You may hear your tax advisor talk about earnings and profits. Why is it important to compute earnings and profits? The answer is: this calculation allows a business to determine whether a distribution paid to shareholders would be treated as a taxable dividend, a nontaxable return of capital, or capital gain.

A distribution is only a dividend if it exceeds current year E&P and/or accumulated E&P after 1913.   Amounts exceeding such E&P will be a return of capital which would grind down the basis of the shares in the shareholders’ hands.

If the basis reaches zero, the remaining amount would be treated as capital gain to the shareholder.  To learn what each of these concepts is and how they are taxed, read our articles on The ABC’s of Distributions and Withholding Taxes.

Very often, the calculation of E&P begins with a determination of the corporation’s taxable income (which in turn would be derived from taking the book or accounting income and making the appropriate adjustments) , and then various adjustments are made to arrive at the E&P.

Upward adjustments to E&P include:

  1. Income recognized for accounting purposes, but not for tax purposes (e.g. tax-exempt income);
  2. Amounts received by the corporation that are subject to special deductions or exclusions in determining taxable income (e.g. the intercorporate dividends received deduction); and
  3. Tax depreciation: the corporation may use accelerated depreciation or immediate expensing of certain assets for income tax purposes, but is required to use a straight–line depreciation method for E&P purposes. [1]

Downward adjustments to earnings and profits may include:

  1. Non tax-deductible expenses (e.g. federal income taxes paid, travel expenses, etc.);
  2. Interest paid which was not deducted for federal income tax purposes; and
  3. E&P depreciation.

The notion is that with such adjustments, the E&P of a corporation is a better measure of the ability of the corporation to make distributions.

Note that upon the distribution of a dividend, the corporation’s E&P will be reduced, but it will not go below zero in the current year’s E&P.[2]

Example 1:

Suppose that a U.S. corporation has a book net income of $20 million, $500,000 of book depreciation, $1 million of tax depreciation, $500,000 of earnings and profits depreciation, $2.5 million interest paid but not deducted for federal income tax purposes, $1.5 million of federal income taxes paid, and $3 million of meals and entertainment expenses. The taxable income and current earnings and profits calculations should be as follows:

Calculation of Taxable Income Amount
Book Income $20,000,000
(+) Book depreciation $500,000
(+) Federal income taxes paid $1,500,000
(+) 50% of meals and entertainment $1,500,000
(-) Tax depreciation $(1,000,000)
Taxable Income $22,500,000
Calculation of E&P Amount
Taxable Income $22,500,000
(+) Tax depreciation $1,000,000
(-) E&P depreciation $(500,000)
(-) Federal income taxes paid $(1,500,000)
(-) Interest paid but not deducted $(2,500,000)
(-) 50% of meals and entertainment $(1,500,000)
E&P $17,500,000

One consideration to take into account when calculating E&P is the “nimble dividend rule.”

Nimble Dividend Rule

If a corporation has a positive balance in its current E&P account, and a negative balance in its accumulated E&P account at the end of the year, then this rule would require that the distribution first come out of the current E&P account.[3]

This is an important consideration for any investment, such as infrastructure investments, that has years of deficits before turning profitable. Consider the following example:

In the chart below, we see that Corporation A had a deficit of $100 in its accumulated earnings and profits, a positive increase of $120 in its current earnings and profits, and the shareholder has a tax basis of $100 in Corporation A’s shares.

Corporation A:

Accumulated E&P Current E&P Tax Basis Distribution
­­­–($100) +($120) $100 $200
Deficit Positive    

If the corporation decides makes a distribution of $200, the nimble dividend rule would apply such that the deficit in the accumulated E&P account of $100 cannot be used to reduce the dividend portion of the distribution from $120 to $20.  In this situation, the shareholder would be considered to have received a dividend of $120, and the remaining $80 of the distribution would be a return of capital, reducing the shareholder’s basis in the shares to $20.

Conclusion

Calculating and maintaining accurate E&P records is a critical step in determining the tax treatment of a distribution.

Depending on the amount of current year and/or accumulated E&P, a distribution may be a dividend, a return of capital, or a capital gain, with each category creating a different tax impact on the distribute shareholder.

It is not a bad idea to perform E&P calculations annually even if there is no existing plan to make a distribution.  Otherwise, when a distribution is imminent, the corporation may find itself under tremendous time pressure to complete an E&P calculation for every year of its existence all at once to arrive at the corporation’s accumulated E&P.

[1] IRC § 168(k).

[2] IRC § 168(k).

[3] IRC § 316(a); Treas. Reg. § 1.316-2(a)