Schedule M-2: What It Analyzes on Each Business Return

Three schedules with the same name and different jobs

Form 1120. The heading says it: analysis of unappropriated retained earnings per books, Schedule L line 25. Beginning balance, net income per books, other increases, then distributions split between cash, stock and property, then other decreases, giving the ending balance. It reconciles to the balance sheet directly.

Form 1120-S. Four columns: the accumulated adjustments account, shareholders' undistributed taxable income previously taxed, accumulated earnings and profits, and the other adjustments account. Line 2 is the ordinary income from page 1 line 22.

This is the one that confuses people. The S corporation M-2 follows tax rules, not book rules, so it is not expected to equal book retained earnings on Schedule L. Nondeductible expenses, differences between book and tax depreciation and any history as a C corporation all drive the two apart.

Form 1065. Analysis of partners' capital accounts: beginning balance, capital contributed in cash and property, net income, other increases, then distributions in cash and property, other decreases, and the ending balance. The IRS position is that this should equal the total of the item L amounts across every partner's K-1.

The roll forward as a control

Beginning equity, plus income, less distributions, plus or minus adjustments, equals ending equity. That one line of arithmetic finds most balance sheet problems:

• Difference equals the distributions: they were never entered or never closed
• Difference equals net income: the year was never closed, or page 1 is incomplete
• Difference equals twice an account: a sign is reversed
• Difference of a dollar or two: rounding, not worth the hunt

The AAA conversation worth having

On an S corporation, a distribution larger than the accumulated adjustments account is not automatically an error. It can simply mean the company has distributed more than its accumulated taxable income, which is normal for a business funded by debt or by earlier contributions.

What it does mean is that the shareholder basis question is live. A distribution is tax free to the extent of stock basis and generally capital gain beyond it, and that is decided on the shareholder's own return rather than here.

Accumulated earnings and profits

The third column of the S corporation M-2 exists for former C corporations. Old C corporation earnings and profits survive the S election, and distributions out of them are taxable dividends rather than tax free distributions.

A company with C corporation history and a blank E&P column is worth a second look, because the ordering rules for distributions have real consequences for the shareholders.