Now that the corporate tax extension deadline is past and we all prepared, signed and filed our 2012 1120-S IRS forms (yeah right!), I write to report some of my codified thoughts on Analysis of Accumulated Adjustments Account, Schedule M-3, Other Adjustments Account, and Shareholders’ Undistributed Taxable Income Previously Taxed. Or in tax speak the “AAA”.

Generally your corporation’s Accumulated Adjustments Account (AAA) is an account of the corporation. It belongs to the corporation, not to you the shareholder. If you have elected S-Corporation Status the AAA tracks the amount of undistributed income that has been subject to income tax at each respective shareholder’s marginal tax rate. Its treatment is similar in nature to the manner in which earnings and profits generally track a C corporation’s undistributed income.

The AAA became relevant in 1983, so if you formed your S-Corp any time then or later the first day of the first year your corporation is an S corporation the balance of the AAA is zero. Each year after that the AAA is adjusted under mandate. I’ll address how to adjust the AAA a bit later in the post.

The significance of the AAA is that it allows previously taxed but undistributed income to be distributed income tax-free to shareholders up to the value of the shareholder’s investment in the corporation. This can be a difficult concept to grasp and without adequate bookkeeping even more difficult to track.

Here’s why…

If you are a shareholder of a financially successful Sub-chapter S Corporation your corporation will most likely have accumulated earnings and profits in which the corporation can decide to (or decide not to) distribute to you and the other shareholders in cash or other assets. Regardless if distributions are made by the corporation or not, for income tax purposes earnings and profits still pass through directly and proportionally to the shareholders via Schedule K-1.

According to IRC 1368(c)(1) if the distribution is essentially not greater than your stock basis or investment in the S-Corp the distribution is generally speaking treated as a return of capital. If the distribution depletes basis but does not deplete the Accumulated Adjustment Account (AAA), the distribution is treated as a capital gain. That is essentially how Governor Romney was able to lower his marginal income tax rate as he has done. If the distribution is greater than the accumulated earnings and profits of the S corporation the portion of the distribution that remains, if any, is treated as if there were no accumulated earnings and profits in the corporation.

In my humble opinion even though there are many reasonable explanations generally speaking it seems corporations that distribute assets to shareholders in excess of both shareholder basis and the AAA usually are withering on the vine as it were in anticipation of dissolution and have generally been victimized by insufficient record keeping.

Now if you happen to still be with me here are a few more thoughts:

1. The AAA is adjusted similar to the stock basis adjustments except that there is no consideration for tax-exempt income or related expenses and deductions do not necessarily have to be limited to stock basis. In other words according to IRC 1368(e) the AAA may have a negative balance at year end. .

2. An S corporation without accumulated earnings and profits (E&P) does not need to maintain the AAA in order to determine the tax effect of distributions. However …

3. If an S corporation without accumulated E&P engages in certain transactions to which IRC 381(a) applies, like merging into an S corporation with accumulated E&P, both corporations must be able to calculate their respective AAAs at the time of the merger for purposes of determining the tax effect of post-merger distributions. Basically though most Sub-S corporations don’t tend to merge so much as acquire each other’s assets. Nevertheless…

4. I always recommend that AAA be maintained by all S corporations.

How to adjust AAA:

Straight from the IRS Form 1120-S Instructions…

(1) Increase the AAA by income (other than tax-exempt income) and the excess of the deduction for depletion over the basis of the property subject to depletion (unless the property is an oil and gas property the basis of which has been allocated to shareholders)

(2) Decrease AAA by the sum of the following items with respect to the corporation for the tax year: (a) the items of loss or deduction that must be separately stated; (b) any non-separately computed loss; (c) any expense of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account, other than federal taxes attributable to any tax year in which the corporation was a C corporation and expenses related to income that is exempt from tax; and (d) the sum of the shareholders’ deductions for depletion for any oil or gas property held by the corporation described in Code Sec. 1367(a)(2)(E) (Code Sec. 1368(e)(1)(A); Reg. Sec. 1.1368-2(a)(3)).

Some further personal observations:

1. The AAA is decreased by noncapital, nondeductible expenses even though a portion of the noncapital, nondeductible expenses is not taken into account by a shareholder under the elective ordering rule in Reg. Sec. 1.1367-1(g).

2. The AAA is also decreased by the entire amount of any loss or deduction even though a portion of the loss or deduction is not taken into account by a shareholder under the loss limitation rule or is otherwise not currently deductible. However, in any subsequent tax year in which the loss, deduction, or non-capital, nondeductible expense is treated as incurred by the corporation with respect to the shareholder, no further adjustment is made to the AAA.

(3) Decrease AAA (but not below zero) by any portion of a distribution from: (a) an S corporation without any accumulated earnings and profits, or (b) any portion of a distribution from an S corporation with accumulated earnings and profits where the distribution does not exceed the AAA (Reg. Sec. 1.1368-2(a)(3)(iii)).

(4) Decrease AAA by any net negative adjustment. The term “net negative adjustment” means, with respect to any tax year, the excess (if any) of: (1) the reductions in the account for the tax year (other than for distributions), over (2) the increases in such account for the tax year.

IF you’ve made it with me this far, Schedule M-3 Column (b). Other Adjustments Account is adjusted for tax-exempt income (and related expenses) and federal taxes attributable to a C corporation tax year. After these adjustments are made, the account is reduced for any distributions made during the year.

In regards to schedule M-3 Column (c). Shareholders’ Undistributed Taxable Income Previously Taxed. The shareholders’ undistributed taxable income previously taxed account, also called previously taxed income (PTI), is maintained only if the corporation had a balance in this account at the start of its 2012 tax year. If there is a beginning balance for the 2012 tax year, no adjustments are made to the account except to reduce the account for distributions made under IRC 1375(d). Also:

1. each shareholder’s right to nontaxable distributions from PTI is personal and cannot be transferred to another person, and

2. the corporation is required to keep records of each shareholder’s net share of PTI.