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11747: 1120S - Calculating Schedule M-2


1120S S corporation

How does Form 1120-S, Schedule M-2 work?

 

Form 1120-S, Schedule M-2 analyzes adjustments to the accumulated earnings account, other adjustments account, and previously taxed income account. Unlike on Form 1120, Schedule M-2 on Form 1120-S is not a reconciliation of retained earnings.

Schedule M-2 is divided into four columns and is used to reconcile the accounts that affect a shareholder's basis.

  • Column (a) is for the Accumulated Adjustments Account (AAA).
  • Column (b) is for shareholders' undistributed taxable income previously taxed. 
  • Column (c) is for accumulated earnings and profits.
  • Column (d) is for other adjustments.

Schedule M-2, Column (a)

Enter data for certain lines of Schedule M-2, column (a) using screen M2 (Accumulated Adjustment Account). Some lines are direct entry and others are adjustment fields. Details are as follows:

  • Line 1, Balance at start of year – Enter the AAA balance at the start of the year. Note that Schedule M-2, line 1 may, or may not, match Schedule L, line 24(b) (retained earnings at the beginning of the year).
  • Line 2, “Ordinary income from page 1, line 22” – This amount is automatically calculated and cannot be overridden or adjusted. 
  • Line 3, Other additions – Adjusts the sum of the following Schedule K lines; see “Statement 29” in View/Print mode:
    • Line 4, “Interest income” 
    • Line 5a, “Dividends – Ordinary dividends” 
    • Line 5b, “Dividends – Qualified dividends”
    • Line 6, “Royalties” 
    • Line 10, “Other income (loss)” 
  • Line 4, “Loss from page 1, line 22” – This amount is automatically calculated and cannot be overridden or adjusted.
  • Line 5, Other reductions – Adjusts the sum of the following Schedule K lines; see “Statement 30” in View/Print mode:
    • Line 12a, “Charitable contributions:” 
    • Line 12b, “Investment interest expense”
    • Line 12c, “Section 59(e)(2) expenditures”
    • Line 12d, “Other deductions”
  • Line 6, “Combine lines 1 through 5” – This amount is automatically calculated and cannot be overridden or adjusted.
  • Line 7, Nondividend distributions – Adjusts the amount that flows from Schedule K; amount is limited based on IRS guidelines (see Line 7 – Calculation Explained below)
  • Line 8, Balance at end of year – This amount is automatically calculated and cannot be overridden or adjusted. This amount may be negative if it is the result of losses instead of distributions. (See Line 7 – Calculation Explained below.)

Line 7 – Calculation Explained

Distributions are entered on screen DIST (Distributions) and carried to Schedules K and K-1, line 16d, as well as Schedule M-2, line 7 (if allowed). An adjustment field for Schedule M-2, line 7 is available on screen M2. Review the following information before making an entry in the adjustment field and to see why Schedule M-2, line 7 may be limited.

Per the 1120-S instructions and IRC Sec.1.1368-2(a)(3)(iii), Schedule M-2, column (a) (AAAs) cannot be negative as a result of distributions. Therefore, line 7 of Schedule M-2 may differ from what is entered on screen DIST.

The distribution limit is determined as follows:

   Beginning AAA balance (line 1)
+ Net adjustment (sum of lines 2 – 5)
= Distributions limit (line 6)

The amount reported on Schedule M-2, line 7 is based on line 6 and determined as follows:

  • If line 6 is positive, line 7 is limited to the lesser of line 6 or the total distribution reported on Schedule K. 
  • If line 6 is negative, line 7 is based on line 1:
    • If line 1 is positive, line 7 is limited to the lesser of line 1 or the total distribution reported on Schedule K. 
    • If line 1 is negative, no amount is allowed on line 7.

A distribution reported on Schedule K, line 16d that exceeds the amount allowed on Schedule M-2, line 7 may be taxable to the shareholders due to the lack of basis in the AAA account. See Related Links below for information about distributions in excess of basis on Form 1040.

Examples

For the following examples, since distributions (line 7) are limited to the lesser of line 6 or the total Schedule K distribution, we will assume that distributions from Schedule K are always greater than line 6.

Example (a) (b) (c) (d) (e)
Beginning AAA Balance (line 1) Net Adjustment (sum of lines 2 – 5) Distributions Limit (line 6; (a) + (b)) Total Distributions from S Corp. Allowed Distributions (line 7)
1 ($200) $400 $200 $600 $200
2 $0 $600 $600 $600 $600
3 $200 $600 $800 $400 $400
4 $200 ($600) ($400) $400 $200
5 ($200) $600 $400 $200 $200
6 $7,500 $71,000 $78,500 $81,000 $78,500

Examples – Additional Explanations

  1. Since line 6 is positive and $600 in distributions is greater than the calculated $200 limit, line 7 is limited to $200.
  2. Since line 6 is positive and $600 in distributions is not greater than the calculated $600 limit, line 7 is not limited and therefore equals $600.
  3. Since line 6 is positive and $400 in distributions is not greater than the calculated $800 limit, line 7 is not limited and therefore equals $400.
  4. Since line 6 is negative, we must refer to line 1. As line 1 is positive, the AAA balance for the beginning of the year is used for line 7; therefore, line 7 equals $200.
  5. Since line 6 is positive and $200 in distributions is not greater than the calculated $400 limit, line 7 is not limited and therefore equals $200.
  6. Since line 6 is positive and $81,000 in distributions is greater than the calculated $78,500 limit, line 7 is limited to $78,500.

Schedule M-2, Columns (b), (c), and (d)

Columns (b), (c), and (d) are generally used in the 1120-S package only if the entity either:

  • Filed an 1120 return in a prior year,
  • Was classified as an 1120-S prior to 1983.

Other things to keep in mind:

  • Column (b) is based on earnings and income; thus, it should never have a negative amount.
  • Net operating loss (NOL) carryovers from an 1120 corporation are suspended until either the NOLs expire, or the corporation loses its status as an S corporation. An exception to such suspensions is when PPP loan forgiveness needs to be reported; see the 1120-S instructions for details.

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