Unless you elect different treatment, for shareholder income tax purposes S corporation distributions are applied in the following order:
1. To reduce the Accumulated Adjustment Account (AAA) determined without regard to any net negative adjustment for the tax year but not below zero.
According to IRC 1368 if distributions during the tax year exceed the AAA at the close of the tax year determined without regard to any net negative adjustment for the tax year the AAA is allocated pro rata to each distribution made during the tax year.
2. If applicable – as in pre 1983 – to reduce shareholders’ Previously Taxed Income (PTI) account for any IRC section 1375(d) distributions associated with tax imposed when passive investment income of the corporation has accumulated earnings and profits in excess of 25% of the gross receipts.
A distribution from the PTI account is tax free to the extent of a shareholder’s basis in his or her stock in the corporation. This is rarely seen any more as there are few S Corps with pre 1983 PTI remaining. Read more