Making tax-free distributions to the extent of AAA

The accumulated adjustments account (AAA) tracks the amount of undistributed income that has been taxed to S corporation shareholders after 1982. S corporations with accumulated earnings and profits (AE&P) can distribute AAA (to the extent of basis) to a shareholder free of further tax. S corporations without AE&P determine the taxability of distributions without reference to AAA (Sec. 1368); however, practitioners should keep track of the AAA balance in any event because part or all of the amount in AAA can be distributed tax-free if the S corporation election terminates. Also, the AAA balance may be beneficial or necessary to know when certain redemptions or mergers occur.

Identifying items that increase and decrease AAA

AAA begins at zero on the first day of the S corporation’s first tax year beginning after 1982. It is increased by (Sec. 1368(e)(1)(A); Regs. Sec. 1.1368-2(a)):

• Separately and nonseparately stated items of income (but not by tax-exempt income), and by
• The excess of the shareholder’s deduction for depletion (excluding oil and gas) over the allocable basis in the property subject to depletion.

It is decreased by:

• Separately and nonseparately stated items of loss or deduction;
• Corporate expenses that are neither deductible nor capitalizable (such as the nondeductible portion of business meal expenses, fines, and political contributions) (excluding expenses related to tax-exempt income and federal taxes attributable to any tax year in which the corporation was a C corporation);
• The amount of the shareholder’s deduction for depletion for any oil and gas property to the extent such deduction does not exceed the shareholder’s proportionate share of the corporation’s basis in the property; and
• Distributions that are not dividends (e.g., distributions other than those made from AE&P and distributions made out of AAA).

AAA can be increased or decreased by a redemption distribution that is treated as an exchange under Sec. 302(a) or Sec. 303(a) (Sec. 1368(e)(1)(B); Regs. Sec. 1.1368-2(d)).

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, created the Paycheck Protection Program (PPP) under which the U.S. Small Business Administration guaranteed loans made to certain businesses to help keep their workforce employed during the COVID-19 pandemic. If certain conditions were met, lenders forgave these loans. The Consolidated Appropriations Act, 2021, P.L. 116-260, confirmed that forgiven PPP loan proceeds are excluded from income and further clarified that these proceeds are to be treated as tax-exempt income under Sec. 1366. In addition, eligible expenses paid for with forgiven PPP loan proceeds are fully deductible.

While deductible expenses associated with PPP loan forgiveness are included in the S corporation’s nonseparately stated income or loss, these expenses will not reduce AAA. According to the instructions for the 2021 Form 1120-S, U.S. Income Tax Return for an S Corporation, expenses paid with PPP loans that are forgiven reduce the other adjustments account (OAA). Since the forgiveness of a PPP loan results in tax-exempt income, AAA will not be increased by the amount forgiven; instead, OAA will be increased.

Federal income taxes attributable to prior C corporation period

An exception exists to the rule that nondeductible expenditures reduce AAA. If the S corporation pays federal income taxes attributable to a prior C corporation period, the shareholder’s basis is reduced, but AAA is not adjusted (Sec. 1368(e)(1)(A); Regs. Sec. 1.1368-2(a)(3)(i)(C)(1)).

AAA adjustments due to credit recapture

AAA is decreased by the reduction in an asset’s basis when general business credits cause such reduction under Sec. 50(c)(1). Similarly, AAA is increased by the recapture of general business credits under Sec. 50(a)(1) when such recapture causes a corresponding addition to an asset’s basis. (See Sec. 50(c) and former Sec. 48(q)(6); this cite relates to a shareholder’s basis adjustment, but H.R. Rep’t No. 861, 98th Cong., 2d Sess. 1227, reprinted in 1984-3 C.B. Vol. 2 481, indicates that AAA must be adjusted also.)

LIFO recapture

LIFO recapture paid by the S corporation does not reduce AAA because LIFO recapture is a federal tax attributable to a C corporation year, and AAA is not reduced by such items. Also, under Sec. 1363(d)(5), basis is not reduced by LIFO recapture; however, LIFO recapture payments reduce AE&P.

Income in respect of decedent

A person acquiring stock in an S corporation from a decedent reduces the stepped-up basis in the inherited S corporation stock to the extent the stock’s value is attributable to income in respect of a decedent (IRD) (Sec. 1367(b)(4); Regs. Sec. 1.1367-1(j)). AAA is not reduced by the IRD items.

Adjusting AAA in the proper order

The AAA balance at the beginning of the year is adjusted in the following order (Sec. 1368(e)(1)):

• Increased for items of income and gain (the first two bulleted items under “Identifying Items That Increase and Decrease AAA”).
• Reduced by items of loss or deduction (the third, fourth, and fifth bulleted items under “Identifying Items That Increase and Decrease AAA”), but this reduction is limited to the amount of the increase for income and gain items.
• Decreased for nondividend distributions (the sixth bulleted item under “Identifying Items That Increase and Decrease AAA”).
• Decreased by the excess, if any, of the aggregate loss and deduction items over the aggregate income and gain items.
• Decreased or increased for a redemption distribution.

