The tax treatment of distributions to shareholders of an S corporation depends on whether the S corporation has accumulated earnings and profits (AEP) from the time prior to making the S election when it was a C corporation. If an S corporation doesn't have accumulated earnings and profits (AEP), then the tax treatment of distributions is straightforward: a distribution is a tax-free recovery of capital to the extent of the shareholder's stock basis (any excess is treated as a gain from the sale or exchange of property). If an S corporation does have accumulated earnings and profits (AEP), then the following ordering rules are used to determine the tax treatment of the distribution: (1) the distribution first reduces the accumulated adjustments account (AAA) and is a tax-free recovery of capital (2) after AAA reaches zero, the distribution next is a taxable dividend to the extent of accumulated earnings and profits …
