The Other Adjustments Account, usually shortened to OAA, is a Schedule M-2 tracking account that an S corporation uses to keep tax-exempt income and its related expenses separate from every other pool of corporate earnings. It only becomes consequential when the S corporation carries accumulated earnings and profits (AE&P) from prior C corporation years, because that is when the source of each distributed dollar changes its tax treatment for shareholders.1Internal Revenue Service. Distributions with Accumulated Earnings and Profits – Sourcing from OAA
What Goes In the OAA and What Stays Out
The Accumulated Adjustments Account (AAA) is defined to exclude tax-exempt income and expenses tied to that income, so the corporation needs a separate account to hold them.2Office of the Law Revision Counsel. 26 USC 1368 – Distributions That account is the OAA.
On the income side, the OAA captures items like interest from municipal bonds and life insurance proceeds received on the death of an insured officer. On the expense side, it captures costs directly connected to producing tax-exempt income, such as interest on debt used to buy tax-exempt bonds and premiums on corporate-owned life insurance. The account also holds any federal taxes carried over from C corporation years.3Internal Revenue Service. 2025 Instructions for Form 1120-S – Schedule M-2 Column (d)
The split of non-deductible expenses is where most bookkeeping errors happen. Non-deductible items that have nothing to do with tax-exempt income belong in the AAA: fines, penalties, the non-deductible portion of business meals, and political contributions. Only expenses directly connected to producing tax-exempt income go in the OAA.4Internal Revenue Service. Distributions with Accumulated Earnings and Profits
Getting the split wrong has real consequences. Reducing the AAA for a tax-exempt-related expense understates the AAA and pushes distributions into the AE&P tier sooner than they should get there, turning a tax-free distribution into a taxable dividend. Parking a routine non-deductible expense in the OAA does the opposite: it inflates the AAA and can make a taxable distribution look tax-free.
When the OAA Actually Matters
The OAA carries weight for S corporations that were once C corporations and still have accumulated earnings and profits on the books. Those companies distribute through a multi-tier ordering system, and the OAA is the account that identifies exactly how much corporate value came from tax-exempt activity rather than from taxed S corporation income or older C corporation earnings.
For S corporations that have never been C corporations and have no AE&P, the picture is far simpler. Distributions reduce stock basis with no tax consequence, and anything above basis is treated as gain from a sale of stock.2Office of the Law Revision Counsel. 26 USC 1368 – Distributions These corporations still record tax-exempt items on Schedule M-2, but the sourcing analysis that gives the OAA its bite doesn’t apply to them.
Where the OAA Sits in the Distribution Order
When an S corporation has AE&P, every distributed dollar runs through a six-step sourcing order. The OAA sits at step four:
- Step 1, AAA. Distributions come first from the Accumulated Adjustments Account, representing S corporation income already taxed to shareholders. Tax-free to the extent of stock basis.
- Step 2, PTI. Any remainder comes from Previously Taxed Income under IRC 1379(c), which is pre-1983 S corporation earnings already taxed to shareholders.
- Step 3, AE&P. The next tier draws from C corporation accumulated earnings and profits and is treated as a taxable dividend, subject to qualified dividend rates.
- Step 4, OAA. Only after the first three tiers are exhausted do distributions reach the OAA. They are non-taxable to the extent they don’t exceed remaining stock basis.
- Step 5, remaining basis. Further distributions reduce stock basis dollar-for-dollar with no tax consequence.
- Step 6, excess. Anything beyond basis is taxed as a capital gain.
This ordering comes from IRC 1368(c) and 1379(c).4Internal Revenue Service. Distributions with Accumulated Earnings and Profits Because the OAA is fourth in line, distributions actually sourced from it are uncommon. The AAA, PTI, and AE&P have to be fully depleted first.
The AAA Bypass Election
An S corporation with AE&P can elect to flip the first three tiers so that distributions come from accumulated earnings and profits first, then from the AAA.5eCFR. 26 CFR 1.1368-1 – Distributions by S Corporations
Volunteering to take taxable dividends before tax-free AAA distributions sounds backwards, but the point is usually to purge the AE&P balance. Once AE&P hits zero, the corporation is out of the multi-tier system entirely and future distributions follow the simpler rules for S corporations without AE&P. When the AE&P balance is small, shareholders can sometimes wipe it out in a single year at a manageable tax cost.
The election applies to every distribution made during the tax year, requires the consent of every shareholder, and must be attached as a statement to a timely filed Form 1120-S, including extensions.5eCFR. 26 CFR 1.1368-1 – Distributions by S Corporations It is made year by year, so the corporation can return to the default ordering in any later year.
How OAA Items Affect Shareholder Stock Basis
The OAA is a corporate account, but the items inside it flow through to each shareholder’s stock basis. Tax-exempt income increases basis and non-deductible expenses related to that income decrease it, whether or not the corporation distributes the funds.6Office of the Law Revision Counsel. 26 USC 1367 – Adjustments to Basis of Stock of Shareholders
Shareholders get the numbers on Schedule K-1. Box 16, Code A reports tax-exempt interest income, Code B reports other tax-exempt income, and Code C reports nondeductible expenses.7Internal Revenue Service. Shareholders Instructions for Schedule K-1 Form 1120-S These amounts don’t appear on the shareholder’s return as taxable items, but they still have to be factored into the running basis calculation.
When a distribution is eventually sourced from the OAA, it reduces stock basis dollar-for-dollar. Anything past remaining basis is a capital gain.4Internal Revenue Service. Distributions with Accumulated Earnings and Profits A shareholder who never added tax-exempt income to basis in prior years may think a distribution exceeds basis when it doesn’t, or the reverse.
Reporting the OAA on Form 1120-S
The OAA lives in column (d) of Schedule M-2 on Form 1120-S. The schedule tracks the beginning balance, additions for tax-exempt income and federal taxes from C corporation years, reductions for related expenses, and a subtraction for any distributions sourced from the account during the year. The ending balance carries forward as next year’s beginning balance.8Internal Revenue Service. Instructions for Form 1120-S – Schedule M-2
Additions to column (d) should tie directly to the tax-exempt income reported on Schedule K, line 16a.9Internal Revenue Service. 2025 Instructions for Form 1120-S The Schedule M-2 figures also have to match the corporation’s internal books, and the Box 16 K-1 amounts flow into each shareholder’s personal basis records, so a corporate-level error becomes a shareholder-level error automatically.
Fixing Prior-Year OAA Errors
If a prior year’s OAA balance was wrong, the correction starts with an amended Form 1120-S. Check box H(4) on page 1 of the amended return and attach a statement identifying each amended line item, the corrected amount, and an explanation. If any shareholder’s K-1 was affected, file amended K-1s with the “Amended K-1” box checked and give copies to those shareholders.9Internal Revenue Service. 2025 Instructions for Form 1120-S
The current year’s Schedule M-2 should open with the corrected ending balance from the prior year, not the figure originally reported. An uncorrected error carries forward indefinitely, and every subsequent year’s distribution sourcing can be pulled from the wrong tier as a result.