Updated October 18, 2026. Quick answer: Schedule M-2 tracks four accounts in four columns: the accumulated adjustments account, shareholders’ undistributed taxable income previously taxed, accumulated earnings and profits, and the other adjustments account. Each column runs from a beginning balance on line 1 to an ending balance on line 8. The instructions include a worksheet and a worked example, which you should read on the instruction pages themselves.
What Schedule M-2 is
Schedule M-2 is at the bottom of page 5 of the Form 1120-S return. The heading is “Analysis of Accumulated Adjustments Account, Shareholders’ Undistributed Taxable Income” followed by the other two accounts. The form’s columns are headed “Accumulated adjustments account”, “Shareholders’ undistributed taxable income previously taxed”, “Accumulated earnings and profits” and “Other adjustments account”.
The form’s lines 1 to 8
The form lists eight lines for each column. Line 1 is “Balance at beginning of tax year”. Line 2 is “Ordinary income from page 1, line 22”, line 3 is “Other additions”, line 4 is “Loss from page 1, line 22” and line 5 is “Other reductions”. Line 6 reads “Combine lines 1 through 5”, line 7 is “Distributions”, and line 8 reads “Balance at end of tax year. Subtract line 7 from” line 6. The page 1 ordinary income and loss behind lines 2 and 4 is covered on the page 1 lines 13 to 22 page.
Column (a): the accumulated adjustments account
The instructions describe the AAA this way: “The accumulated adjustments account (AAA) is an account of the S corporation that generally reflects the accumulated undistributed net income of the corporation for the corporation’s post-1982 years.” “On the first day of the corporation’s first tax year as an S corporation, the balance of the AAA is zero.” “At the end of the tax year, adjust the AAA for the items as explained below and in the order listed.”
The instructions then list the order. Item 1 reads “Increase the AAA by income” with the exceptions stated there. Item 2 reads “Generally, decrease the AAA by deductible losses and expenses, nondeductible expenses” with more wording on the instruction page. Item 3 reads “Decrease AAA (but not below zero) by property distributions” with an exception stated there, and item 4 reads “Decrease AAA by any net negative adjustment.” The instructions also say “The AAA may have a negative balance at year end.”
On who must keep it: “An S corporation without AE&P doesn’t need to maintain the AAA in order to determine the tax effect of distributions.” “Therefore, it is recommended that the AAA be maintained by all S corporations.”
Columns (b), (c) and (d)
Column (b) is the previously taxed account, which, in the instructions’ words, “is maintained only if the corporation had a balance in this account at the start of its 2025 tax year.” “Each shareholder’s right to nontaxable distributions from PTEP is personal and can’t be transferred to another person.”
Column (c), accumulated earnings and profits: “If the corporation was a C corporation in a prior year, or if it engaged in a tax-free reorganization with a C corporation” the instruction continues from there, and “Estimates based on retained earnings at the end of the tax year are acceptable.”
Column (d), the other adjustments account: “The other adjustments account is adjusted for tax-exempt income (and related expenses) and federal taxes attributable to a C corporation tax year.” “After these adjustments are made, the account is reduced for any distributions made during the year.”
Line 7: distributions and the order they reduce accounts
The instructions give the default order: “Unless the corporation makes one of the elections described below, property distributions (including cash) are applied in the following order”. The order runs from the AAA, to the previously taxed account, to accumulated earnings and profits, to the other adjustments account, then to any remaining shareholders’ equity accounts. For the first step, “the AAA is allocated pro rata to each distribution made during the tax year.”
The instructions describe three elections to change the order and how to make them: “make any of the above elections, the corporation must attach a statement to a timely filed original or amended Form 1120-S”. Read the instruction page for the election names and consent rules. Distributions are reported on Schedule K line 16d, covered on the Schedule K lines 14 to 16 page, and the shareholder basis effect is on the Form 7203 page.
The worksheet and the worked example
The instructions include a table titled “Schedule M-2 Worksheet” marked as a record for the corporation to keep, and a worked example with its own numbered list of items per return. Both are tables of figures, so this page does not reproduce them: read them in the instructions. The example states its assumption: “In this example, the corporation has no PTEP or AE&P.” It also shows that “distributions can’t reduce the AAA below zero.” Use it to check your own column arithmetic, not as a source of rules beyond what the instruction paragraphs above say.
Where the number comes from
Line 2 or line 4 comes from page 1, line 22. The other additions and reductions come from the Schedule K items, as the worked example in the instructions shows for each item. Distributions on line 7 come from the corporation’s distribution records. The corporation also keeps the accounts in the instructions’ worksheet for its own records.
Where it goes next
The instructions say the corporation keeps these accounts “to determine the tax effect of distributions”. The same page of the return carries the Schedule M-1 reconciliation and the Schedule L balance sheet.
Edition and line numbers
This page reads the 2025 Form 1120-S and its 2025 instructions, the current files irs.gov served on 2026-10-18. They are the files for the tax year 2025 return, filed in 2026. Form 1120-S prints the title line “U.S. Income Tax Return for an S Corporation”, with the header “For calendar year 2025 or tax year beginning”. Check the tax year printed on the form you are filling in and use the line numbers on that year’s form, because a different year’s form can number or word its lines differently.
Common mistakes
- Reducing the AAA below zero with distributions. The instructions say “Decrease AAA (but not below zero) by property distributions”
- Using the wrong order for the year-end adjustments. The instructions say “At the end of the tax year, adjust the AAA for the items as explained below and in the order listed.”
- Making a distribution election without the statement. The instructions say “make any of the above elections, the corporation must attach a statement to a timely filed original or amended Form 1120-S”
Related: Form 1120-S, Form 7203, Schedule K-1 box 16, and S corporation election and Social Security.
Sources
- Instructions for Form 1120-S, U.S. Income Tax Return for an S Corporation (2025): https://www.irs.gov/pub/irs-pdf/i1120s.pdf
- Form 1120-S, U.S. Income Tax Return for an S Corporation (2025): https://www.irs.gov/pub/irs-pdf/f1120s.pdf
Read from the IRS documents linked above on October 18, 2026. General information, not tax advice. Your own facts decide the outcome, and a preparer, the account provider or the IRS is the right place to confirm anything consequential.