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 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 Form 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 Drake Tax - 1040 - Distributions in Excess of Basis from 1120-S for information.

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

Additional Explanations

• Since line 6 is positive and $600 in distributions is greater than the calculated $200 limit, line 7 is limited to $200.

• 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.

• 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.

• 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.

• 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.

• 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.