My understanding has been that if there are no E&P (which is the case for most of my clients) then paid-in capital CAN affect the taxability of the distribution because it will increase the stockholder's basis and therefore could be distributed as part of tax-free distributions. If, however E&P exists, then the taxability of the distribution is determined with reference to AAA, which does NOT include capital contributions. I looked for some guidance and found this in this article (https://www.forbes.com/sites/anthonynitti/2014/04/08/tax-geek-tuesday-are-those-s-corporation-distributions-taxable/#71dcc8d06a22) in Forbes:
Stock Basis
... A shareholder must increase the basis of his S corporation stock for capital contributions, items of income (including tax-exempt income), and the excess of the deductions for depletion over the basis of the property subject to depletion....
..Of utmost importance is the order in which these adjustments are required to be made. This is because while distributions reduce basis, in many cases, it is the shareholder’s stock basis that will in turn determine the taxability of a distribution...
Accumulated Adjustment Account
...The maintenance of the AAA is critical when an S corporation possesses accumulated E&P because it is the AAA balance that will serve as the line of demarcation between those distributions made from S corporation income, which should not be taxed a second time, from those made from C corporation E&P, which must be taxed as a dividend to the recipient shareholders. The larger the AAA balance, the more likely a distribution will not be taxed as a dividend.
Each year, an S corporation must adjust its AAA in a manner similar to a shareholder’s required adjustments to stock basis. Unlike stock basis, however, the AAA is a corporate-level attribute and is generally not affected by shareholder-level transactions like sales or exchanges.
Specifically, an S corporation increases its AAA for the same items that increase basis, except AAA is not increased for capital contributions or tax-exempt income. Similarly, AAA is decreased for the same items that decrease basis, except for non-deductible expenses related to tax-exempt income.
Unlike stock basis, AAA may be reduced below zero, but only by losses, not by a distribution....