1. Accumulated Adjustments Account (AAA).
    1. In General.
      1. The AAA is an account of the S corporation which is increased and decreased for the "S period" in a manner similar to adjustments to the basis of stock of S corporation shareholders (§ 1368(e)(1)(A)), with two exceptions:
        1. No adjustment is made for tax-exempt income and related expenses or for Federal taxes attributable to any taxable year in which the corporation was a C corporation (§ 1368(e)(1)(A)).
          1. This rule could actually cause distributions of tax-exempt income to be taxable as dividends if the S corporation has accumulated earnings and profits, since tax-exempt income does not increase AAA (§ 1368(c) and (e)(1)).
        1. The corporation's AAA can be reduced below zero, in which case the AAA must be restored to a positive amount before taxable distributions from accumulated earnings and profits can be avoided. The AAA, however, cannot be reduced below zero by distributions. Distributions by an S corporation with accumulated earnings and profits (AEP) are tax-free only to the extent of the AAA and stock basis (§ 1368(c)(1) and (b)(1)). If an S corporation has a negative AAA, a distribution of current income that restores the account to zero will still be "in excess of the AAA" and therefore considered a dividend to the extent of AEP. Income distributed under these circumstances is taxed twice: once as a pass-through item and once as a dividend.
          1. The one consolation a stockholder has in such circumstances is that the income that restores the AAA to zero also increases his basis in debt or stock, which then reduces or eliminates gains that would otherwise accrue upon selling the stock or having the loan repaid.
        1. The purpose of the AAA is to measure income from taxable years after 1982 that has already been taxed but not distributed to shareholders. All S corporations, even corporations without accumulated earnings and profits, need to calculate the AAA, however, because under § 1371(e) certain distributions may be made by a corporation tax-free to the shareholders after its S corporation election has been terminated. The amount that may be distributed tax-free, however, is limited to the S corporation's AAA.
      1. The "S period" is the most recent continuous period during which the corporation has been an S corporation, not including any taxable year beginning before January 1, 1983 (§ 1368(e)(2)).
        1. If an S corporation's election is terminated, the corporation's AAA cannot be saved in the event the corporation subsequently re-elects S corporation treatment.
        1. The AAA is kept at the corporate level. Consequently, the AAA can be used by a shareholder regardless of how or when he acquired his stock. Under prior law, each shareholder's previously taxed income account was personal and could not be transferred. The AAA, on the other hand, can be used by a shareholder regardless of how or when he acquired his stock. For example, if he purchased stock from another shareholder, the transferor shareholder's AAA will be allocated to the purchaser. If the shareholder is admitted to the corporation and receives 25% of the S corporation's stock, 25% of the S corporation's AAA will be allocated to the newly-admitted shareholder.
      1. Redemptions of stock under §§ 302(a) or 303(a) reduce the AAA by an amount which corresponds to the percentage redeemed, i.e., the redeemed shares proportionate share of AAA (§ 1368(e)(1)(B)). (See § 312(n)(7) for similar reduction of C corporation's earnings and profits.)
        1. For example, a 20% redemption of an S corporation's stock would require the balance in the AAA to be reduced by 20%.
      1. As noted above, the AAA is a corporate-level account. Consequently, distributions from an S corporation's AAA are unaffected by stock sales or other transfers. All shareholders treat distributions from an S corporation's AAA in the same manner, regardless of when they acquired their stock.
