Is Schedule M-2 Required for Form 1120-S?

An S corporation files Form 1120-S to report its income, gains, losses, deductions, and credits. A component of this return is Schedule M-2, which analyzes the corporation’s accumulated adjustments account and other equity items. This schedule reconciles the changes in these accounts from the beginning to the end of the corporation’s tax year. However, specific conditions may exempt a corporation from the need to complete it.

The Filing Requirement and Its Exception

Generally, every S corporation must file Schedule M-2 as part of its Form 1120-S tax return. The schedule provides the IRS and shareholders with information to determine the tax treatment of distributions.

There is, however, a specific exception that relieves certain smaller corporations from this requirement. This exception also applies to filing Schedule L (Balance Sheet) and Schedule M-1 (Reconciliation of Income). To qualify, the corporation’s total receipts for the tax year and its total assets at the end of the tax year must both be less than $250,000.

Understanding the Accumulated Adjustments Account (AAA)

The primary column on Schedule M-2 is for the Accumulated Adjustments Account (AAA). This account tracks the cumulative total of the S corporation’s income, gains, losses, and deductions that have already been passed through to shareholders. Its main function is to differentiate between taxable and nontaxable distributions. The AAA begins at zero on the first day of the corporation’s first year as an S corporation.

Distributions from an S corporation to its shareholders are generally considered tax-free returns of capital, but only to the extent of the shareholder’s stock basis and the corporation’s AAA balance. If a corporation has accumulated E&P, the AAA separates tax-free distributions from taxable dividends. Distributions up to the AAA balance are tax-free, while amounts exceeding the AAA may be taxed as dividends.

The AAA should not be confused with a shareholder’s stock basis or the corporation’s retained earnings. A shareholder’s stock basis is their individual investment in the company, while retained earnings is an accounting figure representing cumulative net income per its books. The AAA is a tax-specific account that can be decreased by losses and distributions. Unlike stock basis, it can go below zero due to losses but not due to distributions.

How to Complete Schedule M-2

For corporations that do not meet the exception, completing Schedule M-2 involves transferring figures from other parts of the tax return. The form is broken down into several lines that build upon each other to calculate the year-end balances. The process begins with Line 1, the balance at the beginning of the tax year, which should match the ending balance from the prior year’s Schedule M-2.

Line 2 is for the ordinary business income from Form 1120-S, Schedule K. Line 3, “Other additions,” includes separately stated income items, such as interest and dividend income, which are also found on Schedule K. These lines are summed to calculate the total additions to the account.

Next, the form accounts for reductions. Line 5 is for distributions paid out to shareholders, not including wages. This amount cannot reduce the AAA balance below zero. Line 6, “Other reductions,” includes separately stated loss and deduction items, like charitable contributions. Line 8 shows the computed ending balance, which is the beginning balance plus additions, minus any distributions and other reductions.