The Three Ledgers of an S Corporation
Stock basis, AAA, and retained earnings track similar activity, but each answers a different question for S corporations and shareholders
S corporations blend tax and accounting rules of corporations and passthrough entities (i.e., partnerships and sole proprietorships). This blending necessitates tracking adjustments to various amounts to ensure proper tax treatment and reporting.
Three key amounts—retained earnings, the accumulated adjustments account, and shareholder stock basis—have distinct meanings but similar calculations. This can cause confusion among shareholders and their tax advisors on their importance for understanding the tax implications of S corporation transactions.
In this article, I provide working definitions for these three key amounts and offer a simplified comparison of their calculations to demonstrate the subtle yet critical distinctions among them. I close with a case study that demonstrates how these measures relate yet differ.
In general, these three measures answer three different questions: retained earnings shows what happened, AAA determines what kind, and basis determines how much.
Retained earnings shows accumulated profits over time
At the end of each accounting period—usually the calendar year for most taxpayers—net income from the profit and loss statement closes, or transfers and zeroes out, into retained earnings. Distributions also close to RE at the end of each period. So, RE represents the cumulative net income a company holds rather than distributes to shareholders.
RE can take any value, positive or negative. A company may distribute cash or property in excess of accumulated profit, for example, by funding expenses with debt.1 Negative RE might represent already-distributed future profits.
Positive RE may indicate a business that has been relatively profitable at a given point in time and could distribute those profits to shareholders, whereas negative RE could indicate a history of losses or debt in excess of profits. Like any balance sheet account, the best way to analyze RE is by its change over time and in context with other amounts, such as total liabilities.
The accumulated adjustments account displays undistributed passthrough profits
The accumulated adjustments account reflects the cumulative, undistributed passthrough income of an S corporation.2 An S corporation may have existed as a C corporation prior to making the S election. This means retained earnings includes both C corporation earnings and passthrough S corporation profits. AAA ensures that S corporation earnings are distributed before any C corporation earnings and profits are treated as dividends.
Although it seems similar to RE, AAA differs in two important ways: first, distributions do not reduce AAA below zero;3 second, tax-exempt income increases RE, but it does not increase AAA.4
Like positive RE, positive AAA indicates earnings that could be distributed tax-free from the corporation. If an entity has no history as a C corporation, then AAA may seem unimportant; however, it still provides a useful account of undistributed profits. Even in these cases, AAA reminds us of the original purpose of Subchapter S: to prevent corporate earnings from being taxed twice via passthrough treatment.
Stock basis tracks shareholders’ limitations on deductions and nontaxable distributions
Stock basis (and then debt basis) limits the aggregate amount of losses and deductions a shareholder can deduct5 and the amount of nontaxable distributions a shareholder can take.6
Contributions, income (including tax-exempt income), and gains increase stock basis; and distributions, losses, and nondeductible expenses decrease basis, but not below zero.7 Since tax year 2021, S corporation shareholders calculate and report basis using Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations.
Note that contributions increase basis but not RE or AAA. Include contributions in Capital stock (Line 22) or Additional paid-in capital (Line 23) on Schedule L, Balance Sheets per Books.
Example distinguishing RE, AAA, and basis
Jessica registers Lighthouse LLC by filing articles of organization, with herself as the sole member, on January 2, 20X1. On that date, she opens a checking account in the name of Lighthouse LLC and funds it with $1,000 of her savings. She also timely and correctly files Form 2553, Election by a Small Business Corporation, effective January 2, 20X1.
At the end of December 31, 20X1, Lighthouse LLC has nonseparately computed income of $84,000, municipal bond interest income of $500, and nondeductible meals and entertainment expense totaling $4,000. Jessica also received cash distributions totaling $35,000.
