The Accumulated Adjustments Account (AAA) is an S-corporation equity account that tracks the corporation's cumulative income, losses, and distributions since its S election. For most S-corps that have always been S-corps (no prior C-corp history), the AAA is essentially a bookkeeping formality - all distributions come out tax-free up to the shareholder's basis and excess is capital gain. The AAA becomes critically important for S-corps that converted from C-corporations, because accumulated C-corp earnings and profits (AE&P) lurking in the S-corp can transform what looks like a capital distribution into a fully taxable dividend.
Pure S-corp (always been an S-corp, no AE&P): AAA tracks cumulative income minus losses minus distributions. Distributions are tax-free up to shareholder basis; excess is capital gain. AE&P is zero, so the ordering rules are simple. Most small business S-corps fall into this category.
Former C-corp with AE&P: If the S-corp has accumulated earnings and profits from its C-corp years (AE&P), those AE&P sit like a tax bomb inside the S-corp. Distributions come out of AAA first (tax-free to the extent of basis). Once AAA is exhausted, any distribution up to AE&P is a fully taxable dividend - ordinary income, not capital gain. Only after both AAA and AE&P are exhausted do distributions come from other accumulated adjustments (OAA) or as return of basis.
AAA starts at zero on the date of the S election (or is inherited from a prior S election). Each year, AAA is increased by the shareholder's pro-rata share of ordinary income and separately stated income items (but not tax-exempt income, which goes to the Other Adjustments Account). AAA is decreased by distributions, losses, and deductions - but not below zero (unlike shareholder basis, AAA cannot go below zero due to loss allocations; it can be negative due to distributions, but only to the extent distributions exceed the positive AAA balance). At year-end, after all income and loss allocations, distributions reduce AAA.
When an S-corp has accumulated AE&P from its C-corp years, the corporation must be careful about how distributions interact with the AAA and AE&P ordering rules. Under IRC §1368(c): distributions from an S-corp with AE&P are first applied to reduce the AAA (tax-free up to basis), then to reduce AE&P (taxable dividend), then to reduce OAA, then as return of basis (tax-free), then as capital gain. A large distribution in a year when AAA is low and AE&P is high can trigger unexpected dividend income.
The passive investment income (PII) rules create a related trap: if an S-corp with AE&P has passive investment income exceeding 25% of gross receipts for three consecutive years, the S election terminates. An S-corp that converted from a C-corp and holds investment assets must monitor passive income relative to gross receipts to avoid inadvertent termination of the S election.
Under IRC §1368(e)(3), an S-corp and its shareholders may elect to have distributions bypass AAA and come directly from AE&P first. This "bypass election" (or "distributing AE&P first election") is made annually with the consent of all affected shareholders. The bypass election is useful when the shareholders prefer to eliminate AE&P (by paying dividend tax on it now) rather than risk the passive investment income termination risk or the AE&P trap on future distributions. After AE&P is eliminated, the bypass election has no further effect - all subsequent distributions come from AAA normally.