S Corporation Taxation in 15 Minutes: Basis, AAA, and Distributions (CPA REG Notes)

An S corporation pays no federal income tax itself. Instead, every item of income, loss, deduction, and credit flows through to the shareholders. They report it on their own returns whether or not the corporation actually distributed any cash. That single pass-through idea drives almost every REG question on S corporation taxation. It decides who pays tax, on how much, and what happens to their stock basis along the way. This note covers the three pillars examiners test relentlessly: shareholder basis ordering, debt basis, and the AAA/E and P distribution rules. It includes two worked examples and the traps that fail candidates.

S corporation taxation: eligibility and the pass-through idea

To elect S status, a corporation must be domestic, have no more than 100 shareholders, and have only one class of stock. Its shareholders must be eligible: individuals, estates, and certain trusts. Partnerships, corporations, and nonresident aliens cannot hold S stock. Shareholders make the election on Form 2553 by unanimous consent. Differences in voting rights do not create a second class of stock. Disproportionate distributions do, and a second class of stock terminates the election.

Once elected, the S corporation files Form 1120-S and issues each shareholder a Schedule K-1. Ordinary business income passes through as one number. Separately stated items keep their character in the shareholder’s hands. These include capital gains and losses, charitable contributions, Section 179 expense, and tax-exempt income. A shareholder reports the pro-rata share for the entire year even if they sold their shares mid-year. The allocation is generally pro-rata by day unless everyone agrees to an interim closing of the books.

Shareholder stock basis and the ordering rules

Every REG candidate must be able to walk a shareholder’s stock basis up and down. Basis controls two exam-critical outcomes: the deductible loss amount and the tax treatment of distributions. The starting basis is what the shareholder paid for the stock (or contributed). Then IRC Section 1367 applies a strict ordering, and the order is the most tested fact in this entire topic:

1. First, INCREASE basis for all income items (ordinary income and separately stated income, including tax-exempt income).
2. Then, DECREASE basis for distributions.
3. Then, DECREASE basis for nondeductible, noncapital expenditures (fines, 50% of meals).
4. Finally, DECREASE basis for deductible losses and deductions.

Basis can never go below zero. If losses exceed stock basis, the shareholder looks to debt basis next (see below). Any remaining loss stays suspended and carries forward indefinitely until basis is restored. Note the trap: distributions reduce basis BEFORE losses do. A year with both a distribution and a loss leaves less basis available to absorb the loss than candidates expect.

S corporation taxation: worked example (stock basis)

A shareholder starts the year with $50,000 of stock basis. During the year the S corporation allocates $30,000 of ordinary income and a $25,000 ordinary loss. It also makes a $20,000 cash distribution and incurs $5,000 of nondeductible fines. Walk the ordering: Start: $50,000. Step 1 (income): $50,000 + $30,000 = $80,000. Then Step 2 (distributions): $80,000 – $20,000 = $60,000. Next, Step 3 (nondeductible): $60,000 – $5,000 = $55,000. Finally, Step 4 (losses): $55,000 – $25,000 = $30,000 ending basis. The full $25,000 loss is deductible because basis never hit zero. Now change one fact: suppose the distribution had been $70,000 instead of $20,000. Step 2 would take basis from $80,000 to $10,000. Only $10,000 of the $25,000 loss would be deductible, and the remaining $15,000 suspends and carries forward. That single reordering is worth marks on exam day.

Debt basis

When stock basis hits zero, debt basis can absorb the remaining losses. Only bona fide direct loans from the shareholder to the corporation qualify. A shareholder’s personal guarantee of corporate debt does NOT create debt basis. Neither does a loan from a related party routed around the shareholder. This is a favorite exam trap. The fact pattern dangles a “shareholder guaranteed the bank loan” detail precisely to tempt you into counting it. Debt basis works like stock basis. Losses reduce it after stock basis is exhausted. Later income restores it under the net increase rule, which restores reduced debt basis BEFORE increasing stock basis.

