The Net Negative Adjustment Rule for S Corporation AAA

The net negative adjustment rule for S corporation AAA, found in IRC §1368(e)(1)(C), changes the order in which losses and distributions hit the Accumulated Adjustments Account during a year when the corporation’s decrease items outweigh its increase items. Instead of netting all income and losses first and then subtracting distributions, the rule pulls distributions out of AAA before the excess loss is applied. That sequencing usually preserves enough AAA to let shareholders receive their money tax-free, even when the corporation lost ground for the year.

When a Net Negative Adjustment Exists

A net negative adjustment exists when the items that reduce AAA for the year, excluding distributions, exceed the items that increase it.¹ The difference between the two totals is the NNA amount. Testing for it is the first thing to do each year, because it determines which ordering sequence applies on Schedule M-2.

Items that increase AAA include ordinary business income, separately stated income items such as capital gains or rental income, and the excess of the depletion deduction over the property’s basis. Tax-exempt income does not increase AAA. It sits in a separate account called the Other Adjustments Account.²

Items that decrease AAA include deductible business losses, separately stated loss and deduction items, and non-deductible non-capital expenses such as the non-deductible portion of meals, penalties, and fines. Federal taxes from prior C corporation years and expenses tied to tax-exempt income are excluded. Distributions themselves are not counted in the NNA calculation, even though they reduce AAA in their own step.²

A quick check: a corporation earns $50,000 of ordinary income, incurs $60,000 in deductible losses, and adds $15,000 in non-deductible expenses. Increases total $50,000. Decreases (excluding distributions) total $75,000. The net negative adjustment is $25,000.

The Ordering Rule in an NNA Year

In a normal year, everything nets out and distributions come off whatever balance remains. In an NNA year the regulation splits the loss in two and inserts distributions in the middle of the sequence.² The steps run in this order:

Increase AAA by the year’s income items and excess depletion.
Decrease AAA by loss, deduction, and non-deductible expense items, but only the portion that is not the net negative adjustment. Because the NNA is defined as the excess of decreases over increases, this step exactly offsets the income added in the first step, effectively returning AAA to its beginning-of-year balance.
Reduce AAA by distributions, but not below zero.
Apply the net negative adjustment.

The effect is that distributions come out of the beginning AAA balance rather than an AAA that has already absorbed the year’s losses.

A Worked Example

An S corporation begins the year with a $100,000 AAA balance. During the year it earns $50,000 of ordinary income, incurs $75,000 of deductible losses and non-deductible expenses, and distributes $80,000 to its sole shareholder. Decreases of $75,000 minus increases of $50,000 produce a $25,000 net negative adjustment.

Applying the ordering: AAA rises to $150,000 after the income step, drops back to $100,000 after the non-NNA decreases, falls to $20,000 after the $80,000 distribution, and finishes at negative $5,000 once the $25,000 NNA is applied. The entire $80,000 distribution is sourced from AAA and treated as a tax-free return of previously taxed income.

Run the same numbers without the rule: beginning AAA of $100,000, plus $50,000 income, minus $75,000 in losses and expenses, leaves $75,000. The $80,000 distribution would exceed AAA by $5,000. For a corporation with accumulated earnings and profits from prior C corporation years, that $5,000 would be a taxable dividend. The NNA rule is what prevents that outcome.

How the Distribution Is Taxed Once Ordering Is Applied

The tax character of the distribution turns on what remains in AAA after the distribution step and whether the corporation carries AE&P.

For a corporation with AE&P, the portion of a distribution that does not exceed AAA (measured after the Step 3 reduction) is treated the same as a distribution from a corporation with no earnings and profits: it reduces the shareholder’s stock basis and is otherwise tax-free. Any excess over AAA is a dividend to the extent of AE&P, taxed at qualified dividend rates of 0%, 15%, or 20% depending on the shareholder’s income. Anything left after both accounts are exhausted reduces stock basis, and distributions beyond basis are capital gain.¹

For a corporation with no AE&P, the AAA ordering still runs, but distributions simply reduce stock basis dollar for dollar. Once basis reaches zero, further distributions are capital gain from the sale of property.¹ Without AE&P in the mix, there is no dividend reclassification risk, so the ordering rule matters less in practice.

When more than one distribution is made during an NNA year, the AAA available at year-end (computed without the NNA) is allocated among the distributions in proportion to their size. A shareholder who receives $60,000 in March and $40,000 in November splits the available AAA 60/40 between them rather than sourcing the earlier one entirely from AAA.

When AAA Goes Negative

Distributions cannot push AAA below zero. That floor is built into Step 3 of the ordering. Losses and non-deductible expenses can, and often do, drive the account below zero.² Several consecutive loss years can leave a corporation with a deeply negative balance.

A negative AAA carries no immediate tax cost, but it blocks future tax-free distributions. Before any distribution can be sourced from AAA again, the account has to climb back above zero through profitable years. Until it does, distributions from a corporation with AE&P will be taxed as dividends, even if the shareholders already paid tax on the earlier income that ran through the corporation.

Electing to Bypass AAA

An S corporation with AE&P sometimes wants distributions to come out of AE&P first. That happens most often when the corporation is trying to drain its AE&P balance to avoid the tax on excess passive investment income under IRC §1375, or to head off the loss of S status after three consecutive years of excess passive investment income while carrying AE&P.

Section 1368(e)(3) allows the corporation to elect to distribute from AE&P before AAA.¹ Shareholders will owe dividend tax on those distributions, but reducing the AE&P pool can prevent bigger problems later. The election is made by attaching a statement to a timely filed Form 1120-S, original or amended, and it applies only to the year it is made. Every shareholder must consent, though the corporate officer’s signature on the return is sufficient. It is irrevocable for the year, but the corporation can choose whether to make it again in a later year.

Reporting on Schedule M-2

AAA is reported in Column (a) of Schedule M-2 on Form 1120-S. The schedule walks through the same steps: beginning balance, increases, decreases (or the NNA-modified version when applicable), distributions, and ending balance.³ AE&P and the Other Adjustments Account, if either applies, sit in adjacent columns on the same schedule.

Because the NNA rule only changes ordering during loss years, the test has to be run every year before Schedule M-2 is completed. Total the decrease items (excluding distributions), total the increase items, and compare. If decreases win, the modified sequence applies. If increases win, the standard ordering applies and distributions come off whatever balance is left after netting.

1
Office of the Law Revision Counsel. 26 USC 1368 – Distributions
2
eCFR. 26 CFR 1.1368-2 – Accumulated Adjustments Account
3
Internal Revenue Service. Instructions for Form 1120-S