Question

Taxation of Subchapter S Corporations How do we used the accumulated adjustments account for S Corporation distributions?

Answer 1

• An S corporation, unlike a C corporation, generally escapes income tax at the corporate level; instead, its items of income, deduction, credit, etc., flow through to its shareholders, who calculate and pay any tax due.
• The treatment of an S corporation distribution depends on the shareholder’s basis in his or her S corporation stock and the S corporation’s earnings and profits (E&P) and accumulated adjustments account (AAA).
• An S corporation will have E&P only if it was previously a C corporation or it acquired the assets of a C corporation in a Sec. 381 transaction. An S corporation distribution from E&P is treated as a dividend.
• The treatment of a distribution made by an S corporation without accumulated E&P depends only on the shareholder’s basis in the S corporation stock.

The Accumulated Adjustments Account is used by S-Corporations to determine how shareholders must treat distributions of property from the S-Corporation. This is a snapshot of the cumulative balance of all separately stated items and non-separately stated items (ordinary) of the S-Corporation. AAA adjustments are similar to how basis is handled for separately and non-separately stated items. However, it is calculated without considering any net negative adjustments such as excess losses and deductions over income and gain.

• AAA is not affected by any transactions that occurred when it was a corporation (federal income tax.)
• Expense items that are not deductible by the S-Corporation decrease basis in stock and the AAA.
• No adjustments are made to AAA for tax-exempt income (which increases basis) or nondeductible expenses related to them (which reduces basis.) These types of adjustments are made to the Other Adjustment Account (OAA.)

Note: An S-Corporation's AAA can be reduced below zero. However, the AAA of an S-Corporation cannot be reduced below zero by distributions.