SEE Class Update

Clarifications for OCEA SEE Class Students re: Distributions from OAA:

 

Below is an excerpt from PPC’s 1120S Deskbook that clarifies that the distribution ordering rules for an S Corporation with E&P is a 6-tier system, not a 5-tier system as detailed on page 383 of the text.  Further, when I reviewed the discussion to question 34 on page 395, the phrase “distributions cannot be treated as coming from the OAA” is correct for this particular question from the standpoint that the balance of the distribution in the question’s fact pattern can be absorbed by E&P, and E&P must be distributed BEFORE OAA.

I hope this clarification is helpful.  Vicki Mulak, EA, CFP

 

Checkpoint Contents
  Federal Library
    Federal Editorial Materials
      PPC's Federal Tax Compliance Library
        1120S Deskbook
          Balance Sheet and Equity Accounts
            Chapter 25: Schedule M-2
              Key Issue 25C: Determining the Effect of the Other Adjustments Account on Distributions and Schedule M-2.

 

Key Issue 25C: Determining the Effect of the Other Adjustments Account on Distributions and Schedule M-2.

Schedule M-2 includes a reconciliation of the other adjustments account (OAA). The OAA is used to record items that affect the shareholder's basis without affecting the AAA. The items recorded in the OAA are (1) tax-exempt income, (2) expenses directly related to tax-exempt income, and (3) federal income taxes paid that are attributable to any C corporation tax period [IRC Sec. 1368(e)(1)(A)].

Example 25C-1: Impact of current activity on OAA.

Jim Dalton owns all of the shares of JD, Inc., a company that incorporated 10 years ago. JD elected S status on January 1 of the current year, at which time it had an unappropriated retained earnings balance of $40,000 and an AE&P balance of $50,000. Jim's stock basis was $30,000.

The corporation passes through $47,000 of ordinary income from the business, $4,000 of tax-exempt interest income, and $450 in interest expense on a loan to purchase the tax-exempt bonds.

The pass-through items that affect basis without affecting the AAA are recorded in the OAA. Thus, the $47,000 increases the AAA, the $4,000 increases the OAA, and the $450 decreases the OAA. Illustration 25-3 shows this information in a filled-in Schedule M-2.

Unlike AAA and PTI, the OAA is not used to measure the taxability of distributions. (See Example 25C-2 and Key Issues 21I, 25A, 25E, and 25F.)

Example 25C-2: Treatment of distributions that reduce OAA.

Shades, Inc., an S corporation, has the following balances on January 1 of the current year:

AAA

$ 40,000

PTI

35,000

OAA

25,000

AE&P

30,000

 

Sandy, the sole shareholder, has basis of $90,000 in her stock at that date. During the year, Shades passes through ordinary income from operations of $18,000 and distributes $150,000 toSandy.

If the corporation has AE&P, the AAA, PTI, and OAA balances, if any, must be calculated before stock basis is determined. This calculation order is necessary because stock basis is not reduced by any portion of the distribution that reduces AE&P. As shown in the following paragraphs, $108,000 of the $150,000 distribution is nontaxable, $30,000 is a dividend, and $12,000 is long-term capital gain.

The corporation's AAA, PTI, OAA, and AE&P balances at December 31 are determined as follows:

 

 

AAA

 

PTI

 

AE&P

 

OAA

Balances, beginning of year

$ 40,000

$ 35,000

$ 30,000

$ 25,000

Nonseparately stated income

18,000

— 

— 

— 

Loss and deduction items

— 

— 

— 

— 

Balances, before distributions and loss items

58,000

35,000

30,000

25,000

Distributions of AAA and PTI

(58,000)

(35,000)

— 

— 

Dividend distributions

— 

— 

(30,000)

— 

Distributions of OAA

— 

— 

— 

(25,000)

Balances, end of year

$ -0-

$ -0-

$ -0-

$ -0-



Preparation Pointer: Distributions cannot reduce AAA, PTI, OAA, or AE&P below zero.

After AE&P has been distributed, nontaxable distributions reduce the OAA, in accordance with the IRS instructions to Form 1120S.

Sandy's stock basis is determined as follows:

Basis, beginning of year

$ 90,000

Pass-through income

18,000

Basis, before distributions and loss items

108,000

Distributions of AAA (nontaxable)

(58,000)

Distributions of PTI (nontaxable)

(35,000)

Distributions of OAA (nontaxable to extent of remaining basis)

(15,000)

Basis, end of year

$ -0-

 

Distributions of AE&P do not reduce basis under IRC Sec. 1367(a)(2)(A).

The distribution is nontaxable to the extent of the AAA and PTI ($58,000 + $35,000) and is a dividend to the extent of AE&P ($30,000). Once AE&P has been reduced to zero, the taxability of further distributions is determined solely by reference to stock basis.

The taxability of the $150,000 of distributions can be summarized as follows:

 

 

Nontaxable

 

Dividends

Capital
Gain

AAA

$ 58,000

$ — 

$ — 

PTI

35,000

— 

— 

AE&P

— 

30,000

— 

OAA (to extent of remaining stock basis)

15,000

— 

— 

Capital gain (to extent of remaining OAA)

— 

— 

10,000

Capital gain

— 

— 

2,000

Totals

$ 108,000

$ 30,000

$ 12,000

 

For purposes of tax return reporting, the OAA balance is reduced by $25,000. This reduction, however, is for tax return tracking of AAA and OAA balances only; it does not affect the taxability of the distributions. Since the corporation no longer has AE&P, distributions are nontaxable to the extent of stock basis and capital gain to the extent they exceed stock basis [IRC Sec. 1368(b)]. A completed Schedule M-2 for this example is at Illustration 25-4.

 

Preparation Pointer: After AE&P has been distributed, the AAA is no longer used as a measure of nontaxable distributions. Instead, distributions are nontaxable to the extent of the shareholder's basis. However, the instructions to Form 1120S state that the AAA and OAA balances should be calculated each year on Schedule M-2, even if there is no AE&P, because the AAA can be distributed tax free during the post-termination transition period (see Key Issue 36F) and because the actual AAA balance must be determined under certain other circumstances, such as when an S corporation without AE&P merges with an S corporation that has AE&P. (See Chapter 21 for further discussion of distributions.)

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