Retained Earnings and M2 Relationship?

[Hamacher]

If a company has always been an S Corp. shouldnt the retained earnings and M2 balance, with the exception of any temporary differences (i.e book vs tax depreciation, etc.)? I have a return that has an M1 item for IRS penalties (i.e. permanent difference) that for some reason is not reducing my M2 balance but is reducing retained earnings.

Thanks in advance for your help.

[OldJack]

I expect that you need an entry for the penalty amount on line 5 of the M2 schedule?

2. Generally, decrease the AAA by
deductible losses and expenses,
nondeductible expenses (other than
expenses related to tax-exempt
income), and the sum of the
shareholders’ deductions for depletion
for any oil or gas property held by the
corporation as described in section
1367(a)(2)(E)........

[JG EA]

M2

It is only recommended that it is filed. You do not have to fill out the M2. From the 1120S instructions:

An S corporation without accumulated E&P does not need to maintain the AAA in order to determine the tax effect of distributions. Nevertheless, if an S corporation without accumulated E&P engages in certain transactions to which section 381(a) applies, such as a merger into an S corporation with accumulated E&P, the S corporation must be able to calculate its AAA at the time of the merger for purposes of determining the tax effect of post-merger distributions. Therefore, it is recommended that the AAA be maintained by all S corporations.

[OldJack]

>>Therefore, it is recommended that the AAA be maintained by all S corporations.<<

That quote from the instructions is a good idea especially since the software usually works best to reconcile to the balance sheet. I always, regardless of small dollar amounts, fill out the balance sheet, M1, and M2 as it is just good accounting especially if you drop dead and someone else has to pick up where you left off.

[JG EA]

That's true

but it really, really bothers me when the bottom line doesn't equal the retained earnings. It bothers me so much I don't include it.

[outwest]

It used to bother me..

until I came to understand that the RE covers everything and AAA is just a subset of RE under it's own rules.

I saw one accountant that setup subaccounts of RE in the books with AAA, Nontaxable Income, and Other accounting Adjustments to track this. I've got several new S Corps this year I may do this with.

[OldJack]

but it really, really bothers me when the bottom line doesn't equal the retained earnings. It bothers me so much I don't include it.

In a S-corp that has always been an S-corp it is very unlikely that the AAA account does not agree with the Retained Earnings account of the balance sheet. About the only exception is tax-free income and few S-corps have that to deal with.

If you can't reconcile M2 with the S-corp balance sheet there is a good chance that you have made an error and the client is paying tax on the wrong amount of taxable income.

[rosieea]

In a S-corp that has always been an S-corp it is very unlikely that the AAA account does not agree with the Retained Earnings account of the balance sheet. About the only exception is tax-free income and few S-corps have that to deal with.

If you can't reconcile M2 with the S-corp balance sheet there is a good chance that you have made an error and the client is paying tax on the wrong amount of taxable income.

Another case that we've discussed before is when distributions are excessive. They cannot take AAA below zero, while, of course, they are applied to retained earnings. I find this situation relatively often. However, some practitioners ignore it and simply allow distributions to reduce AAA below zero.

[OldJack]

Another case that we've discussed before is when distributions are excessive. They cannot take AAA below zero, while, of course, they are applied to retained earnings. I find this situation relatively often. However, some practitioners ignore it and simply allow distributions to reduce AAA below zero.

Well... I expect there is a lot of confusion about the below zero thing. My interpretation of that is not that the M2 reconciliation sheet AAA column can't go below zero, but that deducting losses on the 1040 can't go below zero.

I don't think the IRS intended to get involved in the bookkeeping aspect of the S-corp. Also, I expect that software would simply not allow a negative figure in M2 if that was the case. My S-corp's have negative AAA accounts on the tax return all the time and the IRS has never questioned one.

[dsi]

My understanding of the AAA account is in linewith rosiea's, that is the distributions cannot reduce the AAA account below zero. However, losses can.

[rosieea]

Well... I expect there is a lot of confusion about the below zero thing. My interpretation of that is not that the M2 reconciliation sheet AAA column can't go below zero, but that deducting losses on the 1040 can't go below zero.

I don't think the IRS intended to get involved in the bookkeeping aspect of the S-corp. Also, I expect that software would simply not allow a negative figure in M2 if that was the case. My S-corp's have negative AAA accounts on the tax return all the time and the IRS has never questioned one.

It's not that AAA can't go below zero. It certainly can, but not as a result of distributions. My software alerts me when distributions would allow AAA to fall below zero, but allows me to override if I desire. No such alert appears if a negative AAA results from losses, for example.