...(continued)  In 2013, the sole shareholder took a distribution of $3,000. This was the only activity for the year. After you enter the distribution in your tax preparation software, retained earnings are reduced to ($4,000) while Schedule M-2 AAA remained at ($1,000). Should you be concerned?


For purposes of simply AAA matching retained earnings, no. Unlike a partnership or a C corporation return, Schedule M-2 does not need to match Schedule L, as Schedule M-2 is not a reconciliation of equity. Retained earnings is a concept based on accounting principles (assets = liabilities + equity), while AAA is based on tax law.

Regulation §1.1368-2(a)(3)(iii) specifically states that AAA is not reduced below zero by distributions. The IRS recognizes this difference and is generally not concerned if AAA is different from retained earnings as indicated in the Internal Revenue Manual

The bigger concern is if this is a distribution in excess of stock basis. If the taxpayer does not have any basis, gain will be recognized.