Example 1. Calculating AAA: M is the sole shareholder of P Inc., a calendar-year S corporation. P has AAA of $2,500 and AE&P of $6,750 on Jan. 1. M’s stock basis on that date is $10,000, and he has no basis from any debt owed to him by P. Losses passed through by P are not limited by the passive income or at-risk rules, and M has no other capital gain or loss transactions. During the year, P distributed $6,500 to M, and his Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc., shows the passthrough items in the table “Passthrough Items From M’s Schedule K-1 in Example 1″ (below).

The income and gain items ($9,200) exceed the loss and deduction items ($2,000), so P’s AAA and AE&P are determined as shown in the table “P’s AAA and AE&P in Example 1″ (below).

The distributions of $6,500 reduce stock basis and AAA and are nontaxable. The $2,000 capital loss is fully deductible on M’s Form 1040, U.S. Individual Income Tax Return.

M’s stock basis is determined as shown in the table “M’s Stock Basis in Example 1″ (below).

Note: Both AAA and basis are adjusted by the same items but in a different order. Basis is (1) increased by items of income and gain, (2) decreased by distributions, and (3) decreased by items of loss and deduction. AAA is generally (1) increased by items of income and gain, (2) reduced by items of loss and deduction, and (3) reduced by distributions.

Normally, the step in the fourth bulleted item under “Adjusting AAA in the Proper Order” above (decreasing AAA by the excess of loss items over income items) as well as the limitation in the second step (limiting the reduction for loss items to the increase for income items) will not apply. The limitation and the fourth step are necessary only when there is a net negative adjustment; that is, when the aggregate loss and deduction items that decrease AAA exceed the aggregate income and gain items that increase AAA.

Example 2. Calculation of AAA when there is a net negative adjustment: L is the sole shareholder of S Inc., a calendar-year S corporation. S has AAA of $2,500 and AE&P of $6,750 on Jan. 1. L’s stock basis on that date is $10,000, and he has no basis from any debt owed to him by S. Losses passed through by S are not limited by the passive activity loss rules or the at-risk rules, and L has no other capital gain or loss transactions. During the year, S distributed $6,500 to L, and his Schedule K-1 shows the items in the table “Items From L’s Schedule K-1 in Example 2″ (below).

Because the loss and deduction items ($9,200) exceed the income and gain items ($2,000), there is a net negative adjustment of $7,200. (These are the same facts as in Example 1, except in that example the income item was $9,200 and the loss item was $2,000.)

S’s AAA and AE&P are determined as shown in the table “S’s AAA and AE&P From Example 2″ (below).

L’s stock basis is determined as shown in the table “L’s Stock Basis in Example 2″ (below).

Note that stock basis is not reduced by the $4,000 portion of the distribution that reduced AE&P. L shows that amount as a dividend on his Form 1040. The $2,500 portion of the distribution that reduced AAA is nontaxable to L. His basis was reduced by the loss amount, so L can deduct the entire $9,200 ordinary loss on his personal return.

Calculating AAA before stock basis

Normally, the same accountant will calculate an S corporation’s AAA and AE&P balance as well as determine the shareholders’ bases in stock. However, that will not always be true because calculation of AAA and AE&P is the corporation’s responsibility, while keeping track of basis is each individual shareholder’s responsibility. In any event, if the corporation has AE&P, AAA must be calculated before stock basis is determined because stock basis is reduced by the nontaxable portion of the distribution that reduces AAA but not by any portion that reduces AE&P.

Distributing beginning stock basis or AAA balance free of tax

Distributions received by a shareholder during the year will be tax-free at least to the extent of the lesser of:

• The shareholder’s stock basis at the beginning of the tax year, or
• The corporation’s AAA balance at the beginning of the year.

All or a portion of distributions in excess of the beginning stock basis or AAA balance may be tax-free, too, because basis is increased for the current year’s income before it is reduced for distributions. Also, the beginning balance of AAA is increased by the excess, if any, of aggregate income and gain items over aggregate loss and deduction items before being decreased by distributions.

Example 3. Making nontaxable distributions to the extent of the lesser of beginning AAA or stock basis: E is the sole shareholder of T Inc., a calendar-year S corporation. T has AAA of $3,000 and AE&P of $5,250 on Jan. 1 of the current year. E’s stock basis on that date is $9,500. He has no debt basis. During the year, T distributed $6,500 to E. The only passthrough item on his Schedule K-1 is an ordinary loss from operations of $8,100. The corporation’s AAA and AE&P are determined as shown in the table “T’s AAA and AE&P in Example 3″ (below).

E’s stock basis is determined as shown in the table “E’s Stock Basis in Example 3″ (below).

The $6,500 distribution is nontaxable to the extent it reduced AAA ($3,000) and is a taxable dividend to the extent it reduced AE&P ($3,500). Note that the nontaxable portion is the lesser of the beginning balance of AAA ($3,000) or E’s stock basis at the beginning of the year ($9,500), even though the corporation showed an operating loss for the year.

E has sufficient basis to deduct $6,500 of the loss in the current year. The $1,600 ($8,100 − $6,500) remaining loss carries over to the following year.

In a year when a loss is anticipated, shareholders may want to receive a distribution in the amount of the beginning stock basis or AAA balance. The availability of funds that are not required in the operation of the business will be a major factor when considering whether the distributions should be made.