The Core Purpose of the Other Adjustments Account (OAA)
The Other Adjustments Account (OAA) is a tax record used by S corporations with accumulated earnings and profits (AE&P) from prior C corporation years. Its primary function is to track specific items that affect a shareholder's stock basis but are not part of the Accumulated Adjustments Account (AAA). Because S corporations typically pass profits and losses through to shareholders, tracking these items in the OAA ensures that certain non-taxable gains are correctly accounted for and can be distributed to shareholders tax-free after other accounts have been exhausted. It is reported on Schedule M-2 of Form 1120-S along with the AAA and AE&P.
Specific Items that Increase the OAA
The OAA is increased by various income items that are exempt from federal taxation. These items increase the shareholder's basis in their stock, but because they are not taxed at the corporate level, they do not flow through the AAA. Notable examples include:
- Tax-exempt interest: Income earned from tax-exempt bonds is a common item that increases the OAA.
- Forgiven Paycheck Protection Program (PPP) loans: Forgiven PPP loan proceeds are treated as tax-exempt income for S corporations, and they increase the OAA. While the IRS did allow certain flexibility, the standard treatment was an OAA increase.
- Life insurance proceeds: In cases where an S corporation receives proceeds from life insurance on an officer, these tax-free proceeds are added to the OAA.
Specific Items that Decrease the OAA
Conversely, certain non-deductible expenses are tracked in the OAA. These expenses decrease the shareholder's basis but are not deductible for federal tax purposes. Examples include:
- Expenses related to tax-exempt income: Costs incurred to generate the tax-exempt income that is recorded in the OAA must also be recorded there. For instance, interest expenses on a loan used to buy tax-exempt bonds.
- Nondeductible fines and penalties: Monetary fines or penalties incurred by the S corporation are subtracted from the OAA because they reduce the corporation's overall equity but are not deductible for tax purposes.
- Portion of nondeductible meals and entertainment: Prior to tax law changes, certain nondeductible meal and entertainment expenses were also accounted for here.
- Nondeductible life insurance premiums: Premiums paid on an officer's life insurance policy, if the S corporation is the beneficiary, are not deductible and thus decrease the OAA.
The Ordering of Distributions and the OAA
For an S corporation with accumulated earnings and profits, distributions follow a specific, four-tiered ordering rule for tax purposes. This order is critical for determining how each dollar of a distribution is taxed.
- Distributions from AAA: The first money distributed comes from the Accumulated Adjustments Account. These distributions are tax-free to the extent of the shareholder's stock basis.
- Distributions from AE&P: Once the AAA is exhausted, distributions are considered to come from the Accumulated Earnings and Profits. This portion of the distribution is taxed to the shareholder as a dividend.
- Distributions from OAA: After AE&P is reduced to zero, any remaining distribution comes from the OAA. These are treated as a non-taxable return of capital to the shareholder, further reducing their stock basis.
- Distributions reducing stock basis: Finally, any distribution exceeding the balances in the AAA, AE&P, and OAA is treated as a return of capital and reduces the shareholder's stock basis to zero. Any further distributions beyond this point are typically treated as a capital gain.
OAA vs. AAA: A Comparison
To fully understand the OAA, it's helpful to see how it differs from the AAA, the more commonly discussed S corporation account. Both are used to track a shareholder's basis, but they track different types of items.
| Feature | Other Adjustments Account (OAA) | Accumulated Adjustments Account (AAA) |
|---|---|---|
| Primary Function | Tracks tax-exempt income and related non-deductible expenses. | Tracks the S corporation's accumulated taxable income and losses. |
| Key Additions | Tax-exempt interest, life insurance proceeds, forgiven PPP loans. | Ordinary income, separately stated income items (excluding tax-exempt income). |
| Key Reductions | Non-deductible expenses related to tax-exempt income, fines, penalties. | Ordinary losses, separately stated loss/deduction items, distributions. |
| Distribution Priority | Third in line, after AAA and AE&P. | First in line. |
| Basis Impact | Impacts shareholder stock basis directly, as it includes non-taxable items. | Reflects taxable income that was previously taxed to shareholders. |
| Related Account | Only exists if the S corporation has prior AE&P from a C-Corp history. | Exists for most S corporations to track earnings and distributions. |
Conclusion: The Importance of Accurate OAA Tracking
Understanding what is included in OAA is not merely a technicality; it is a fundamental part of proper S corporation tax accounting, especially for businesses with a history as a C corporation. Accurate tracking ensures that tax-exempt items, such as forgiven PPP loans or tax-free bond interest, do not inadvertently become taxable upon distribution. It also helps shareholders correctly determine their stock basis, which is crucial for determining the tax consequences of distributions and the sale of stock. By meticulously maintaining the OAA, S corporation owners can navigate the complexities of corporate distributions and tax obligations with greater clarity and precision.
For more information on the complexities of S corporation distributions and basis calculations, the IRS offers comprehensive guidance in its publications, including instructions for Form 1120-S and related schedules.
How OAA Impacts Shareholder Basis
- Increases shareholder stock basis: Tax-exempt income recorded in the OAA directly increases a shareholder's basis in their S corporation stock, even though it is not subject to income tax.
- Decreases shareholder stock basis: Non-deductible expenses recorded in the OAA reduce a shareholder's basis, reflecting the reduction in the company's equity.
- Affects timing of tax-free distributions: Distributions from the OAA are considered a tax-free return of capital, but they can only be made after the Accumulated Adjustments Account (AAA) and Accumulated Earnings and Profits (AE&P) have been exhausted.
- Determines taxable gain on stock sale: Since OAA adjustments modify a shareholder's basis, they play a direct role in calculating the taxable gain or loss upon the sale of their S corporation stock.
- Helps reconcile book vs. tax differences: The OAA provides a way to reconcile the differences between a corporation's book income and its tax basis, particularly regarding permanently different items.
