maintain the AAA; however, it is a best practice, in case the AAA is later needed. One example of this would be a merger with another S corporation that has AE&P.
On the first day of the first tax year of the S corporation, the account is $0. It is then adjusted in the following order per Treas. Reg. §1.1368-2(a):
Increased by separately and non-separately stated items of income, except tax-exempt income, then
Decreased by separately and non-separately stated items of deduction and loss, except expenses related to tax-exempt income and federal taxes attributed to a C corporation period, then
Decreased by non-AE&P distributions.
Separately and non-separately stated items of deduction and loss can reduce the AAA below $0; however, distributions cannot reduce the AAA below $0.
Schedule M-2 on Form 1120S tracks the AAA as well as these other accounts:
Pre-1983 previously taxed earnings and profits (PTEP),
C corporation AE&P, and
Other adjustments account (OAA), which consists of tax-exempt income, expenses related to tax-exempt income, and federal taxes attributed to a C corporation period.
In general, S corporation distributions come from the above accounts in the following order (unless an election permits a different ordering):
C corporation AE&P, then
Other shareholder equity accounts.
It is important to note that the S corporation stock basis, the AAA balance, and book retained earnings are different accounts representing different attributes; therefore, they generally will not be the same amount.
Here is an example of a tax year 2020 S corporation that started operations in 2020 that also received a Paycheck Protection Program (PPP) loan:
Some notes about the above computations:
The $25,000 capital contribution is a tax-deferred §351 exchange.
The S corporation shows a $20,000 loss for tax purposes, but only a $5,000 loss for book purposes, with the difference being the $15,000 PPP loan forgiveness, which is a Schedule M-1 book-to-tax adjustment.
The PPP loan forgiveness and related expenses are OAA items; therefore, $15,000 must be added to AAA to reflect the expenses moved to OAA. These adjustments are outlined in the 2021 Form 1120S instructions.
The $2,000 distribution can neither reduce AAA nor OAA as those accounts would be reduced below $0.
If you’d like to learn more about S corporations, I am teaching a S corporation webinar series in May 2022:
S Corps - Formation and Return Preparation - May 5, 2022
S Corps - Basis, Disposition, and Planning - May 19, 2022
These live webinars are also available as part of the Compass Tax Educators 2022 webinar season all-access pass! Get over 30 CE/CPE of live webinar education at a bundled rate plus access to my recorded Tax Season Support Sessions, which are going on now. Click here for additional information and to purchase.
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