        1. Despite the fact that the AAA is a corporate account, shareholders' actions can affect it. The determination of AAA is similar to the basis adjustments made to the S corporation shareholder's stock under § 1367 (§ 1368(e)(1)(A)). The failure by any shareholder to include an S corporation pass-through item of income in gross income on his return precludes a basis increase and probably prevents an increase in AAA as well. Section 1367(b)(1) provides that an amount required to be included in a shareholder's gross income and shown on his return shall cause a basis increase under § 1367(a)(1) only to the extent such amount is included in the shareholder's gross income on his return, increased or decreased by any redetermination of such shareholder's tax liability. This rule causes one shareholder's fraudulent or negligent omission of S corporation income from his return to affect the taxation of distributions to other shareholders. Shareholders should consider preparing an agreement containing appropriate representations about reporting S corporation income and also an indemnification agreement in order to protect against the application of this rule. Practical considerations may well work against the IRS here. Since the AAA is an account that is determined by the corporation, omissions of income by a shareholder generally won't be known to the corporation and probably won't affect the AAA.
    1. Special AAA Problems.
      1. Distributions in Excess of AAA.
        1. Reg. § 1.1368-2(b) provides that if the sum of all distributions (other than distributions made out of earnings and profits or PTI) during the taxable year exceeds the amount in the AAA at the close of the taxable year, the balance of the AAA is allocated among these distributions in proportion to their respective sizes.
        1. In addition, if an S corporation makes a distribution consisting of money and loss property, the basis of which exceeds its fair market value, the AAA must be allocated between the money and other property distributed, based on the proportion of the money or the fair market value of the other property to the amount of the distribution (Reg. § 1.1368-2(c)).
      1. Redemptions.
        1. In the case of a redemption that is treated as an exchange of stock under § 302(a) or § 303(a), the AAA of the corporation is adjusted in an amount equal to the ratable share of the corporation's AAA attributable to the redeemed stock (See § 312(n)(7) for a comparable treatment for a C corporation). (Reg. § 1.1368-2(d)).
        1. In the case of a taxable year in which ordinary distributions and redemption distributions occur, the AAA of the corporation is adjusted first for any ordinary distributions and then for any redemption distributions (Reg. § 1.1368-2(d)(1)(ii)).
      1. Failed Redemptions.
        1. In Rev. Rul. 95-14, 1995-1 C.B. 169, the IRS ruled that a redemption that is characterized as a distribution under § 301 (the redemption does not qualify for sale or exchange treatment under § 302(a) since it does not meet the tests under § 302(b)(1), § 302(b)(2), or § 302(b)(3)) is to be treated as a distribution for purposes of § 1368. If the corporation has Sub C earnings and profits and a positive balance in its AAA account, the entire amount of the distribution is first charged against the distributing corporation's AAA account; if the amount distributed exceeds the distributing corporation's AAA account, the excess is treated as a distribution of earnings and profits, taxable as a dividend distribution under § 301.
      1. Reorganizations.
        1. In the case of an S corporation that acquires the assets of another S corporation in a transaction to which § 381(a)(2) applies, the acquiring corporation succeeds to and merges its AAA with the AAA of the distributor or transferor corporation.
        1. Thus, the AAA of the acquiring corporation after the transaction, is the sum of the AAA of both corporations immediately prior to the transaction (Reg. § 1.1368-2(d)(2)).
      1. Corporate Separations.
        1. In the case of a corporate separation to which § 368(a)(1)(D) applies, the AAA of the distributing corporation immediately before the transaction is allocated between the distributing corporation and the controlled corporation in a manner similar to the manner in which earnings and profits of the distributing corporation are allocated under § 312(h) (See Reg. § 1.312-10(a)) (Reg. § 1.1368-2(d)(3)).
