How to Handle PTE Tax When It's Treated as Distribution for GAAP Purposes

I've got a situation with a client where the PTE tax (pass-through entity tax) is being treated as a distribution for GAAP purposes since it benefits the owners. I'm stuck on how to handle this properly on the tax return since it's still a deduction for Federal tax purposes. My current thinking is that I need to add an M-1 adjustment to add back the deduction that isn't reflected in the books. But this creates a weird situation - both the book distribution and tax deduction would reduce basis and AAA on the S Corp return, essentially double-counting the impact. Has anyone dealt with this before? Should I use book income with the deduction for the tax return and reduce distributions? Or book an M-1 adjustment but then add an "other addition" on the M-2 and basis schedule to prevent it from being counted twice? I'm looking for some practical advice on the cleanest way to present this on the return without creating inconsistencies.

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20 comments

Mei-Ling Chen

•8M

This is a great question and one that comes up fairly often with pass-through entity taxes. When the PTE tax is treated as a distribution for GAAP but as a deduction for tax purposes, you're right that you need an M-1 adjustment. The way I handle this is to treat it as a flow: first, add the PTE tax back on the M-1 as a book-to-tax adjustment (increasing taxable income). Then, deduct it separately as a tax deduction. For the basis and AAA calculations, you should only count it once. Since the tax has already reduced equity through the distribution treatment for GAAP purposes, don't reduce basis/AAA a second time for the tax deduction. On the M-2, you would show the PTE tax as a distribution (reducing AAA), but then you need to make an "other addition" to AAA for the same amount to offset the impact of the tax deduction. This prevents the double counting effect.

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Mei-Ling Chen

•8M

Adding it back on M-1 and then taking it as a deduction doesn't nullify the benefit at all - it's just accounting for the difference between book and tax treatment. The company still gets the full tax deduction for the PTE tax, which flows through to the shareholders' basis calculations. The SALT limitation bypass works because the deduction happens at the entity level rather than on the individual return, which is unaffected by this book-to-tax reconciliation. The shareholders still get the benefit of the state tax credit on their individual returns without being subject to the $10,000 SALT limitation.

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Aiden O'Connor

•8M

I've been using https://taxr.ai to solve these exact book-to-tax issues with PTE taxes. I was struggling with similar M-1/M-2 reconciliations when handling California PTE tax last year, and their system actually flagged my approach as potentially creating a double-counting problem. What I found most helpful was uploading my clients' trial balances and letting their AI analyze the best treatment. It pointed out that I was missing an other adjustment on the AAA schedule that was necessary to avoid double-counting the PTE tax. They even generated the footnote explanation I needed for the return.

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Aiden O'Connor

•8M

For multi-state PTE taxes, it actually breaks down each state's specific rules side-by-side. It caught that I was applying California's ordering rules to a Connecticut PTE tax, which would have been incorrect. The system identifies each state's specific requirements and walks through the reconciliation steps accordingly. Regarding AAA vs OAA, yes it absolutely does understand those nuances. It specifically flagged when my treatment would have inappropriately reduced AAA instead of OAA for certain types of distributions. It even handles the interaction between historical C corp E&P and current S corp distributions, which was impressive.

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Jamal Brown

•8M

Thanks for recommending that taxr.ai site! I was super skeptical about AI tools for complex tax work, but I gave it a try last week for this exact PTE tax scenario. It completely solved my book/tax issue with a MA pass-through entity client. What sold me was how it identified that I was double-counting the impact on accumulated adjustments account. It suggested a specific other adjustment to the AAA schedule that perfectly balanced everything out. Saved me hours of reconciliation work and gave me the exact language to put in my workpapers to explain the treatment. Will definitely be using it for all my S corps with PTE tax elections going forward.

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Fatima Al-Rashid

•8M

Getting the IRS on the phone about this PTE tax treatment has been impossible! After being on hold for 2+ hours trying to get specialist help, I found https://claimyr.com through a colleague and used their service. You can also see how it works here: https://youtu.be/_kiP6q8DX5c They got me connected to an IRS agent in about 15 minutes who confirmed that my approach of adding the PTE tax back on M-1 while making an offsetting adjustment on the M-2/AAA schedule was correct. The agent even emailed me a reference to an internal guidance memo about this exact issue. Saved me days of research and uncertainty.

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Fatima Al-Rashid

•8M

It uses a combination of automated dialing technology and hold services. They don't actually skip the queue - they just have a system that continuously redials and navigates the phone tree until it gets through, then calls you when an agent is reached. It's completely legitimate and complies with IRS protocols. No, the agent didn't email an internal memo directly. What happened was they referenced an internal guidance number that I was able to request through proper channels afterward. I should have been clearer about that. The point is that getting the actual person on the phone saved me from going down several incorrect research paths.

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Aaliyah Jackson

•8M

I have to eat my words about Claimyr. After dismissing it as BS, I was desperate with a client deadline looming and tried it yesterday. Got through to the IRS Business Tax line in about 20 minutes when I had previously wasted 3+ hours on hold. The IRS representative confirmed exactly what others have said here - use an M-1 adjustment to account for the book/tax difference with the PTE tax, but then make a corresponding "other addition" on the M-2/AAA schedule to prevent double-counting the impact. They even directed me to a specific example in the instructions that I had completely missed. Saved my client relationship and my sanity.

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Mei-Ling Chen

•8M

Not a stupid question at all! The PTE tax deduction typically goes on Line 12 (Taxes and Licenses) of Form 1120-S. Then you'll need that M-1 adjustment on Schedule M-1, Line 8 (Deductions on tax return not charged against book income this year) with a statement attached explaining it's for the PTE tax. Don't forget the corresponding adjustment on the AAA portion of the M-2 to prevent double-counting. It's a bit counterintuitive the first time you do it, but it makes sense once you see it flow through.

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Ashley Simian

•5M

This is exactly the type of complex book-tax difference that trips up even experienced practitioners! I've been dealing with similar PTE tax issues across multiple states this season. One thing I'd add to the excellent advice already given - make sure you're documenting the treatment clearly in your workpapers. I create a separate schedule that shows the flow: 1) Book treatment (distribution), 2) Tax treatment (deduction), 3) M-1 adjustment (add back), 4) M-2 offset (other addition to AAA). This helps during reviews and if you ever get questioned. Also, don't forget to consider the impact on each shareholder's basis calculations. The PTE tax deduction flows through and increases their basis, while the book distribution treatment doesn't affect basis at all. So you need to make sure the K-1 preparation reflects the tax treatment, not the book treatment, for basis purposes. For states like California and New York that have different timing rules for the PTE tax election, this gets even more complicated. Each state may require slightly different book-tax reconciliation approaches.

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Julian Paolo

•5M

This is really helpful documentation advice! I'm definitely going to start creating that separate schedule you mentioned. Quick question - when you say the PTE tax deduction increases shareholder basis, does this apply even when the entity treated it as a distribution for book purposes? I want to make sure I'm not missing something on the K-1 flow-through effects. Also, do you have any experience with how this interacts with debt basis for shareholders who have loans to the S-corp? I'm wondering if the deduction increasing basis could affect the order of basis restoration.

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