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10230: 1120S - Calculating Schedule M-2


1120S Sub S Corporate

Why are the distributions not flowing to 1120S, Schedule M-2?

Distributions reported on Line 7 of the Schedule M-2, Form 1120S may carry differently than the amount entered on the Schedule K, Line 16d. The distributions are limited due to the ordering rules under Reg 1.1368.2. These rules are as follows for Schedule M-2, Column a:

  1. The balance at the beginning of tax year, line 1 is either zero or the balance carried forward from line 8 of the previous year. Due to prior year losses and reductions, the amount on line 1 can be negative.
  2. The Accumulated Adjustments Account (AAA) is increased for ordinary income from page 1, line 21 (line 2) and other additions listed on line 3.
  3. The AAA is then decreased for any Loss from page 1, line 21 (line 4) and other reductions listed on line 5.
  4. Once the above adjustments are made, the AAA is reduced by ordinary distributions on line 7, but not below zero. Thus, if the distributions are $20,000, but the net amount on line 6 is $10,000, line 7 will be limited to $10,000. If line 6 is negative, then line 7 will be zero, as to allow an amount on this line would take the AAA to a larger negative number (even more below zero than it is).
1 Balance at beginning of tax year (11,786)
2 Ordinary income and Other additions 58,440
3 Loss and other reductions (489)
4 Combination of lines 1-5 46,165
5 Distributions (total $60,000) (46165)
6 Balance at the end of tax year 0

The preceding rules pertain to when the net adjustment for lines 2 through 5 is positive. When the net adjustment for lines 2 through 5 is negative, the ordering rules are switched and AAA is decreased by ordinary distributions (but not below zero) before the net negative adjustment for lines 2 through 5.

1 Balance at beginning of tax year 11786
2 Distributions (total $60,000) (11786)
3 Net negative adjustment (lines 1-5) (57951)
4 Balance at the end of tax year (57951)

The distributions may be limited on line 7 even when Line 1 and Line 6 are both positive. Line 8 can not be negative due to distributions. The Instructions for Form 1120S, pages 45 and 46, explain this.

1 Balance at beginning of tax year 7500
2 Ordinary income and Other additions 71200
3 Loss and other reductions (100)
4 Combination of lines 1-5 78600
5 Distributions (total $81,000) (78600)
6 Balance at the end of tax year 0

This is not to say that the corporation cannot make distributions greater than the amount on line 6 of the Schedule M-2, but that those distributions may be taxable to the shareholders. Distributions are to be entered on the Schedule K, Line 16d. When they are entered there, they flow automatically to the M-2 and to the Schedule K-1, but are limited based on the preceding rules.


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