Distributions to Shareholders of S Corporations

The tax treatment of distributions to shareholders of an S corporation depends on whether the S corporation has accumulated earnings and profits (AEP) from the time prior to making the S election when it was a C corporation.

If an S corporation doesn't have accumulated earnings and profits (AEP), then the tax treatment of distributions is straightforward: a distribution is a tax-free recovery of capital to the extent of the shareholder's stock basis (any excess is treated as a gain from the sale or exchange of property).

If an S corporation does have accumulated earnings and profits (AEP), then the following ordering rules are used to determine the tax treatment of the distribution:
(1) the distribution first reduces the accumulated adjustments account (AAA) and is a tax-free recovery of capital
(2) after AAA reaches zero, the distribution next is a taxable dividend to the extent of accumulated earnings and profits (AEP)
(3) after AEP reaches zero, the distribution next reduces the other adjustments account (OAA)
(4) after OAA reaches zero, the remaining distribution reduces the shareholder's stock basis and is a tax-free recovery of capital (the shareholder's basis can't go below zero, so any excess is treated as a gain from the sale or exchange of property)

Changes in the AAA, AEP, and OAA accounts are reported on Schedule M-2 of Form 1120S.

In the event the S election is terminated, any cash distributions made within one year of the termination date are treated as a tax-free recovery of capital to the extent that they don't exceed AAA.

0:00 Introduction
0:48 Example with no AEP (Accumulated Earnings and Profits)
2:41 What is AEP (Accumulated Earnings and Profits)
4:48 The ordering rules for distributions
7:13 Schedule M-2 of Form 1120S
8:02 Example with AEP
12:02 Termination of S election
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