Discover Accumulated Adjustment Accounts for S Corporations

In this article, we’ll outline everything you need to know about the Accumulated Adjustments Account on your S Corporation tax return, helping you identify what’s included and its importance to make more informed decisions in your company.  

The Accumulated Adjustments Account (AAA) tracks your S Corporation's gross income, expenses, and distributions. This account is found on Form 1120-S on Schedule M-2. The goal of the Accumulated Adjustment account is to determine if you took any taxable distributions during the year.  

One of the reasons S Corporations are required to report the Accumulated Adjustments Account is because there is a difference between tax and book basis. Basis is the money you have into the company. Book basis includes net income or loss per books plus any distributions and past earnings. Tax basis adjusts for tax-only items, like non-deductible expenses and tax-exempt income, creating discrepancies from book basis.  

This means that on your tax return, the amount reported on the balance sheet in retained earnings will not match the ending balance in your M-2 account. However, your M-2 ending account balance should match the ending capital account for each shareholder on Form 7203 (S Corporation Shareholder Stock and Debt Basis Limitations).  

As we start to explain the components of Schedule M-2 and the calculation of the Accumulated Adjustments Account in more detail, reference the following visual. This is a blank Schedule M-2 from the 2023 1120-S tax return.  

The Accumulated Adjustments Account is one of four columns found on Schedule M-2. Let’s briefly cover each column and the transactions they hold:

• Accumulated Adjustments Account – This column holds current and past S Corporation earnings from 1983 onward.
• Shareholders’ Undistributed Taxable Income Previously Taxed – This account holds S Corporation earnings prior to 1982.
• Accumulated Earnings and Profit – This section holds income earned and taxed at the C Corporation level before switching to an S Corporation.
• Other Adjustments Account – This column will hold miscellaneous adjustments, like tax-exempt income. When companies receive Paycheck Protection Loan forgiveness, this is the account that will hold the amount. However, the IRS subsequently allowed S Corporations to move the amount to the AAA to increase basis.

If your company was never a C Corporation and formed after 1983, you will not have any items in the second or third columns. The use of the Other Adjustments Account is also very limited, meaning most or all of your transactions will be found in the Accumulated Adjustments Account.

The Accumulated Adjustment Account holds a few different items. The first year your S Corporation begins, your AAA will be zero. Then, as you incur transactions, you will either increase or decrease your AAA. Here’s the breakdown of how the Accumulated Adjustments Account is calculated by line item:

1. Balance at the beginning of tax year – This is your beginning balance that is carried over from the prior year. If your business just started, the balance will be zero.
2. Ordinary income from page 1 – Your ordinary income excludes items found on Schedule K, such as Section 179, interest income, dividend income, R&D addbacks, charitable contributions, and capital gains.
3. Other additions – Other income items found on Schedule K, except tax-exempt income, will be added on this line.
4. Ordinary business loss – If your return has a loss on the first page, it will be subtracted here.
5. Other reductions – Non-deductible expenses, depletion deductions, Section 179, and charitable contributions will be deducted here.
6. Distributions – Any distributions taken during the year will be entered here.
7. Balance at end of tax year – This will be your balance at the end of the tax year after taking into account all of the above items.

It’s important to note that contributions aren’t included on Schedule M-2. As an S Corporation, your contributions to the company are considered Additional Paid-In Capital and will be found on Schedule L as a separate line item.

The Accumulated Adjustments Account directly impacts the taxation of distributions and allowance of certain losses. Distributions from S Corporations are considered a return of capital. This means you are taking out a portion of the money you put into the company. Once you withdraw more money than you put into the company, the distribution becomes taxable at long-term capital gain rates.

Let’s say that your ending balance in your Accumulated Adjustment Account is negative by $25,000. During the year, you took $40,000 in distributions. If we add back the distributions to the negative balance, we have an ending AAA of $15,000. This means that the $25,000 of distributions in excess of $15,000 will be taxed as capital gains.

Ensuring you have enough tax basis in your S Corporation prevents you from unwanted capital gains taxes. Additionally, a negative AAA balance can prevent you from deducting losses on your individual return. This draws in the importance of tax planning. Before year-end, you should evaluate your expected ending AAA account. If you notice that your distributions exceed your basis, you can either increase income (such as by forgoing Section 179) or make higher estimated tax payments.

The Accumulated Adjustments Account is an important section of your tax return, controlling the taxability of your S Corporation distributions. This makes it important to ensure accuracy in the calculation each year and highlights the need for tax planning surrounding distributions based on where the balance falls.

For more information on the Accumulated Adjustments Account, including the tax implications of your balance, contact one of our team members to schedule your free consultation.