Turning client books into S corporation tax returns

Client books rarely land on your desk in pristine condition. A retained earnings figure fails to reconcile with Schedule M-2 (Form 1120-S), a credit card ledger displays an unnatural negative balance and your tax preparation software throws warnings you cannot ignore. Tax professionals face these reconciliation puzzles every season.

Navigating S corporation filing exceptions and thresholds

An S corporation doesn't always need to complete Schedule L and Schedule M-1. If both its total receipts for the year and its total assets at year-end are less than $250,000, it can answer "Yes" to question 11 on Schedule B and leave those two schedules blank. This exception does not cover Schedule M-2. That distinction matters especially for a former C corporation with accumulated earnings and profits (AE&P): it must maintain the accumulated adjustments account (AAA) to determine the tax treatment of distributions.

Keep the accumulated adjustments account straight

The AAA causes more confusion than any other line in this area. Distributions can reduce AAA, but only to zero. Operating losses, deductions, and other negative adjustments can push it below zero, and that negative balance carries forward to the next tax year.

On Form 1120-S, U.S. Income Tax Return for an S Corporation, AAA generally increases with taxable income items such as ordinary business income, separately stated income and taxable gains. It generally decreases by deductible losses and expenses, separately stated deductions, nondeductible expenses unrelated to tax-exempt income and certain depletion adjustments. Tax-exempt income, along with the expenses tied to it, usually goes to the other adjustments account (OAA) instead. Remember that AAA isn't normally a general ledger account. It's a tax account kept on Schedule M-2 and adjusted when you prepare Form 1120-S. Your client's bookkeeper won't find it in the chart of accounts.

Reconciling retained earnings and Schedule M-2

Line 24 retained earnings on Schedule L is a per-book number, even though it's reported on the tax return. The ending balances on Schedule M-2 follow tax rules under §1368, so they don't necessarily agree with retained earnings on Schedule L. Don't assume a difference means an error; review and reconcile it.

Handling SMLLC-to-S corporation conversions

A related scenario involves a single-member limited liability company (LLC) reporting on Schedule C (Form 1040) that elects S corporation status. Can it have retained earnings in year one? Yes, from its first-year earnings. Its opening equity, however, generally reflects a capital contribution. Under Reg. §301.7701-3(g)(1)(iv), the owner is deemed to contribute the LLC's assets and liabilities to the corporation in exchange for stock. Therefore, opening net equity ordinarily represents a shareholder's capital contribution, not corporate retained earnings.

Correcting balance sheets and managing software warnings

You can and should correct a prior-year balance sheet when an amount was inaccurate or you find an omitted transaction. Figure out the cause, make the correcting entry and keep documentation explaining it. Current-year beginning balances should generally match the prior year's ending balances, so any difference must be identifiable and supportable, never entered just to make the balance sheet balance. Software warnings flag inconsistencies for your review and don't necessarily mean an audit is coming.

If an error affected net income or other required return information, advise your client on the error and whether to amend the prior-year return. If it didn't, an amended return may not be necessary. Either way, the client makes the final call.

Resolving common bookkeeping anomalies

Most balance sheet discrepancies stem from timing or posting issues:

• Undeposited funds: These represent cash or checks received but not yet deposited. Customer payments are a current asset, not accounts receivable, since the money's already collected. They can remain on the balance sheet at year-end if received before year-end and deposited afterward, subject to the accounting method and surrounding facts.
• Negative credit card balances: These can arise when payments are recorded before related charges. Reconcile to statements and record missing charges to the right expense or asset accounts.
• Negative bank balances: An account may only look negative because deposits haven't been recorded, or the account hasn't been reconciled. Once you enter missing items, the book balance may be positive. It's a bookkeeping issue rather than an actual overdraft.
• Book vs. tax asset values: When book assets and tax assets don't agree, reconcile the difference rather than automatically trying to true them up. Book carrying value and tax basis can legitimately differ because of depreciation or other book-tax differences. Schedule L should reflect the corporation's books and records. If Schedule L itself doesn't balance, investigate and correct it; also investigate any unexplained book-tax difference.
• Manual books: If your client keeps books manually and you don't control them, send adjusting journal entries with clear recording instructions. Keep a copy and confirm the client entered them before you rely on corrected balances. Moving to accounting software can also give you a cleaner audit trail.

Build reconciliation into your routine

Nearly every situation above comes down to one habit: find out why the numbers differ before you change them. For more practice turning client books into tax reporting, explore NATP’s Oct. 21 Interpreting Client Books for Tax Reporting webinar. The webinar is also available on demand after the live event. For ongoing support, explore NATP membership.