Discover more from Tom Talks Taxes
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.
Read This Newsletter on the Substack App
I have exciting news to share: You can now read Tom Talks Taxes in the new Substack app for iPhone.
With the app, you’ll have a dedicated Inbox for my Substack and any others you subscribe to. New posts will never get lost in your email filters, or stuck in spam. Longer posts will never cut-off by your email app. Comments and rich media will all work seamlessly. Overall, it’s a big upgrade to the reading experience.
The Substack app is currently available for iOS. If you don’t have an Apple device, you can join the Android waitlist here.
Share Your Thoughts!
If you are a paid subscriber, use the comments section below to discuss and ask questions about the S corporation AAA.
Join the Tom Talks Taxes Community
Click below to become either a free or paid subscriber. Paid subscribers help keep this newsletter going and receive these benefits:
Bonus editions, including “Ask Tom Anything,” where I’ll answer your technical or practice management related questions, and “Tom’s Reading List,” where I’ll list articles I like and my thoughts on them.
The ability to comment on posts and interact with each other on posts. I’ll interact on the posts as well!
An invitation to the annual “Tom’s Pre-Season Tax Talk” in January to discuss what you need to know as a tax professional for the upcoming tax season.
Additional content as the newsletter grows and expands.