Earnings And Profits Of A C Corporation
Kevin C. Huston 2020-02-14 06:16:13
WHEN PREPARING A CORPORATE TAX RETURN or advising a corporate client on the distribution of dividends, it is important to properly understand the term "earnings and profits."
Earnings and profits (E&P) is a tax term that applies to C corporations and is governed by IRC §312. It is similar to the accounting concept of retained earnings of a C corporation in that it represents undistributed earnings that have been taxed at the corporate entity level, but, as the earnings have not yet been distributed to the shareholders, have not been taxed at the shareholder level. Unlike an S corporation, earnings in a C corporation do not affect a shareholder’s basis in the corporation’s stock.
A C corporation must compute current and accumulated E&P in order to determine whether a distribution to shareholders is taxable as a dividend. A distribution from a C corporation is treated as a dividend to the extent that the corporation has either current E&P or accumulated E&P from prior years.i Distributions in excess of current and accumulated E&P reduce a shareholder’s basis in his stock in the corporation, but not below zero.ii Distributions in excess of E&P and in excess of a C corporation shareholder’s basis are taxed as capital gain when received by the shareholder.
Example 1:
Scott owns all of the stock of ScottCo, a C corporation. Scott’s basis in the stock is $100,000. ScottCo has a total of current and accumulated earnings and profits of$50,000. ScottCo distributes $180,000 cash to Scott with respect to his stock.
The first $50,000 will be taxed to Scott as a dividend (up to the amount of current and accumulated E&P). $100,000 of the remaining $130,000 distribution will reduce Allan’s basis in his ScottCo stock from $100,000 to $0. Scott will also recognize $30,000 in capital gain from this transaction, the portion of the distribution not taxed as a dividend and in excess of basis. Whether the capital gain is short-term or long-term will depend on Scott’s holding period for the stock.
Corporations must report nondividend distributions to the IRS (Form 5452), therefore it is important that they compute E&P when contemplating making distributions to shareholders.
Where a corporation has accumulated E&P, but a current year E&P deficit, dividends are limited to the accumulated E&P as of the date of the distribution.iv When there are two or more distributions in a year, current E&P is allocated ratably to those distributions. If current E&P is insufficient to cover those distributions, then accumulated E&P is applied to those distributions, in the order in which they occur, until used up.
Example 2:
Karen owns 100 percent of the shares of TaxCo, Inc., a C corporation. Her basis in the shares is $30,000. Midyear, Joan acquires Karen’s shares in TaxCo, Inc. for a payment of $35,000, which both agree is the fair market value of the shares. TaxCo, Inc. distributed $100,000 that year to shareholders at the rate of $25,000 per quarter. TaxCo, Inc. has current E&P of $20,000 and accumulated E&P of $41,000 as of the end of the preceding taxable year.
The distributions from TaxCo, Inc. are taxed as shown below:
As of the date of the sale of stock to Joan, Karen’s stock still has a basis of $30,000. When she sells her stock for $35,000 to Joan, Karen has a capital gain of $5,000. Joan’s initial stock basis at purchase is $35,000, but is reduced by the distributions in excess of current and accumulated E&P to zero. Once distributions exceed her basis, she must recognize capital gain. In this example, since she has not owned the shares for longer than one year, the $4,000 capital gain is short-term. Joan’s remaining basis in her TaxCo, Inc. shares is $0.
In addition, E&P must be calculated to properly compute taxable distributions if the C corporation converts to an S corporation, and to properly compute the taxable amount of liquidation proceeds upon the winding down of the corporation.
Earnings and profits are not computed using the tax rules for computing taxable net income of a corporation. Instead, it is computed more closely, but again not exactly in-line with, the generally accepted accounting principles (GAAP) rules. A taxpayer computing taxable income on the accrual method must also use the accrual method to calculate E&P. A cash method taxpayer must use the cash method to compute E&P.
Timing differences between the calculation of taxable income and E&P will require a second set of books in order to properly compute E&P. For example, depreciation must be computed on the straight-line method over the asset’s alternative depreciation system (ADS) recovery period in calculating E&Pvi whereas an accelerated method may have been used to compute taxable income. Property for which the corporation elected §179 expensing must be depreciated over five years, straight-line, in computing E&P. Corporations recognizing income under the completed contract method of accounting must compute E&P from those projects under the percentage of completion method. Income from the discharge of indebtedness does not increase E&P if the corporation elected to reduce its basis in other property owned by the corporation.
Earnings and profits include income that is not taxed for federal income tax purposes, and excludes noncapital expenses paid that are not deductible for tax purposes (i.e., 50 percent of meals, entertainment, fines, penalties, lobbying expenses). Therefore, current E&P is definitely different than the taxable income of a corporation. It is calculated:
Taxable Income or Loss
- Plus positive adjustments:
• Refunds of federal income tax
• Tax-exempt income
• Net operating loss deductions
• Nontaxable life insurance proceeds
• Dividends received deductions used to compute taxable income
• Capital loss carryovers used to compute taxable income
• Charitable contribution carryovers used to compute taxable income
• Deferred gains on installment sales
• Cancellation of debt not reflected in taxable income.
- Negative Adjustments:
• Federal income taxes paid or accrued
• Expenses of producing tax-exempt income
• Nondeductible fines and penalties
• Political contributions and lobbying expenses
• Nondeductible life insurance premiums, including interest on debt
• Nondeductible current capital losses
• Nondeductible charitable contributions
• Nondeductible meal and entertainment expenses
• Other nondeductible, noncapital expenses
• The economic expense reflecting the bargain element arising when employees exercise qualified stock options.
- Current E&P
Example 3:
A.Trebek, Inc. is a C corporation using the accrual method of accounting on a calendar year. During the current year, 2018, A.Trebek, Inc. accrued income and expenses as follows:
Earnings and profit can be negative (termed a deficit). A C corporation with a deficit in accumulated E&P, but with positive current E&P, would still treat distributions as first coming from the positive current E&P. This is basically a last in, first out method. Therefore, a corporation with a negative accumulated E&P desiring to make a distribution to shareholders might prefer to wait until a future year when both current and accumulated E&P is expected to be negative, in order to avoid taxation of the distribution as a dividend. The taxpayer would still have the issue of a distribution in excess of basis to consider.
Distributions treated as dividends reduce E&P. Current distributions do not reduce current E&P until year-end. Distributions that are not taxable as dividends do not reduce E&P and cannot create a deficit in E&P.
Accumulated earnings and profits consist of all of the corporation’s E&P beginning March 1, 1913, until the end of the year immediately preceding the current year.
Kevin C. Huston, EA, USTCP, is the president of Blue Ridge Tax Advisors, Inc. in Asheville, North Carolina. He has a Bachelor of Science degree in Management from Oakland University in Rochester, Michigan; a Master of Business Administration degree in International Business from Georgia State University in Atlanta, Georgia, and holds the chartered life underwriter and chartered financial consultant designations from The American College in Bryn Mawr, Pennsylvania. He is an enrolled agent, an NTPI Fellow®, and is admitted to the United States Tax Court as a United States Tax Court practitioner. Mr. Huston teaches tax and representation topics nationwide with various national associations and state affiliates, and is a co-owner of the online continuing education provider Compass Tax Educators. Mr. Huston was the NAEA Excellence In Education award recipient in 2017.
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