Keeping accurate records of S corporation accumulated adjustments, other adjustments, and previously taxed income can be an overwhelming task for shareholders.
By understanding the purpose of Schedule M-2 and how to properly document relevant activity, you can simplify compliance and basis tracking for S corp owners.
In this article, we will explore key concepts around Schedule M-2, including an overview of accumulation adjustments accounts, determining when and how to file, and using Schedule M-2 to analyze shareholder basis.
Introduction to Schedule M-2 for Form 1120-S
Schedule M-2 is an important supplemental form that must be filed with the annual Form 1120-S return for certain S corporations. It tracks activity in the Accumulated Adjustments Account (AAA), Other Adjustments Account (OAA), and Shareholders' Undistributed Taxable Income Previously Taxed (PTI).
Schedule M-2 provides shareholders and the IRS with necessary information to calculate basis, determine dividend treatment, and report previously taxed income. S corps with assets over $250,000 or with C corporation earnings and profits must complete Schedule M-2 when filing Form 1120-S.
Understanding the Role of Schedule M-2 in Form 1120S
Schedule M-2 accounts for activity that impacts shareholder basis calculations, determines if distributions should be treated as dividends, and tracks previously taxed S corp income.
Specifically, Schedule M-2:
- Records increases and decreases to the AAA account, which tracks the accumulated net income that has already been taxed to shareholders over the history of the S corp
- Tracks OAA activity, which includes income items and deductions that impact basis but bypass the AAA
- Shows PTI, which measures taxed income not yet distributed to shareholders
By providing this information, Schedule M-2 enables proper shareholder-level reporting and taxation.
Determining Filing Requirements for S Corp Shareholders
S corps must complete Schedule M-2 if:
- Total assets at year end exceed $250,000
- The S corp has C corporation earnings and profits at year end
These requirements ensure that only larger S corps or those with complex accounts track AAA, OAA, and PTI. Smaller and simpler S corps meeting certain requirements may not need to file Schedule M-2.
Exploring the Key Components of Schedule M-2
The main sections and accounts covered on Schedule M-2 include:
- Part I: Beginning and ending balances of the AAA and OAA
- Part II: Breakdowns of activity impacting the AAA and OAA during the tax year
- Part III: Calculation of PTI and remaining accumulated earnings and profits
Properly recording increases and decreases to the AAA, OAA, and PTI enables accurate shareholder basis reporting on Schedule K-1 and appropriate taxation of S corp income.
What are recorded on form 1120-S Schedule M-2?
Form 1120-S, Schedule M-2 analyzes adjustments to the accumulated adjustments account, other adjustments account, and shareholders' undistributed taxable income previously taxed.
The key items recorded on Schedule M-2 include:
- Accumulated adjustments account (AAA): This tracks undistributed net income and loss for S-corps. It includes the company's net income, loss, deductions, and non-deductible expenses since becoming an S-corp.
- Other adjustments account: This includes non-separately stated income and loss items that affect AAA, but are not included in it. For example, tax-exempt interest income.
- Shareholders' undistributed taxable income previously taxed (UTPT): This tracks previously taxed income not distributed to shareholders in prior years. It ensures shareholders don't get double-taxed on retained earnings if later distributed.
So in summary, Schedule M-2 provides an analysis of items affecting S-corp shareholders' basis and tax liability for undistributed corporate income. It's an important schedule for tracking S-corp income and loss over time. Proper recording on Schedule M-2 enables accurate pass-through taxation to shareholders.
What is the accumulated adjustments account for S Corp?
The accumulated adjustments account (AAA) tracks the net taxable income and losses of an S corporation over its history. It is used to determine how much income a shareholder can receive tax-free when the S corporation makes distributions.
Some key points about the AAA:
- The AAA starts at $0 when the S corporation is formed
- It is increased by the S corporation's taxable income each year
- It is decreased by any non-dividend distributions made to shareholders
- Shareholders can receive tax-free distributions up to their share of the AAA balance
For example, if an S corp earns $100,000 of taxable income in Year 1 and makes no distributions, its AAA will be $100,000 at the end of the year. If it then distributes $50,000 to shareholders in Year 2 when it has no income, the AAA will be reduced to $50,000. The $50,000 distribution is tax-free to the shareholders.
The AAA ensures that S corporation income is only taxed once - either at the corporate level or the shareholder level when distributions are made. It allows S corps to make tax-free returns of previously taxed income to shareholders. Tracking it properly is essential for determining tax obligations.
Do I have to fill out Schedule M-2?