      1. Election to Terminate Year Under § 1377(a)(2) or Reg. § 1.1368-1(g)(2).
        1. If an election is made under § 1377(a)(2) to terminate the year in the case of termination of a shareholder's interest or under Reg. § 1.1368-1(g)(2) to terminate the year in the case of a disposition of substantial amounts of stock, the AAA is allocated as if the taxable year consisted of separate taxable years, the first of which ends at the close of the day on which the shareholder terminated his or her interest in the corporation or makes a substantial distribution of stock, whichever the case may be (Reg. § 1.1368-2(e)).
      1. Date Distribution Made.
        1. As mentioned above, adjustments to basis in stock - and thus to the AAA - can be made with certainty only after the corporation's taxable year has ended. This can cause reporting uncertainties, because distributions made during the course of the year that are thought to be returns of capital or capital gains because of a positive AAA balance may end up being characterized as dividends because of adjustments that reduce the AAA below zero at year-end.
          1. This situation will not create any reporting problems if the corporation's and shareholder's tax years coincide. Problems arise, however, when a fiscal-year S corporation with AEP makes distributions to a calendar-year shareholder. The AAA balance, which has to be known to establish the character of distributions, cannot be determined until the S corporation's fiscal year ends, which may be substantially after the due date for shareholders' calendar-year returns. The problem here is whether the distribution should be reported in the year of receipt or, instead, reported in the following year since the distribution is deemed to have been paid on the last day of the corporation's taxable year.
          1. Reg. § 1.1368-1(b) states that the distribution is taken into account on the date the corporation makes the distribution, regardless of when the distribution is treated as received by the shareholder.
            Example 17: S Co. is an S corporation with a September 30 fiscal year. S Co. makes a distribution of $1,000 to A, its sole shareholder on December 1, 2002. A's basis in his stock before the distribution is $250, the corporation has $1,000 of AEP, and the AAA is $500. For its fiscal year ending September 30, 2003, S Co. has $250 of taxable income. A's stock basis increases, consequently, to $500, and S Co.'s AAA increases to $750. Since the $1,000 distribution exceeds the $750 AAA balance at September 30, 2002, the remaining $250 is treated as a dividend coming out of AEP. Since the $750 AAA distribution is in excess of A's stock basis of $500, $250 is taxed as a capital gain. The character of the $1,000 distribution to A cannot be determined until after September 30, 2002, though A's return is due on April 15, 2003. If the distribution is deemed to have been made on September 30, 2003, however, A will not have to pay taxes on the dividends and capital gain until April 15, 2004, when his return for 2003 is due. The regulations seem to indicate that both the portion of the distribution that is treated as coming out of AEP, or $250, is required to be included on A's 2003 tax return, as well as the $250 that is taxed as a capital gain.
    1. Examples.
      Example 18: Assume that a calendar-year S corporation makes a $10,000 distribution to its calendar-year sole shareholder in July. Assume further that the shareholder's basis in the stock is $5,000 at the beginning of the year and the corporation sustains a $2,000 loss during the year. Since the distribution ($10,000) and loss ($2,000) exceeds the shareholder's basis, the distribution is taken into account before the loss. If the S corporation has no accumulated earnings and profits, $5,000 of the distribution will be tax free and $5,000 will be treated as received from the sale or exchange of stock (§ 1368(b)). The shareholder also has a loss suspended of $2,000.

