Form 1120S: How to Handle Prior Period Adjustment to Retained Earnings from Change in Accounting Basis

The change from tax basis to GAAP is definitely a tricky situation! This is actually more common than you'd think. When a client switches accounting methods, you're basically dealing with a Section 481(a) adjustment. For your situation, you don't need to amend the prior year return. Instead, you'll need to report the cumulative effect of the change in accounting method on the current year return. This is handled primarily through Schedule M-1 (or M-3 if required). The beginning retained earnings on Schedule L should match what was reported on last year's return. For the difference caused by the switch to GAAP, you'll create an adjustment on Schedule M-1, line 5 "Expenses recorded on books this year not deducted on this return." If the adjustment increases taxable income, it goes on line 3 instead. For your Schedule M-2 issue, you'll need to include the cumulative effect of the accounting change as an "other increase" or "other decrease" to retained earnings, depending on the direction of the adjustment. Make sure to clearly label it as "Sec 481(a) adjustment - change from tax basis to GAAP." This approach maintains proper tax treatment while acknowledging the accounting principle change.

After struggling with a similar Form 1120S accounting basis change issue that was driving me crazy, I discovered taxr.ai (https://taxr.ai) and it was seriously helpful. I uploaded my client's financial statements and prior year return, and the system actually identified exactly where the retained earnings adjustment needed to be made. What was great is that it specifically explained how to handle the Section 481(a) adjustment on both Schedule M-1 and M-2, and provided the proper disclosure language to include with the return. It pointed out that my retained earnings discrepancy was actually related to the accumulated depreciation differences between tax and GAAP basis - exactly what you're dealing with. The system walked me through where each adjustment needed to go, and even flagged that I needed to file Form 3115 for the accounting method change. Saved me hours of frustration trying to figure this out on my own!

Just wanted to follow up about taxr.ai that I asked about earlier. I decided to give it a try with a particularly difficult S-Corp return that had a similar retained earnings issue from a change in accounting method. I was honestly surprised by how well it worked! I uploaded last year's return and the current year financials, and it immediately identified the exact Schedule M-2 imbalance I was struggling with. What really impressed me was that it showed me step-by-step how to properly report the Section 481(a) adjustment, including which specific lines needed adjustments on both Schedule M-1 and M-2. The system even generated the proper disclosure statement language for the tax basis to GAAP change that I could add to the return. Saved me at least 4-5 hours of research and trial-and-error. Definitely worth checking out if you're dealing with these accounting method change issues!

After spending 3 hours on hold trying to get through to the IRS Practitioner Priority Service for guidance on a complex 1120S basis change issue like yours, I finally discovered Claimyr (https://claimyr.com). You can check out how it works here: https://youtu.be/_kiP6q8DX5c I was skeptical at first, but they actually got me connected to an IRS agent in about 15 minutes instead of the usual 2+ hour wait. The agent was able to confirm that our Section 481(a) approach for the accounting method change was correct and gave me specific guidance on the Schedule M-2 reporting. The IRS agent also walked me through the proper way to document the change in accounting method and confirmed we were handling the depreciation adjustments correctly. This saved me from potentially filing an incorrect return and facing amended returns later. Sometimes you just need to speak directly with the IRS to get clear guidance on these complex issues.

I need to eat my words about Claimyr. After posting my skeptical comment, I was still desperate to get through to the IRS about a complex 1120S issue similar to what OP described. Against my better judgment, I decided to try the service. I'm shocked to admit it actually worked. I got a call back in about 45 minutes telling me an IRS agent was on the line. The agent helped clarify exactly how to handle the Section 481(a) adjustment on my client's return and confirmed that we didn't need to amend the prior year. The agent also explained that for S-Corps specifically, the accumulated depreciation difference from the accounting method change should be detailed in a separate statement attached to the return. This was the exact guidance I needed but couldn't find anywhere online. So yeah, I was wrong. If you're stuck on complex S-Corp issues and need IRS guidance, it's worth a shot. Saved me from potentially filing incorrectly and having to deal with notices later.

One approach I haven't seen mentioned yet is using the "other adjustments account" on Schedule L. I had a similar situation with a tax basis to GAAP conversion. What I did was: 1. Keep beginning Schedule L exactly as it was on prior year return 2. Create an "other adjustments" account on Schedule L to balance the beginning balances (basically creating a plug) 3. On M-1, show the adjustment for items that affect current year taxable income 4. On M-2, include the cumulative effect as "other increases/decreases" Make sure you include a detailed statement explaining the conversion from tax to GAAP basis and how it impacts each affected account. The statement is really the key to avoiding questions from the IRS.

Just a warning that my firm handled a similar situation incorrectly and it caused major headaches. We didn't use Form 3115 because we thought it was just a "financial statement change" not an "accounting method change" - big mistake. The IRS questioned the unreconciled differences in Schedules L, M-1 and M-2 during an examination two years later. We ended up having to amend returns and pay penalties for our client. Make sure you document EVERYTHING about this change and consider consulting with a firm that specializes in accounting method changes if you're uncertain. The rules around Sec 481(a) adjustments are complex and fact-specific.

As someone who's dealt with several S-Corp accounting method changes, I want to emphasize that the Form 3115 is absolutely critical here. Don't skip it even if you think it might not be required - it's your protection against future IRS questions. For your specific Schedule M-2 balancing issue, here's what I typically do: 1. Start with beginning retained earnings exactly as reported on last year's return 2. Calculate the cumulative Section 481(a) adjustment (difference between tax basis and GAAP accumulated depreciation/other timing differences) 3. Report this adjustment on Schedule M-2 as "Other increases" or "Other decreases" with clear labeling 4. Make corresponding entries on Schedule M-1 for current year impact The key is that your Schedule M-2 Line 6 should reflect the ending retained earnings per books (GAAP basis), not tax basis. The Section 481(a) adjustment bridges that gap. Also, prepare a detailed statement explaining the change and attach it to the return. Include calculations showing how you determined the adjustment amount. This documentation is crucial if the IRS ever questions the return. Don't try to "fix" the beginning Schedule L balances - that's not the proper approach and could create bigger problems later.

Great question about the accumulated depreciation calculation! For the Section 481(a) adjustment, you typically need to go back to the beginning of each asset's life to calculate the cumulative difference between tax and GAAP depreciation methods. This can be quite a bit of work, but it's necessary to get the adjustment right. Here's how I approach it: 1. Create a spreadsheet listing all depreciable assets 2. For each asset, calculate what depreciation would have been under GAAP from the beginning 3. Compare that to what was actually taken for tax purposes 4. The cumulative difference for all assets becomes your Section 481(a) adjustment If you have assets that were acquired many years ago, this can involve going back quite far. However, you only need to include assets that are still on the books - disposed assets generally don't affect the current adjustment. One practical tip: if your client has been using tax depreciation for book purposes in prior years, the adjustment will typically be the difference between GAAP straight-line and accelerated tax depreciation methods like MACRS. The Form 3115 instructions actually provide worksheets to help calculate these adjustments, and they're worth using to ensure you're capturing everything correctly. Don't forget to also consider any bonus depreciation or Section 179 elections that created timing differences. @Jessica, I hope this helps clarify the calculation process! The research can be time-consuming, but getting it right prevents major headaches down the road.