Monday, February 23, 2009

S-Corp Accumulated Adjustment Account

Retained Earnings may not agree with the Accumulated Adjustment Account.

In most of the examples I have seen illustrating the Accumulated Adjustment Account (AAA) for an S-Corporation show it as being identical in amount with the Retained Earnings Account. This would be possible if the books and the tax returns used exactly the same method of depreciation and the shareholder does not make withdrawals in excess of his stock basis. If different depreciation methods are used, the AAA is not reduced for tax deductions in excess of book deductions.

Many S-Corporations do not use the same method for recording depreciation on the books as they use for income tax. When you depreciate an an asset, the tax method can produce larger deductions in the earlier years, then later produce smaller deductions than the Generally Accepted Accounting Procedures that are used for bookkeeping purposes. However, any method that ultimately fully depreciates the asset results in the same total deductions by the time an asset is fully depreciated.

Some assets may be written off completely or up to a maximum allowable amount under Section 179 in the year purchased. In such cases, it would be best to write the same amount off on the books to avoid confusion. However if they are written off on the tax return and not fully deducted on the books, then a timing difference would again exist just as if different methods of depreciation were used.

In any case, the AAA and Retained Earnings will vary due to timing differences. Over time, unless new assets are continually added, the two would come back into agreement (provided that the owner(s) do not withdraw more than their stock basis.

If shareholders DO withdraw more than their stock basis, they cannot reduce the AAA below zero. Withdrawals in excess of the owner's stock basis are taxable as capital gains.

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