Step 1 — Confirm Whether Schedule L/M‑1/M‑2 Are Required

• Check the small‑S‑corp exception. If total receipts and total assets are each under $250,000 for the year, the corporation is not required to complete Schedules L and M‑1 (see Schedule B, question 11 on Form 1120‑S). Even if you qualify for the exception, completing these schedules is a best practice when reconciling retained earnings and tax‑basis equity accounts (AAA, AE&P, etc.). 2024 Instructions for Form 1120‑S; 2024 Form 1120‑S

• Remember e‑file assembly order and required schedules. The instructions list the proper order and give the context for Schedule L, M‑1, and M‑2 so you can organize your workpapers consistently. 2024 Instructions for Form 1120‑S

Step 2 — Set Your Opening Balances From the Prior Return

• Obtain the prior year’s Form 1120‑S and note: Schedule L ending balances (assets, liabilities, and retained earnings on line 24) and Schedule M‑2 ending balances for each column: (a) AAA, (b) Shareholders’ undistributed taxable income previously taxed (PTI), (c) Accumulated earnings and profits (AE&P), and (d) Other adjustments account (OAA). 2024 Form 1120‑S

• Carry those amounts as your current year opening balances. Investigate any difference between last year’s ending retained earnings (Schedule L, line 24) and the current year’s beginning retained earnings in the books; resolve any mismatch before proceeding (e.g., prior period adjustments). 2024 Form 1120‑S

Step 3 — Map the Current Year Balance Sheet to Schedule L

• Map each asset and liability account from the current balance sheet to the corresponding Schedule L lines (cash, receivables net of allowance, inventories, other current assets, loans to shareholders, fixed assets net of accumulated depreciation; on the liabilities/equity side, accounts payable, short‑term debt, other current liabilities, loans from shareholders, long‑term debt, other liabilities, capital stock, APIC, retained earnings, adjustments, and treasury stock). 2024 Form 1120‑S

• Confirm the accounting equation (Assets = Liabilities + Equity) balances after mapping; tie your mapped totals to the trial balance. 2024 Form 1120‑S

Step 4 — Compute Book Net Income and Prepare a Book‑to‑Tax Reconciliation (Schedule M‑1)

• From the income statement, identify current year book net income (or loss). This lines up with Schedule M‑1, line 1 (book net income). Reconcile book to return income by adding/subtracting permanent and temporary differences (e.g., nondeductible expenses, tax vs. book depreciation). 2024 Form 1120‑S

• Enter typical Schedule M‑1 elements (lines 1–8: book income, income on Schedule K not on books, book expenses not on Schedule K, income recorded on books not on Schedule K, etc.). 2024 Form 1120‑S

• This reconciliation explains how retained earnings changes for book purposes can differ from AAA changes for tax purposes, a key point in S‑corp equity reporting. 2024 Instructions for Form 1120‑S

Step 5 — Prepare Schedule K Totals and Confirm Distribution Reporting

• Using the income statement and your M‑1 adjustments, compute Schedule K items (ordinary business income, interest/dividends, capital gains/losses, section 1231, etc.). Confirm that non‑dividend distributions to shareholders are reported on Schedule K, line 16d; dividends from AE&P (if any) are reported separately on Schedule K, line 17c. 2024 Form 1120‑S

• Cross‑check: Sum of shareholder distributions reported on all K‑1s must equal Schedule K, line 16d and tie to the general ledger. If any portion of a distribution comes from AE&P, it is a dividend and must be reported on Schedule K, line 17c and via Forms 1099‑DIV to shareholders. LB&I Transaction Unit—Distributions with AE&P; 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

Step 6 — Analyze and Roll Forward the Tax‑Basis Equity (Schedule M‑2)

• Column (a) AAA: The Accumulated Adjustments Account tracks cumulative S‑corp pass‑through income, loss, and non‑deductible expenses at the entity level; AAA is increased by taxable income items and excess depletion; decreased by non‑deductible/non‑capital expenses, deductible losses, and then by non‑dividend distributions (without making AAA negative). LB&I Transaction Unit—Distributions with AE&P

• Net negative adjustment rule: If the corporation has a net negative adjustment for the year, distributions can be sourced from beginning AAA before decreases for that year’s losses/non‑deductibles; distributions in excess of beginning AAA are not sourced from AAA. LB&I Transaction Unit—Distributions with AE&P

• Column (b) PTI: “Shareholders’ undistributed taxable income previously taxed” (rare; generally applies only if the S election predates 1983 and shareholders continuously owned stock). If present, distributions may be sourced from PTI before AE&P. LB&I Transaction Unit—Distributions with AE&P

• Column (c) AE&P: Accumulated earnings and profits are C‑corp E&P retained when an S‑corp previously operated as a C‑corp. If AE&P exists, distributions are sourced AAA → PTI → AE&P → OAA → return of capital/basis, and any portion from AE&P is a dividend to shareholders. IRC § 1368(c) overview in LB&I Transaction Unit

• Column (d) OAA: The Other Adjustments Account tracks tax‑exempt income and related expenses; it helps determine distribution sourcing when AAA/PTI/AE&P are exhausted, but distributions from OAA are still non‑dividend for tax purposes (subject to stock basis rules). LB&I Transaction Unit—Distributions with AE&P

