Making tax-free distributions to the extent of AAA.

• Author: Baer, John
• Position: Accumulated adjustments account

The accumulated adjustments account (AAA) tracks the amount of undistributed income that has been taxed to S corporation shareholders after 1982. S corporations with accumulated earnings and profits (AE&P) can distribute AAA (to the extent of basis) to a shareholder free of further tax. S corporations without AE&P determine the taxability of distributions without reference to AAA (Sec. 1368); however, practitioners should keep track of the AAA balance in any event because part or all of the amount in AAA can be distributed tax-free if the S corporation election terminates. Also, the AAA balance may be beneficial or necessary to know when certain redemptions or mergers occur.

Identifying items that increase and decrease AAA

AAA begins at zero on the first day of the S corporation's first tax year beginning after 1982. It is increased by (Sec. 1368(e)(1)(A); Regs. Sec. 1.1368-2(a)):

* Separately and nonseparately stated items of income (but not by tax-exempt income), and by

* The excess of the shareholder's deduction for depletion (excluding oil and gas) over the allocable basis in the property subject to depletion.

It is decreased by:

* Separately and nonseparately stated items of loss or deduction;

* Corporate expenses that are neither deductible nor capitalizable (such as the nondeductible portion of business meal expenses, fines, and political contributions) (excluding expenses related to tax-exempt income and federal taxes attributable to any tax year in which the corporation was a C corporation);

* The amount of the shareholder's deduction for depletion for any oil and gas property to the extent such deduction does not exceed the shareholder's proportionate share of the corporation's basis in the property; and

* Distributions that are not dividends (e.g., distributions other than those made from AE&P and distributions made out of AAA).

AAA can be increased or decreased by a redemption distribution that is treated as an exchange under Sec. 302(a) or Sec. 303(a) (Sec. 1368(e)(1)(B); Regs. Sec. 1.1368-2(d)).

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, PL. 116-136, created the Paycheck Protection Program (PPP) under which the U.S. Small Business Administration guaranteed loans made to certain businesses to help keep their workforce employed during the COVID-19 pandemic. If certain conditions were met, lenders forgave these loans. The Consolidated Appropriations Act, 2021, PL. 116-260, confirmed that forgiven PPP loan proceeds are excluded from income and further clarified that these proceeds are to be treated as tax-exempt income under Sec. 1366. In addition, eligible expenses paid for with forgiven PPP loan proceeds are fully deductible.

While deductible expenses associated with PPP loan forgiveness are included in the S corporation's nonseparately stated income or loss, these expenses will not reduce AAA. According to the instructions for the 2021 Form 1120-S, U.S. Income Tax Return for an S Corporation, expenses paid with PPP loans that are forgiven reduce the other...