How Are S Corp Distributions in Excess of AAA Taxed?

An S corporation passes income and losses through to its shareholders, avoiding tax at the corporate level. While distributions of cash or property are often tax-free, the treatment becomes complex if the S corporation was previously a C corporation. This history can introduce accounts that alter the taxability of distributions, which depends on specific corporate accounts and the shareholder’s investment.

Understanding Key S Corporation Accounts

Accumulated Adjustments Account (AAA)

The Accumulated Adjustments Account (AAA) is a corporate-level account tracking an S corporation’s cumulative taxable income not yet distributed to shareholders. The account starts at zero upon an S election. It increases with business and separately stated income and decreases with losses, deductions, and distributions. AAA is a corporate account, not a personal one for each shareholder, and while losses can make the AAA balance negative, distributions can only reduce it to zero.

Shareholder Stock Basis

Shareholder stock basis is an individual’s economic investment in the corporation, calculated and tracked by each shareholder. Initial basis is the cash and adjusted basis of property contributed for stock. Annually, basis increases by the shareholder’s share of income items, including tax-exempt income, and any additional capital contributions. Basis decreases by distributions received, the shareholder’s share of corporate losses, and nondeductible expenses.

Accumulated Earnings and Profits (E&P)

Accumulated Earnings and Profits (E&P) is a feature of C corporations. An S corporation has an E&P balance only if it was previously a C corporation or acquired one with an E&P balance. E&P represents a C corporation’s accumulated earnings not yet paid out as dividends. The existence of E&P is the primary reason an S corporation distribution can be taxable, as distributions exceeding the AAA balance are considered paid from E&P, which can trigger a taxable dividend.

The Distribution Order for S Corps with E&P

When an S corporation has Accumulated E&P, distributions follow a mandatory system to determine their tax consequences. This hierarchy dictates the order in which corporate accounts are used to cover the payment. Consider an S corporation with a $30,000 AAA balance, $25,000 in E&P, and a sole shareholder with a $50,000 stock basis who receives a $120,000 distribution.

Tier 1: Distribution from AAA

The first portion of any distribution comes from the corporation’s AAA and is tax-free to the extent of the shareholder’s stock basis. In our example, the first $30,000 of the distribution comes from AAA. This amount is tax-free because it is less than the shareholder’s $50,000 basis, reducing the AAA to zero and the shareholder’s basis to $20,000.

Tier 2: Distribution from Accumulated E&P

Once AAA is depleted, the next portion of the distribution is sourced from the corporation’s Accumulated E&P. This amount is a taxable dividend and does not reduce the shareholder’s stock basis. In the example, the next $25,000 of the distribution comes from E&P. This amount is taxable dividend income, and the shareholder’s $20,000 stock basis is unchanged.

Tier 3: Distribution as a Return of Basis

If a distribution exhausts the AAA and E&P accounts, the next part of the payment is a tax-free return of the shareholder’s remaining stock basis. This portion is not taxed but reduces the shareholder’s basis. In our example, the distribution has accounted for $55,000 ($30,000 from AAA and $25,000 from E&P). The next $20,000 of the distribution is a tax-free return of the shareholder’s remaining basis, reducing it to $0.

Tier 4: Distribution in Excess of Basis

Any remaining distribution amount after AAA, E&P, and the shareholder’s stock basis have all been reduced to zero is taxed as a capital gain. To conclude the example, $75,000 has been accounted for ($30,000 AAA, $25,000 E&P, and $20,000 basis). The final $45,000 of the $120,000 distribution is taxed as a capital gain.

Optional Election to Distribute E&P First

S corporations can elect to alter this distribution order by choosing to distribute E&P before AAA, which requires the consent of all shareholders. This strategic tool is often used to clear the E&P balance to avoid associated penalties or taxes. When this election is made, the first part of the distribution becomes a taxable dividend to shareholders.

Tax Reporting for Distributions

The S corporation is responsible for tracking its accounts and reporting distributions. It maintains its AAA balance on Form 1120-S, Schedule M-2, and reports total distributions to a shareholder on Schedule K-1 in Box 16, code D. The K-1 shows the total distribution but does not specify how much is taxable. It is the shareholder’s responsibility to apply the distribution ordering rules using corporate information and their own basis records to correctly determine the taxability of what they receive.

Reporting Dividend and Capital Gain Income

If a portion of the distribution is from E&P, it is a taxable dividend, and the S corporation issues Form 1099-DIV to the shareholder. The shareholder reports this dividend on Form 1040. Any distribution amount that is a capital gain because it exceeded stock basis is reported on Form 8949, with totals carried to Schedule D of Form 1040.