• Rollforward procedure:

  • Enter each column’s beginning balance from last year’s M‑2 (Step 2). 2024 Form 1120‑S

  • Add current‑year increases/decreases per ordering rules; then subtract distributions (line 7) with proper sourcing; line 8 becomes ending balances. Ensure ending balances align with Schedule K distribution reporting (line 16d for non‑dividend; line 17c for dividends). 2024 Form 1120‑S

Step 7 — Reconcile Retained Earnings (Schedule L, line 24)

• Retained earnings (book) are reconciled as: Beginning retained earnings + current year book net income (per income statement, after Schedule M‑1 reconciliation) − dividends and distributions recorded on books ± any book‑only adjustments (prior period adjustments) = ending retained earnings (Schedule L, line 24). 2024 Form 1120‑S

• Important: Retained earnings on Schedule L will not necessarily equal AAA on Schedule M‑2; AAA is a tax‑basis account with strict ordering rules; retained earnings is a book capital account—keep these distinct to avoid misstatements. 2024 Instructions for Form 1120‑S; LB&I Transaction Unit—Distributions with AE&P

Step 8 — Confirm Distribution Classification (Non‑Dividend vs. Dividend) and Downstream Effects

• No AE&P present (most S‑corps): Distributions are non‑dividend and reduce AAA (to the extent of positive AAA; then reduce stock basis), with any excess over stock basis treated as capital gain to the shareholder. LB&I Transaction Unit—Distributions with AE&P

• AE&P present: Distributions are sourced AAA → PTI → AE&P → OAA; any portion from AE&P is a dividend and reported on Schedule K, line 17c and 1099‑DIV; retained earnings (book) typically decreases for all distributions recorded on books, whether dividend or non‑dividend. LB&I Transaction Unit—Distributions with AE&P; 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

Step 9 — Officer Compensation and Loans Cross‑Checks

• Officer wages must be properly treated as wages; “reasonable compensation” for shareholder‑employees is required and reported on Form W‑2 (not as distributions). Ensure wages are recorded properly (affects M‑1 and Schedule K). IRS Fact Sheet: Wage Compensation for S Corporation Officers

• Review loans to/from shareholders (Schedule L lines 7 and 19). Confirm that distributions were not misclassified as loans (and vice versa); improper classification distorts both retained earnings and tax‑basis equity reporting. 2024 Form 1120‑S

Step 10 — Tie‑Outs and Consistency Checks

• Tie Schedule L totals to your mapped balance sheet; verify Assets = Liabilities + Equity. 2024 Form 1120‑S

• Tie Schedule M‑2 ending balances to beginning balances plus current year changes (including distributions line 7). Confirm distributions and dividends agree with Schedule K (lines 16d and 17c) and the sum across K‑1s. 2024 Form 1120‑S; 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

• If the small‑S‑corp exception applies and you choose not to file Schedules L/M‑1/M‑2, retain full workpapers so you can substantiate retained earnings and tax equity movement. 2024 Instructions for Form 1120‑S

Step 11 — Recordkeeping and Documentation

• Keep a complete set of workpapers: prior return tie‑out; current trial balance mapping to Schedule L; M‑1 reconciliation details; M‑2 ordering calculations (especially AAA decreases/increases and distribution sourcing); and K/K‑1 distribution tie‑outs. Good records are required to substantiate return positions and reconcile book/tax equity movements. IRS Recordkeeping Guidance

Step 12 — Filing/Admin Reminders

• Assemble the return in the order shown in the instructions; e‑file is generally required if the corporation files 10 or more returns in the calendar year. 2024 Instructions for Form 1120‑S

• Double‑check Schedule K vs. Schedule M‑2 and Schedule L consistency, and ensure any dividend portion from AE&P is handled properly under the sourcing hierarchy. LB&I Transaction Unit—Distributions with AE&P

Quick Checklist (to Avoid Common Pitfalls)

• Opening retained earnings equals prior Schedule L ending retained earnings; opening AAA/AE&P/PTI/OAA equal prior Schedule M‑2 endings. 2024 Form 1120‑S

• Schedule K distributions (line 16d) and dividends (line 17c) tie to books and to M‑2 line 7 sourcing. 2024 Form 1120‑S

• AAA computed using correct ordering; apply the net negative adjustment rule when applicable. LB&I Transaction Unit—Distributions with AE&P

• AE&P (if any) used only to source dividends under the AAA → PTI → AE&P → OAA order; AE&P is not adjusted by current year S‑corp taxable income/loss. LB&I Transaction Unit—Distributions with AE&P

• Retained earnings (book) reconciled independently from AAA; do not force them to match. 2024 Instructions for Form 1120‑S

• Officer compensation correctly treated as wages (W‑2) and not distributions; check loans to/from shareholders. IRS Fact Sheet: Wage Compensation for S Corporation Officers; 2024 Form 1120‑S

By following this sequence—opening balance confirmation, careful Schedule L mapping, book‑to‑tax reconciliation (M‑1), rigorous tax‑basis equity rollforward (M‑2) under the AAA/AE&P rules, and a clean retained earnings reconciliation—you will file balance sheet items and retained earnings accurately, even with limited source documents. 2024 Instructions for Form 1120‑S; 2024 Form 1120‑S