The calculations for RE, AAA, and basis at the end of 20X1 are as follows:
RE $84,000 + 500 – 4,000 – 35,000 = $45,500
AAA $84,000 – 4,000 – 35,000 = $45,000
Basis $1,000 + 84,000 + 500 – 35,000 – 4,000 = $46,500
NB The $500 of nontaxable interest does not increase AAA, but it would increase the Other Adjustments Account.
The following year, Lighthouse LLC makes significant investments in operations, mostly funded through debt. At the end of December 31, 20X2, Lighthouse LLC reports the following for the year: nonseparately computed loss of $17,000, municipal bond interest income of $500, and nondeductible meals and entertainment expense totaling $4,000. Jessica also received cash distributions totaling $35,000.
The calculations for RE, AAA, and basis at the end of 20X2 are as follows:
RE $45,500 – 17,000 + 500 – 4,000 – 35,000 = –$10,000
AAA $45,000 – 17,000 – 4,000 – 35,000 = $0
Basis $46,500 + 500 – 35,000 – 4,000 – 17,000 = $0
NB AAA is $24,000 before subtracting distributions; however, distributions cannot reduce AAA below zero. Basis is $8,000 before subtracting the loss; however, basis cannot go below zero, so $9,000 of the loss would be suspended and carried over in the next year. Both AAA and basis are zero, but Jessica still has suspended losses, highlighting that AAA and basis track different limitations.
In the next year, Lighthouse LLC returns to profitability despite significantly increased operating costs. At the end of December 31, 20X3, Lighthouse LLC reports the following for the year: nonseparately computed income of $10,500, municipal bond interest income of $500, and nondeductible meals and entertainment expense totaling $4,000. Jessica also received cash distributions totaling $15,000, a lesser amount due to reduced profits and a shortage of funds.
RE –$10,000 + 10,500 + 500 – 4,000 – 15,000 = –$18,000
AAA $0 + 10,500 – 4,000 – 15,000 = $0
Basis $0 + 10,500 + 500 – 15,000 – 4,000 – 9,000 = $0
NB Basis is $11,000 before subtracting distributions, resulting in $4,000 of capital gain income. The carried over loss from the prior year carries over into the subsequent year. The nondeductible expenses do not carry over unless Jessica makes an election under Reg. § 1.1367-1(g).
Conclusion
Although similarly computed, S corporation RE, AAA, and stock basis have important differences in their calculations and interpretations. Shareholders and their advisors should be familiar with the concept of basis, track it annually, and take it into consideration whenever running tax projections or considering distributions.
Accounting for an S Election
The S election combines corporate and pass-through tax and accounting rules with the legal rules of the underlying state entity. This causes confusion over the correct balance sheet presentation, especially the equity section.
Expenses paid with debt, such as loans or credit cards, are deductible when incurred. See Granan v. Comm., 55 T.C. 753 (1971) and Rev. Rul. 78–39.
See IRC § 1368(e)(1) and Reg. § 1368–2.
Form 1120-S, Schedule M-2, which tracks AAA, includes an “Other adjustments account” for tax-exempt income and related expenses.
The shareholder carries over deductions and losses in excess of basis indefinitely, treating them as incurred in the subsequent tax year. See IRC § 1366(d).
Distributions in excess of basis are treated as capital gain. See IRC § 1368.
See IRC § 1367(a). Note that Reg. § 1.1367-1(f) reduces basis by distributions, then nondeductible, noncapital expenses, and finally by separately and nonseparately stated items of loss or deduction; however, Reg. § 1.1367-1(g) allows a shareholder to elect to reduce her basis by separately and nonseparately stated items of loss or deduction before nondeductible, noncapital expenses. Under the nonelective ordering rules, nondeductible, noncapital expenses in excess of basis do not carry over and are lost. The elective ordering rules allow the shareholder to carry forward nondeductible, noncapital expenses in excess of basis. Once made, the election remains in effect unless the shareholder receives permission from the Commissioner.
This is one of the most succinct, understandably written differentiations of the 3 categories I've read. Really appreciate your skill at this Jeremy & for sharing it out!