Basis

Distribution

Adjusted basis at the beginning of the year before distribution

$5,000

Amount of distribution

$10,000

Tax-free return of basis

(5,000)

(5,000)

Adjusted basis in stock - year end

$ 0

Remainder of distribution treated as sale or exchange of stock

$ 5,000

Suspended loss

$(2,000)

             
      Example 19: Assume the same facts as in Example 18, except that the S corporation has $1,000 of accumulated earnings and profits and a $4,000 AAA at the beginning of the year. In this case, $5,000 of the distribution will be tax free, $1,000 will be treated as a dividend, $4,000 will be treated as received from the sale or exchange of stock and the shareholder will have a suspended loss of $2,000 (§ 1368(c)).

Distribution

AAA

Accumulated Earnings and Profits

Basis

Beginning balance

$ 4,000

$1,000

$5,000

Amount of Distribution

$10,000

Return of Basis

(4,000)

(4,000)

(4,000)

Dividend

(1,000)

(1,000)

Return of Basis

(1,000)

(1,000)

Sale or exchange of stock

4,000

Balance before S corporation loss

0

0

0

S corporation loss

(2,000)

Balance at end of year

$10,000

($2,000)

$ 0

$ 0

      Loss suspended of $2,000 due to basis limitation.
      Example 20: A is the sole shareholder of S Co., a calendar-year S corporation with an AAA of $1,000 and accumulated AEP of $1,000 on January 1, 2003. If S Co.'s passive investment income during 2003 exceeds 25% of its gross receipts, the corporation will be subject to a penalty tax under § 1375 since it has subchapter C earnings and profits (AEP) and also excess passive investment income. If A elects to treat 2003 distributions as coming out of AEP and the distributions are sufficient to eliminate the AEP before year-end, the penalty tax will not be imposed. Similarly, if it happens that 2003 would make the third consecutive year that S Co. has both AEP and passive investment income exceeding 25% of gross receipts, the S election would terminate under § 1362(d)(3). An election under § 1368(e)(3) to treat 2003 distributions as coming out of AEP rather than AAA - if sufficient to eliminate the AEP prior to year-end - would prevent such a termination.
      Example 21: Assume that S Co. has no earnings and profits as of January 1, 2003. S Co.'s sole shareholder, A, holds 10 shares of S stock with a basis of $10 per share. On March 1, 2003, S Co. makes a distribution of $380 to A. For S Co.'s 2003 taxable year, A's pro rata share of the items relating to increases in basis of stock is $500 and A's pro rata share of the items relating to decreases in basis of stock is $260.
      Since distributions and losses ($640) exceeds A's basis plus income items ($600), the adjustments to the basis of A's stock in S Co. are made before the distributions and loss items. Thus, A's basis per share in the S Co. stock is $60 ($10 + $50) before taking into account any distribution. The amount of the distribution that is attributable to each share of A's stock is $38 ($380 distribution/10 shares). A has a basis of $60 in each share, and A's basis in each share is reduced to $22 ($60 - $38). Of the $26 reduction in basis due to the loss items, A is limited to $22, and the remaining $4 is suspended. As of January 1, 2004, A has a basis of $0 in his shares of stock and a loss suspended of $40.
      Example 22: B, an individual, organizes a C corporation on January 1, 2002. B transfers $1,000 to the C corporation in exchange for 10 shares of the C corporation's stock, representing all of the C corporation's outstanding shares. Thus, B's basis in each share of stock is equal to $100. In addition, B lends $300 to the C corporation evidenced by a demand note. For its 2002 taxable year, the C corporation does not elect to be an S corporation. The C corporation's accumulated earnings and profits as of December 31, 2002, are $400. The C corporation elects to be an S corporation for its taxable year beginning January 1, 2003. During 2003, the S corporation has a loss of $1,500. The S corporation makes no distributions to B during 2003. Under § 1366(d)(1), B is allowed a loss equal to $1,300, the amount equal to the sum of B's bases in his shares of stock and his basis in the debt. Under § 1367, the loss reduces B's adjusted basis in the stock and debt to $0. Under Reg. § 1.1368-2(a)(3), the S corporation's AAA as of December 31, 2003, has a deficit of $1,500 as a result of the S corporation's loss for the year.
      For 2004, the S corporation has $2,400 of income, of which $600 is interest from tax-exempt bonds. During 2004, the S corporation distributes $1,100 to B. For 2004, B is allocated $2,400 of the S corporation's 2004 income and the $200 of loss from 2002 (which is treated as incurred by the S corporation with respect to B in 2004 under § 1366(d)(2)). Under Reg. § 1.1367-2(c), there is a net increase of $2,200 with respect to B. Thus, B's basis in the loan is fully restored to $300, and B's basis in the stock (before taking the distribution into account) is increased from $0 to $190 per share (($2,220 - $300)/10). The AAA (-$1,500 from 2002) is first increased by $1,800 to $300 under Reg. § 1.1368-2(a)(2) for items of income (the $600 of tax-exempt income does not increase the AAA). The AAA is decreased by $300 to $0 for the portion of the $1,100 distribution that is treated as being from the AAA. The $800 remainder of the distribution is considered a dividend to B to the extent of the S corporation's $400 of earnings and profits and finally as a $400 reduction of B's basis in the S corporation's stock. Thus, B's basis in the S corporation stock as of December 31, 2003, is $120 per share ($1,900 - $700 (portion of the distribution that is not a dividend/10 shares)). The balance in the AAA is $0, the S corporations earnings and profits is $0, and B's basis in the loan is $300.
