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1120-S Retained Earnings and AAA account


Ringers
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Assuming that the books of the 1120-S corporation are being kept on a TAX (rather than accounting) basis,  and the corporation has ALWAYS been an S corp, are the following statements true:

 

1.  If the corp has shown an overall profit since the date of incorporation and there are no "timing" differences between the books and the return, then the AAA account will equal Retained Earnings and Retained Earnings will have a positive balance.

 

2.  If the corporation has shown an overall loss since the date of incorporation, the AAA account will be $0 and the Retained Earnings account will be negative (representing the accumulated loss from inception).

 

3.  When profits bring the Retained Earnings account above $0 again, the the AAA account will again equal the Retained Earnings.

Again, these three questions assume that the Corporation has always been an S corporation,  that the books are done on a tax rather than accounting basis, and there are no timing differences, such I as depreciation methods, in play at any time.

I "inherited" five large accounts from an accountant friend who is having memory issues, has lost all computer copies and has no backups of all prior year returns, has no paper files or trial balances or fixed asset and depreciation statements.  I know his tax return balance sheets are plugged, but for all of the S corps (with all the above assumptions holding true for all of them) the retained earnings account is in general $300000 over the AAA account.  I think I will have to do a "reset" of the ending 2018 tax return balance sheet to get a new "opening" balance sheet for tax year 2019.  He also has loans to officers in excess of $100000 about which the officers have no idea.  He is bordering on dementia and his wife swears there are no documents anywhere in the house.

For depreciation going forward I was thinking of taking the balance sheet Fixed Assets minus Accum. Deperciation and depreciating that amount over a nominal period of 7 years Straight Line, since the corporation officers do not have asset lists either because "John always took care of those things."

I know Jack would say "Run Forest Run" but someone has to help these clients get out of this mess.  Most of them have been with him for 20 years or more.

 

Any suggestions?  Thanks in advance!!!!

 

 

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15 minutes ago, Ringers said:

Any suggestions?

Talk to the clients about prior-year K-1's.  Perhaps someone has *something* that will give you a clue where to start digging.  They may not know anything about those booked loans (for example) but the K-1's may have information that will help you to nudge their memories.  

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3 hours ago, Ringers said:

1.  If the corp has shown an overall profit since the date of incorporation and there are no "timing" differences between the books and the return, then the AAA account will equal Retained Earnings and Retained Earnings will have a positive balance.

#1 could be true if the S corp doesn't have anything that would flow to the Other Adjustments Account, usually tax-exempt income and related deductions.

 

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2.  If the corporation has shown an overall loss since the date of incorporation, the AAA account will be $0 and the Retained Earnings account will be negative (representing the accumulated loss from inception).

#2 - This is incorrect.  S corp losses can result in AAA being a negative balance, but distributions can't reduce it below zero.  Shareholder's basis that can't be reduced below zero. 

 

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3.  When profits bring the Retained Earnings account above $0 again, the the AAA account will again equal the Retained Earnings.

#3 - See #2 above.  Well, ignoring the error related to #2 and that AAA can be negative, if this was an S corp since inception, always on the tax basis of reporting, no timing differences, and no other activity that would be in the OAA, it is a possibility that AAA and retained earnings could be the same.

 

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Some other suggestions and thoughts -

  1. What records were used to prepare these returns that the client can provide? Possible clues may be found there.
  2. Depending on #1, you may be looking at amended returns for all open years.
  3. Does the client have copies of any returns?
  4. Have client request copies of returns from IRS?
  5. Form 4562 should be included with any year that has asset additions. Use that to reconstruct the fixed asset schedule as best you can and see how close you are.  Consider a plug for the remaining differences of cost and accumulated depreciation to tie in to the lastest balance sheet figures, but do NOT depreciate those "plugged" tie-in amounts since you really don't know what those are.

I'd have to know what your clients can dig up before commenting further. 

 

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First, I would move the shareholder loans to additional paid in capital. S corp debt basis is an unnecessary complication.

Too many preparers plug the balance sheet, which I hate! If the balance sheet is wrong, the tax return is probably wrong too.

Ideally, you should recreate all the returns from inception and reconstruct basis too. You didn't mention stock basis so I'm guessing the prior preparer didn't track that?

Are there actual balanced books for these companies?

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13 hours ago, Ringers said:

He also has loans to officers

Obviously, if this was money going out TO the officers and is shown as an asset, it can't be add'l pd in capital as Abby Normal suggested. Also, I know Abby has an adversion to debt basis in an S corp, but the transactions should be recorded based on the actual facts, clients' actions, and their intentions, not what we want them to be. 

Either way, this is a big mess!  Clients have convenient memories when it comes to money they've taken out of their corporations or have used the company checkbook as their own, and those amounts can easily result in large sums if this has occurred over many years. It's also possible that the accountant didn't know how to handle distributions in excess of AAA and was creative. 

This reminds me to mention reasonable compensation, if the owners are on payroll, and the status of quarterly and year end payroll reporting.  

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WOW!!!  Three of this board's heaviest hitters responding to my questions.  As was often said on Wayne's World, "I'm not worthy!!!"

All of the information and suggestions were excellent.  First of all, with regard to negative AAA, my understanding now is that it CAN be negative, but can not be made negative or reduced below 0 by distributions, which would then be treated as capital gains to the shareholder--is that correct?