Generally, Schedule M-2 (Form 1120-S) must be completed if the S corporation has accumulated earnings and profits or has shareholders' undistributed taxable income previously taxed. Specifically:
- S corporations with accumulated earnings and profits (E&P) from C corporation years must complete Schedule M-2 to track E&P and any distributions made out of E&P. This allows the IRS to determine if distributions should be taxed as dividends.
- S corporations must also track shareholders' previously taxed undistributed taxable income. Schedule M-2 keeps track of this accumulated account to determine if distributions should be tax-free returns of basis.
So in summary, Schedule M-2 provides a way for S corps to report accumulated adjustment accounts, other adjustments accounts, and track taxability of shareholder distributions. It allows both the S corp and shareholders to determine correct tax treatment of distributions.
Some exceptions do apply. S corps with total assets under $25,000 at year end may not need to file Schedule M-2. See the form instructions for details. But in most cases, any S corp with C corporation E&P or previously taxed income should complete Schedule M-2.
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What is the difference between retained earnings and accumulated adjustments account?
The main difference between retained earnings and the accumulated adjustments account (AAA) on Form 1120-S is related to timing differences between book and tax reporting obligations.
Specifically:
- Retained earnings is an account that tracks the accumulated net income or losses of an S corporation based on financial accounting standards. It reflects the company's net earnings or losses over its lifetime.
- The accumulated adjustments account (AAA) tracks the cumulative net taxable income or loss of an S corporation throughout its existence. The balance directly impacts the tax liability of S corporation shareholders when distributions are made.
In other words:
- Retained earnings is based on financial accounting income/loss.
- AAA is based on taxable income/loss.
Because book and tax rules differ, there may be timing differences that cause discrepancies between retained earnings and AAA:
- For example, if book depreciation is less than tax depreciation, retained earnings would be higher than AAA. This is because more depreciation expense is deducted for tax purposes.
- Conversely, if tax depreciation is less than book, AAA would exceed retained earnings. Here, more depreciation is recorded on the financial statements.
The key takeaway is that retained earnings and AAA can differ due to differences in the way income and expenses are recognized for book versus tax purposes. Monitoring the relationship between these accounts is important from both a tax and financial reporting perspective.
Navigating Form 1120-S Instructions for Schedule M-2
Reporting Accumulated Adjustments Account Activity
The Accumulated Adjustments Account (AAA) tracks an S corporation's accumulated undistributed net income and losses over its lifetime. Any increases or decreases to the AAA balance during the tax year must be reported on Schedule M-2.
To calculate AAA activity:
- Start with the AAA balance at the beginning of the tax year
- Add or subtract current year income, losses, distributions, and other adjustments
- The ending AAA balance should equal the beginning balance plus any adjustments
For example, if the beginning AAA balance was $100,000, and the S corp had $50,000 of undistributed net income in the current tax year, the ending AAA balance would be $150,000. This $50,000 increase to AAA would be reported on Schedule M-2.
Provide clear descriptions of any increases or decreases to AAA on the applicable lines of Schedule M-2. The total net change should equal the difference between the beginning and ending AAA balances.
Detailing Other Adjustments Account Activity
The Other Adjustments Account (OAA) tracks items like nondeductible expenses and depletion in excess of basis. Any changes to the OAA balance during the tax year must also be reported on Schedule M-2.
To determine OAA activity:
- Start with the beginning year OAA balance
- Add new adjustments like nondeductible meals, travel, and vehicle expenses
- Subtract any distributions or other reductions made to the OAA balance
- The net change in the OAA account should be reflected on Schedule M-2
For example, if the beginning OAA balance was $5,000, and there were $2,000 in nondeductible business expenses added during the current tax year, the ending OAA balance would be $7,000. The $2,000 increase to the OAA would be reported on Line 7 of Schedule M-2.
Tracking Shareholder PTI Activity
The Previously Taxed Income (PTI) account tracks undistributed taxable income for each individual shareholder from prior tax years. Any distributions of PTI to shareholders during the current year must be reflected on Schedule M-2.
To track PTI activity:
- Review each shareholder's beginning PTI balance from last year’s Schedule K-1
- Add any PTI generated from current year distributions
- Subtract any PTI distributions made to the shareholder this year
- Report the ending PTI balance on this year's Schedule K-1
For example, if Shareholder A had a beginning PTI balance of $5,000 and received a $2,000 distribution of PTI in the current year, their ending PTI would be $3,000. The $2,000 reduction in Shareholder A's PTI would be reported on Schedule M-2, Line 8.