AAA, E and P, and the distribution ordering

Here is where candidates lose the most marks. An S corporation that has never been a C corporation has no accumulated earnings and profits (E and P). Its distributions are simple. They are tax-free to the extent of the shareholder’s stock basis, and any excess counts as capital gain (usually long-term). But an S corporation WITH accumulated E and P must track the Accumulated Adjustments Account (AAA). This typically applies to a converted C corporation. AAA measures previously taxed but undistributed S corporation income. Distributions then follow a mandatory order:

1. From AAA: tax-free (shareholders already paid tax on this income).
2. From pre-1983 previously taxed income, if any.
3. From accumulated E and P: taxed as a DIVIDEND.
4. From the Other Adjustments Account (OAA, which tracks tax-exempt income): tax-free.
5. From shareholder stock basis: tax-free return of capital, reducing basis; any excess over basis is capital gain.

AAA is a corporate-level account. S corporation income increases it (excluding tax-exempt income), and distributions and losses decrease it. The AAA bypass election lets the corporation elect to distribute E and P first. This purges E and P. It also escapes the built-in gains tax and the excess passive investment income tax that apply to former C corporations.

S corporation taxation: worked example (distribution with E and P)

An S corporation has AAA of $40,000 and accumulated E and P of $10,000. A shareholder with $60,000 of stock basis receives a $55,000 cash distribution. Apply the ordering. The first $40,000 comes from AAA and is tax-free. The next $10,000 comes from E and P, and the shareholder reports it as dividend income. The remaining $5,000 is a tax-free return of capital. It reduces the shareholder’s stock basis from $60,000 to $55,000. If the distribution had instead been $75,000, the extra $15,000 beyond basis would be capital gain. Notice the two different kinds of “tax-free”. The AAA portion is tax-free because shareholders already paid tax on it. The basis portion is tax-free because it is a return of the shareholder’s own investment.

Exam traps that fail candidates

1. Basis ordering. Income up first, then distributions down, then nondeductible items, then losses. A distribution and a loss in the same year interact through this order.
2. Guaranteed debt is not debt basis. Only direct shareholder-to-corporation loans count; guarantees and back-to-back loans do not.
3. AAA is not stock basis. AAA is a corporate-level account tracking previously taxed income; stock basis is shareholder-level. Distributions reduce both, but they are different numbers.
4. Dividend treatment needs E and P. Without accumulated E and P, S corporation distributions are never dividends; they are tax-free to basis, then capital gain.
5. One class of stock. Voting differences are fine; disproportionate distributions terminate the S election.
6. Former C corporation taxes. The built-in gains tax and the excess net passive income tax can hit S corporations with C history; the AAA bypass election exists to purge E and P.
7. Loss limits stack. A loss must clear three hurdles: basis limitation (stock then debt), at-risk limitation, and passive activity limitation, in that order.
8. Debt basis restoration. Income restores reduced debt basis before it increases stock basis (net increase rule).

One-Page Revision: S Corporation Taxation

• S corporation: pass-through entity; shareholders taxed pro-rata on K-1 income whether distributed or not.
• Eligibility: domestic, 100 or fewer shareholders, one class of stock, eligible shareholders only; elect on Form 2553.
• Stock basis ordering (IRC 1367): (1) increase for income, (2) decrease for distributions, (3) decrease for nondeductible items, (4) decrease for losses. Basis floor is zero.
• Losses exceeding stock basis go to debt basis (direct shareholder loans only; guarantees do not count); remainder suspends and carries forward.
• Net increase rule: income restores reduced debt basis before increasing stock basis.
• No E and P: distributions tax-free to basis; excess over basis is capital gain.
• With E and P: distribution order is AAA (tax-free), pre-1983 PTI, E and P (dividend), OAA (tax-free), stock basis (return of capital), then capital gain.
• AAA bypass election distributes E and P first to purge it.
• Separately stated items keep their character; ordinary income is the residual.
• For background on the entity itself, see the IRS S corporation page; for more CPA coverage, see our related CPA FAR notes.

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CA Luhsna Awrak

CA L Awrak is a Chartered Accountant writing on CA exams, tax and finance careers.