      Example 23: S Co., has earnings and profits of $30,000 and a balance in the AAA of $10,000 on January 1, 2003. C, an individual and the sole shareholder of S Co., has 100 shares of S Co. stock with a basis of $100 per share. On July 3, 2003, C sells 50 shares of his S Co. stock to D, an individual, for $2,500. For 2003, S Co. has taxable income of $10,000 of which $5,000 was earned on or before July 3, 2003, and $5,000 earned after July 3, 2003. During its 2003 taxable year, S Co. makes the following distributions: $10,000 to C on February 1; and $10,000 to each of C and D on August 1.
      S Co. does not make the election under § 1368(e)(3) to distribute its earnings and profits before its AAA. S Co. makes the election under Reg. § 1.1368-1(g)(2) to treat its taxable year as if it consisted separate taxable years, the first of which ends at the close of July 3, 2003, the date of the qualifying disposition.
      Under Reg. § 1.1368-1(g)(2), for the period ending on July 3, 2003, S Co.'s AAA is $5,000 ($10,000 AAA as of January 1, 2003 + $5,000 of income earned from January 1, 2003 through July 3, 2003 - $10,000 distribution made on February 1, 2003). C's bases in his shares of stock is decreased to $50 per share ($100 original adjusted basis + $50 increase per share for income - $100 decrease per share for distributions).
      The AAA is adjusted at the end of the taxable year for the period July 4 through December 31, 2003. It is increased from $5,000 (AAA as of the close of July 3, 2003) to $10,000 for the income earned during this period and is decreased by $10,000, the portion of the distribution ($20,000 in total) made to C and D on August 1 that does not exceed the AAA. The $10,000 portion of the distribution that remains after the AAA is reduced to $0 is attributable to earnings and profits. Therefore, C and D each have a dividend of $5,000, which does not effect their basis or the S Co.'s AAA. The earnings and profits account is reduced from $30,000 to $20,000.
      As of December 31, 2003, C and D have bases in their shares of stock of $0 ($50 basis as of July 4 + $50 of income per share - $100 distribution per share). C and D each will report $5,000 as dividend income, which does not effect their basis or the S Co.'s AAA.
      Example 24: S Co. has been a calendar year C corporation since 1990. For 1999, S Co. elects for the first time to be taxed under subchapter S. As of January 1, 2003, S has a AAA of $100 and $1,000 of sub C earnings and profits. For 2003, S Co. has $2,000 of taxable income and the AAA is increased to $2,100 (before taking distributions into account). During 2003, S Co. distributes $1,800 to its shareholders. With its 2003 tax return, S Co. properly elects under § 1368(e)(3) to distribute its earnings and profits before its AAA.
      Because S Co. elected to distribute its earnings and profits before its AAA, the first $1,000 of the distribution is characterized as a distribution from Sub C earnings and profits. Because $1,000 of the distribution is from earnings and profits, the shareholders of S Co. have a $1,000 dividend. The remaining $800 of the distribution is a distribution from S Co.'s AAA and is treated by the shareholders as a return of capital or gain from the sale or exchange of property. S Co.'s AAA, as of December 31, 2003, equals $1,300 ($2,100 - $800).
      Example 25: On January 1, 2003, S Co. has $400 of earnings and profits and a balance in the AAA of $1,000. S Co. has two shareholders, E and F, each of whom own 50 shares of S Co.'s stock. For 2003, S Co. has taxable income of $500, which increases the AAA to $1,500 as of December 31, 2003 (before taking into account distributions made during 2003). On February 1, 2003, S Co. distributes $600 to each shareholder. On September 1, 2003, S Co. distributes $300 to each shareholder. S Co. does not make the election under § 1368(e)(3) to distribute its earnings and profits before its AAA.
      The sum of the distributions exceeds S Co.'s AAA. Therefore, a portion of S Co.'s $1,500 balance in the AAA as of December 31, 2003, is allocated to each of the February 1 and September 1 distributions based on the respective sizes of the distributions. Accordingly, S Co. must allocate $1,000 ($1,500 AAA x $1,200 February 1 distribution/$1,800 sum of distributions) of the AAA to the February 1 distribution and $500 ($1,500 x ($600/$18,000)) to the September 1 distribution. The portion of the distributions to which the AAA is allocated is treated by the shareholder as a return of capital or gain from the sale or exchange of property, as appropriate. The remainder of the two distributions is treated as a dividend to the extent that it does not exceed S Co.'s earnings and profits. E and F must each report $100 of dividend income for the February 1 distribution. For the September 1 distribution, E and F must each report $50 of dividend income.