All clients have copies of their returns which they have provided but 4562 forms just have depreciation from prior year assets or are simply not included.  New assets are sometimes listed on the return as "new acquisitions"  rather than increasing fixed assets.  Even when the fixed assets rise from 2017 to 2018 on Sch L, they are not listed on the 4562 forms.  The clients have bank reconciliations that they do and some receipts for recent fixed assets, but little else.   The original accountant had both 1120-S corps set up with no compensation paid to shareholders but with other C corps. used to pay shareholders and other employees and then "lease" them back to S corp for an inflated price.  Individuals own the vehicles used by the S corp (both Dental practices) and are being depreciated on the individual 1040 returns at 95% and 100% business use with no mileage figures give.   Both shareholders say that the vehicles are used mostly for commuting and just occasionally for lab work.  One client has at least part of the dental practice on QB and I am getting that as well as whatever information they can get me in terms of fixed assets.  One of the dental clients, however, asked me "what is a balance sheet."  

Abby, the $110000 loan is a loan TO the shareholder which he has no idea how it got there!

I Have given all of the taxpayers a detailed spreadsheet citing all of the missing items for each entity and asking for their help in reconstructing all of the inaccurate or incorrect items.  Between two clients, we are talking about 2 1120-S, 2 1120-C employee leasing corporations, 1 1065 LLC owning one of the office buildings, and the 2 1040 returns (one with 2 schedule C's), all prepared by the same accountant whose wife, thus far, has not been able to find ANY written records.  

I am not trying to belittle the prior accountant.  We have known each other a long time socially and both went to the same school in IN (the one with the leprechaun mascot).  He is a 
CPA with a JD as an international tax attorney, but as I said it has been a struggle for him to prepare these clients' returns for the past 3 or 4 years due to declining health.   The clients' responses to my queries have been "I trusted him to prepare my returns for the last 20 years."  Unfortunately, they did not keep the records they supplied him and neither did he.

I truly appreciate your combined help in this situation.

 

Respectfully,

 

Ringers

 

 

 

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2 hours ago, Ringers said:

the $110000 loan is a loan TO the shareholder

These mostly arise when the shareholder has zero basis and the preparer doesn't want the shareholder to pay capital gains tax on distributions. It's a ruse the would not pass IRS scrutiny, especially if there are no loan documents, interest rate or regular repayments, and they likely totally ignored imputed interest rules.

You'll have to move those to distributions if the shareholder can't/won't repay the money.

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On 7/26/2020 at 9:12 AM, Abby Normal said:

If the balance sheet is wrong, the tax return is probably wrong too.

Absolutely.  I will often not transmit a balance sheet if the corporation is below the limits, but I always print it out.  Just a year or two ago there was a $30,000 loan to a corporation recorded nowhere - but the balance sheet was off, so we knew something was very wrong.  Sent the clients off to dig (and it took them some time, too - these particular clients are clueless) and they finally found the supporting documentation for that loan - including the loan schedule and interest rate (hey, they'd forgotten that interest expense, too - real winners; we're now doing monthly bookkeeping for them).  

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22 hours ago, Ringers said:

Three of this board's heaviest hitters responding to my questions.  As was often said on Wayne's World, "I'm not worthy!!!"

Hope you are not including me in that three - I'll re-quote you and say I'm not worthy!  Judy's the expert, and Abby is right up there too.  Remember my accounting and tax knowledge is due only to years of study at HKU (Hard Knock University).

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3 hours ago, Catherine said:

Hope you are not including me in that three - I'll re-quote you and say I'm not worthy!  Judy's the expert, and Abby is right up there too.  Remember my accounting and tax knowledge is due only to years of study at HKU (Hard Knock University).

Uh, I'm no expert and there are those here with more expertise or knowledge here that will correct my errors. I just help where I'm able, when the post interests me, or when I see a post isn't getting any responses.

And Ringers, ever since your "wow" comment I've had SNL's Wayne's World theme stuck in my head, although my version is more like Wayne's mom starting at about 50 sec mark in the clip below.  Party On! 😄
 

 

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Thanks to EVERYONE who has responded.  I agree with Catherine completely about balance sheets--if the Balance Sheet doesn't balance,  then you can't trust anything else in the return.  I finished inputting the 2018 corporate and personal returns for 6 different entities in the two clients that have come to me from my acquaintance, and I found numerous serious errors in ALL of them.  One balance sheet for an S corp was off by over $200000, with $0 cash entered.  Another had $58000 in Retained Earnings but $145000 in the AAA account.  Incomplete postings of the K-1 to the personal returns associated with them.  HSA accounts posted on the 8889 but not carried to the Schedule 1.  The scariest items of all were 2 schedule C's, one for a music business with $2800 income and $114000 in expense and another for a pottery business with no income and $28000 of expense, both schedule C's on the same 1040.  Furthermore,  this same "hobby"loss total has been going on for 2016 and 2017 also with the same amounts of loss.  I am warming up to tell that client that they can expect their Fed tax to go up by about $28000 for the year, but the good news is they don't have to keep their business records any longer.  I also feel compelled to tell them that their 2016 through 2018 person return taxes were understated by about the same $28000 for EACH year not counting penalties.   I don't even think they could get HRB to file those Schedule C's.  SMH!!!!

 

 

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With regard to this 1120-S, here is where things stand.  The S-corp was always S for 22 year existence.  Books were always on on TAX basis.   Cash basis.  There has never been exempt income.

Net earnings for 2018 were $189000.

2018 Schedule L shows $50000 cash as only asset, no liabilities, $1000 stock and $49000 retained earnings.  AAA account at $180000 even after $150000 distribution.  

Bank reconciliation shows 12/31/18 balance in all checkbooks as $1400 TOTAL.

Schedules M-1, M-2 are all plugged figures.

 

How would you prepare the 2019 tax return for this S-corp so that the 2019 Schedule L and stockholder basis statement made sense?  What would you do with opening balances for 2019 on the 2019 Schedule L?  Former accountant has no prior year data on his computer, no workpapers, and diminished mental capacity.  Client does not have a clue as to what has happened,  since he relied explicitly on the accountant for all fillings.

Client has 4 years of returns only.  All are plugged in a similar fashion to 2018.

 

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