U.S. Business Taxpayers reporting income using IRS Form 1120S who like to drill down into the tax forms my team prepares usually tend to get a little freaky over the Accumulated Adjustment Account (AAA) reported on Schedule M-2, specifically why the entry doesn't tie out to what their books and records show for retained earnings.
Rightfully so, it is a very hard concept to wrap ones arms around. To assuage those concerns and for the benefit of efficient review a standard operating procedure we use quite effectively is to have a spreadsheet prepared in support of the differences running year over year as well as a separate and distinct spreadsheet to track shareholder basis.
This consistent approach to "practicing matters of taxation" is one of the many benefits of having a long term relationship with a professional #EnrolledAgent.
Generally speaking the retained earnings balances are reported on Schedule L, and are not necessarily analyzed on Form 1120S. Because the retained earnings balances are based on transactions per the books, the retained earnings balance will generally not be the same as the AAA balance, or the combined AAA, OAA, and PTI balances, which are based on tax return amounts.
So it really is not to worry about - as long as it is being tracked and can be explained.
It is a good idea to reconcile the AAA with Retained Earnings so you at least know what is causing the difference. This is one of those extra services that separates true tax professionals from the crowd of reprobates hanging their shingle as a tax pro.
In addition to tracking AAA v. Retained Earnings year over year it is also important to separately track both your debt and equity basis (or investment) that you have in your entity. While doing this make sure to account for the fact that your basis changes all the time contingent on many factors including ordinary business income and owner draws claimed, etc.
Takeaways from this post:
- If spreadsheets help you explain the difference between AAA and Retained Earnings (3 years from filing date when it is usually scrutinized) and to also track basis then yes use spreadsheets. I do.
- The Schedule M-1 accrual to cash adjustment is IMHO the #1 factor that would cause the difference between the AAA and retained earnings on Schedule M-2.
- In the case of distributions, the AAA cannot go below zero without having tax implications. But, otherwise, it can go below zero in case of a loss.
- Be careful to identify whether the ordinary business loss reported in the period should be suspended or passed to the shareholder via Schedule K-1.
- If you are still confused on what else would cause differences between the AAA and retained earnings accounts be sure to look closely at distribution limits and timing differences (book to tax depreciation, etc.) as well as 50% of meals and entertainment, penalties and fines, etc.
- The IRS actually moved the the language governing this section of the tax return to IRM to 188.8.131.52.2.2(3) found here -> https://www.irs.gov/irm/part4/irm_04-010-003-cont01.html