Trap 11 · The AAA · From Chapter 9
AAA and Excess Distributions: Tax-Free Until It Isn't
The accumulated adjustments account is the running balance of undistributed S-corp income — distributions drain AAA tax-free first, then E&P as dividends, then stock basis, with any remainder taxed as gain from the sale of stock.
The ordering
Section 1368 stacks every distribution: AAA first and tax-free, then accumulated earnings and profits as dividend income, then the shareholder's remaining stock basis tax-free. Each layer must empty before the next begins.
AAA in, AAA out
AAA rises with S-corp income and falls with losses and distributions — it can even go negative from losses, though distributions cannot drive it below zero. Track it yearly; the ending AAA balance on Form 1120-S is next year's starting point.
The capital-gain tail
Distributions beyond AAA, E&P, and stock basis are treated as gain from the sale or exchange of stock — generally capital gain. Pair this page with stock and debt basis and distributions vs salary to see the full basis picture.
Trap questions, answered
- What is AAA?
- The accumulated adjustments account — a running record of undistributed S-corp income that shareholders can withdraw tax-free before any dividend layer begins.
- When do S-corp distributions become dividends?
- Only when the corporation carries C-corp earnings and profits and distributions exceed AAA — that E&P slice comes out as dividend income.
- What happens when distributions exceed all basis?
- The excess is treated as gain from the sale or exchange of stock, generally taxed as capital gain.
The law: 26 U.S.C. §1368 · Full Ch. 9 summary
The other traps: Distributions vs Salary · Stock and Debt Basis · S Election Eligibility · Late S Election Relief