Form 1120S - Resolving Prior Period Adjustment to Retained Earnings due to Basis Change from Tax to GAAP

This is actually a common issue when switching between tax basis and GAAP accounting. Since you're dealing with a basis change (not an error correction), you're right that you don't need to amend the prior return. What you're experiencing is the natural result of changing accounting methods. For your specific questions: 1) You don't need to amend the prior year return. This is a current year adjustment. 2) The difference should be reported as an adjustment to the beginning balance of retained earnings on Schedule M-2, Line 2 "Other additions." You'll need to attach a statement explaining that this addition is due to a change in accounting method from tax basis to GAAP. 3) You'll need both M-1 and M-2 adjustments. On M-1, you'll reconcile the current year book-tax differences. On M-2, you're reconciling the cumulative retained earnings effect, which includes prior period impacts. 4) Don't change the beginning Schedule L balances. They should match what was filed last year. The adjustment happens through M-2, not by restating Schedule L. Hope this helps get you on the right track!

Just wanted to share that I had a similar issue last year and found https://taxr.ai incredibly helpful. I was banging my head against the wall with an S-corp return where we switched from cash to accrual, and the retained earnings adjustment was giving me fits. I uploaded all my documentation and the prior year return to taxr.ai, and they helped identify exactly where the disconnect was happening. In my case, it turned out I had missed some accrued expenses that were affecting the retained earnings calculation. The tool showed me exactly which accounts were causing the imbalance and how to fix the M-2. Saved me hours of frustration and helped me understand what was happening rather than just getting a "here's the answer" from someone else.

I was skeptical about using an online tool for this kind of complex issue, but I gave taxr.ai a shot after seeing it mentioned here. I'm actually impressed with how it handled my S-corp's change from cash to accrual basis. The analysis was surprisingly detailed - it identified that I had incorrect beginning balances for accounts receivable that were throwing off my retained earnings. The tool generated a complete reconciliation worksheet showing exactly how the cumulative effect of the change should flow through the M-2. What I found most helpful was the way it explained the conceptual framework - helping me understand not just what to do but why it works that way. For anyone dealing with basis changes or accounting method switches, it's definitely worth checking out.

Hey there! After reading about your situation, I wanted to share something that really helped me with a similar issue. I was also dealing with an 1120S with complicated basis adjustments, and I was getting nowhere with the IRS when I needed clarification. I tried using https://claimyr.com and was actually able to get through to a real IRS agent within about 20 minutes. You can see how it works here: https://youtu.be/_kiP6q8DX5c The agent walked me through exactly how to handle the retained earnings adjustment on the M-2 when switching from tax to GAAP basis. She explained that I needed to include a detailed statement with the return explaining the nature of the adjustment and showing the calculation of the cumulative effect on retained earnings. Saved me days of research and uncertainty!

I have to eat my words here. After my skeptical comment, I decided to try Claimyr myself for an issue with an S-corp basis calculation that had been lingering for weeks. I was connected to an IRS business tax specialist in about 25 minutes. The agent not only understood my question about Schedule M-2 and basis changes but directed me to a specific section in Publication 550 that addressed exactly how to report the adjustment. They confirmed that the proper approach is to: 1) Leave Schedule L beginning balances unchanged from prior year 2) Make the cumulative effect adjustment on M-2, line 2 3) Include a detailed statement explaining the change The agent even emailed me a template for the explanatory statement. I'm genuinely impressed and apologize for my skepticism.

I had the exact same issue last year! The key is understanding that this is NOT an error correction, but rather a change in accounting method. What worked for me: 1. Leave Schedule L beginning balances exactly as they were on last year's return 2. Put the cumulative effect of the change (total pre-2025 impact) on Schedule M-2, Line 2 "Other additions" with an attached explanation 3. On Schedule M-1, only include the current year differences One thing to note - you need Form 3115 (Application for Change in Accounting Method) if this is a formal method change. However, if your client was previously incorrectly using tax basis when they should have been on GAAP all along per their operating agreement, you might be able to treat this as a correction rather than a method change. Either way, don't touch those beginning Schedule L balances!

Has anyone else noticed that the 1120S instructions are super vague on this topic? I've been doing these for years and the instructions barely touch on accounting method changes affecting retained earnings.

This is a great discussion! I'm dealing with a similar situation right now where my client switched from tax basis to GAAP, and I was getting confused about whether this required a Form 3115 or could be handled as a simple adjustment. From what I'm gathering here, the key points are: 1) Don't touch the beginning Schedule L balances 2) Use M-2 Line 2 for the cumulative adjustment with an explanatory statement 3) Handle current year differences through M-1 One thing I'm still unclear on - how do you determine if this is truly a "change in accounting method" requiring Form 3115 versus just a correction of how financial statements are prepared? My client's operating agreement has always required GAAP, but they've been filing tax basis financials. Does that make it a correction rather than a method change? Also, for those who have been through this - how detailed should the explanatory statement be? Should I include a full reconciliation of all affected accounts or just a summary of the major categories? Thanks for all the helpful insights in this thread!

This is exactly the kind of situation that makes transitioning from audit to tax so challenging! You're dealing with a classic accounting method change issue, and the good news is that several people here have given you solid guidance. I'll add one practical tip that helped me when I faced a similar situation: create a simple reconciliation worksheet that shows the cumulative book-tax differences from all prior years. This becomes the basis for your M-2 Line 2 adjustment and also serves as your supporting documentation. The worksheet should show: - Beginning tax basis retained earnings (from prior year Schedule L) - Plus: Cumulative GAAP adjustments (mainly your depreciation differences) - Equals: GAAP basis retained earnings (what should be on current year books) The difference between tax and GAAP retained earnings is your M-2 Line 2 adjustment. One thing I haven't seen mentioned yet - make sure your depreciation differences are calculated correctly for ALL prior years, not just recent ones. I made the mistake of only going back a few years initially and had to redo everything when I realized the cumulative impact was much larger. Also, regarding the Form 3115 question that's been raised - if your client's books and records have always been maintained on a tax basis and you're now switching to GAAP for financial reporting purposes, this is likely a method change requiring Form 3115. The fact that the operating agreement may have required GAAP doesn't change how the books were actually maintained. Hang in there - once you get through this first one, similar situations become much more manageable!