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paid for with forgiven PPP loan proceeds
are fully deductible. Passthrough items from M’s Schedule K-1 in Example 1
While deductible expenses associated
Nonseparately stated income $9,200
with PPP loan forgiveness are included in
Capital loss (2,000)
the S corporation’s nonseparately stated
income or loss, these expenses will not
reduce AAA. According to the instruc-
tions for the 2021 Form 1120-S, U.S. P’s AAA and AE&P in Example 1
Income Tax Return for an S Corporation,
AAA AE&P
expenses paid with PPP loans that are
Balances, beginning of year $2,500 $6,750
forgiven reduce the other adjustments
Nonseparately stated income 9,200 —
account (OAA). Since the forgiveness of
Balances before loss items and distributions 11,700 6,750
a PPP loan results in tax-exempt income,
Capital loss (2,000) —
AAA will not be increased by the amount
Balances, before distributions 9,700 6,750
forgiven; instead, OAA will be increased.
Distributions (6,500) —
Federal income taxes attributable Balances, end of year $3,200 $6,750
to prior C corporation period
An exception exists to the rule that non-
deductible expenditures reduce AAA. If Income in respect of decedent over the aggregate income and gain
the S corporation pays federal income A person acquiring stock in an S cor- items.
taxes attributable to a prior C corporation poration from a decedent reduces the ■ Decreased or increased for a redemp-
period, the shareholder’s basis is reduced, stepped-up basis in the inherited S cor- tion distribution.
but AAA is not adjusted (Sec. 1368(e)(1) poration stock to the extent the stock’s
(A); Regs. Sec. 1.1368-2(a)(3)(i)(C)(1)). value is attributable to income in respect Example 1. Calculating AAA: M
of a decedent (IRD) (Sec. 1367(b)(4); is the sole shareholder of P Inc.,
AAA adjustments due to credit Regs. Sec. 1.1367-1(j)). AAA is not a calendar-year S corporation. P
recapture reduced by the IRD items. has AAA of $2,500 and AE&P of
AAA is decreased by the reduction in an $6,750 on Jan. 1. M’s stock basis
asset’s basis when general business credits Adjusting AAA in the proper on that date is $10,000, and he has
cause such reduction under Sec. 50(c)(1). order no basis from any debt owed to
Similarly, AAA is increased by the recap- The AAA balance at the beginning of him by P. Losses passed through
ture of general business credits under Sec. the year is adjusted in the following order by P are not limited by the pas-
50(a)(1) when such recapture causes a (Sec. 1368(e)(1)): sive income or at-risk rules, and
corresponding addition to an asset’s basis. ■ Increased for items of income and M has no other capital gain or loss
(See Sec. 50(c) and former Sec. 48(q)(6); gain (the first two bulleted items transactions. During the year, P
this cite relates to a shareholder’s basis under “Identifying Items That distributed $6,500 to M, and his
adjustment, but H.R. Rep’t No. 861, 98th Increase and Decrease AAA”). Schedule K-1, Shareholder’s Share
Cong., 2d Sess. 1227, reprinted in 1984-3 ■ Reduced by items of loss or deduction of Income, Deductions, Credits, etc.,
C.B. Vol. 2 481, indicates that AAA must (the third, fourth, and fifth bulleted shows the passthrough items in the
be adjusted also.) items under “Identifying Items table “Passthrough Items From M’s
That Increase and Decrease AAA”), Schedule K-1 in Example 1.”
LIFO recapture but this reduction is limited to the
LIFO recapture paid by the S corpora- amount of the increase for income The income and gain items ($9,200)
tion does not reduce AAA because LIFO and gain items. exceed the loss and deduction items
recapture is a federal tax attributable to ■ Decreased for nondividend distribu- ($2,000), so P’s AAA and AE&P are de-
a C corporation year, and AAA is not tions (the sixth bulleted item under termined as shown in the table “P’s AAA
reduced by such items. Also, under Sec. “Identifying Items That Increase and and AE&P in Example 1.”
1363(d)(5), basis is not reduced by LIFO Decrease AAA”). The distributions of $6,500 reduce
recapture; however, LIFO recapture pay- ■ Decreased by the excess, if any, of the stock basis and AAA and are nontaxable.
ments reduce AE&P. aggregate loss and deduction items The $2,000 capital loss is fully deductible

www.thetaxadviser.com April 2022 39