Properly tracking PTI activity for each shareholder ensures the accurate reporting of distributions on individual Schedule K-1s. Maintaining detailed records of increases and decreases to PTI is key.
Analyzing Shareholder Basis with Schedule M-2 Entries
Schedule M-2 tracks activity in a S corporation's Accumulated Adjustments Account (AAA) and Other Adjustments Account (OAA), which can impact a shareholder's stock and debt basis for loss limitation purposes.
Adjusting Stock Basis with AAA Activity
The AAA account tracks an S corporation's net income, losses, and distributions over its history. Shareholder's adjust their stock basis by their pro-rata share of each year's AAA activity.
- Income and losses flow through to adjust basis
- Distributions decrease basis
- Tracking basis annually prevents loss limitation surprises
Basis adjustments are essential for shareholders to claim their full share of S corporation losses each year.
Identifying OAA Transactions Affecting Debt Basis
The OAA tracks specific S corporation transactions that can increase or decrease a shareholder's debt basis. Examples include:
- Capital contributions can increase debt basis
- Loan repayments decrease debt basis
Monitoring debt basis adjustments from OAA transactions allows shareholders to maximize interest deductions on loans to the S corporation.
Processing PTI Distributions to Shareholders
Previously taxed income (PTI) represents income earned but not distributed. When PTI is actually distributed tax-free to shareholders, Schedule M-2 provides the reporting mechanism.
- PTI basis started with accumulated adjustment account
- Tax-free PTI distributions decrease shareholder AAA basis
- OAA tracks PTI paid tax-free to shareholders
Proper PTI transaction reporting maintains balanced AAA and OAA accounts.
Careful tracking of Schedule M-2 activity each year enables shareholders to monitor their stock and debt basis, claim losses, and receive PTI tax-free. Consistent annual analysis prevents lost deductions.
Filing Schedule M-2: Deadlines, Extensions, and E-Filing
Schedule M-2 must be filed along with Form 1120-S by the original due date of the S corporation tax return, typically March 15th for calendar year filers. However, extensions and e-filing mandates impact requirements.
Utilizing Form 7004 for Extended Filing Deadlines
S corporations can receive an automatic 6-month extension to file Schedule M-2 and other tax forms by submitting Form 7004 by the original due date. This pushes the filing deadline from March 15th to September 15th for calendar year filers. Complete Form 7004 accurately, indicating the extended due date, and file it before the unextended deadline to avoid late filing penalties.
Understanding E-Filing Mandates and Waivers
Effective for tax years ending on or after December 31, 2021, S corporations with assets of $10 million or more must e-file Schedule M-2 along with other forms as mandated by the IRS. Request a waiver using Form 8508 if facing undue hardship to comply with this electronic filing requirement. Waivers are evaluated on a case-by-case basis.
Complying with Schedule M-2 Filing Deadlines and Locations
For S corporations not eligible for extensions or e-filing waivers, Schedule M-2 must be filed by the original due date of the return (typically March 15th). Paper forms must be mailed to the applicable IRS address listed in the Form 1120-S instructions. Failure to comply risks penalties for late filing or failure to file.
Conclusion: Ensuring Compliance with Schedule M-2 Filings
Recapping Schedule M-2 Filing Essentials
S corporations must file Schedule M-2 to report activity in their accumulated adjustments account (AAA), other adjustments account, and shareholders' previously taxed undistributed income. This schedule impacts shareholder basis calculations. Key points to remember:
- S corps with over $250,000 in gross receipts or assets must file Schedule M-2 with Form 1120S
- The AAA tracks income, losses, distributions, and basis. Undistributed income increases basis while losses/distributions decrease it
- The other adjustments account tracks tax-exempt income and nondeductible expenses
- Shareholders must track previously taxed undistributed income to determine taxability of future distributions
Leveraging IRS Resources for Schedule M-2 Compliance
The Instructions for Schedule M-2 (Form 1120S) provide guidance on filling out the form accurately. IRS Publication 589 also covers shareholder basis calculations. Notices 2014-52 and 2016-39 clarify AAA maintenance requirements.
Taking Next Steps for Accurate Schedule M-2 Reporting
Properly tracking activity in the AAA, other adjustments account, and previously taxed income is complex. Consult a tax professional to review your Schedule M-2 compliance. They can ensure accurate reporting and help maintain proper shareholder basis accounts going forward. Taking these proactive steps will minimize audit risk and tax headaches down the road.
