It is important for businesses organized and taxed as regular corporations (so-called C corporations, from subchapter C of the Code governing corporate tax treatment) to maintain a current, accurate accounting of their earnings and profits (E&P). Almost every corporate transaction affects E&P, and many transactions require an accurate accounting of the corporation’s E&P to determine the appropriate tax treatment.
Although corporations are not required to report corporate E&P on Form 1120, U.S. Corporation Income Tax Return, they are responsible for knowing the company’s E&P when it is relevant to determining the correct tax treatment of a transaction. As will be seen from this case study, maintaining an up-to-date accounting of a company’s E&P is much easier than preparing the calculation after many years of neglect. A company with a current E&P calculation is in the best position to respond to business transaction opportunities.
The E&P operating rules generally require an accounting of a corporation’s current-year E&P and the accumulated E&P (i.e., generally the cumulative E&P balance at the end of the prior tax year). These two E&P balances must be determined and taken into account separately to determine the correct tax treatment of a corporate distribution, E&P allocation, or deemed distribution.
When E&P Is Needed
Although the tax laws do not define E&P or provide specific rules for how to compute it, there is authority for when E&P affects a transaction and the adjustments that must be made to determine E&P. The basic E&P concept is not difficult to describe and understand—it is generally viewed as a corporation’s economic ability to pay dividends. Actually applying the mechanics of the existing E&P rules, however, may be challenging for many practitioners.
Determining E&P is not a simple process, or one in which the calculation can be performed quickly when and if needed. It is best performed when working from a carefully considered work plan, by a practitioner or project team with a sound understanding of the relevant authorities and with the detailed source records readily at hand (this last point often is one of the more difficult aspects of an E&P study, particularly for foreign corporations).
This case study describes, in general terms, the relevant authorities that govern the determination of E&P using a hypothetical fact pattern to illustrate how the calculations are performed and provides a process and format to facilitate the efficient calculation of E&P.
AnyCo Inc. is a midsize manufacturing company that has been in business for six years. 1 The company has a single class of nonpublicly traded common stock outstanding held by a small group of unrelated shareholders. The company has primarily domestic U.S. sales, has been profitable in all but its second year of operations (during the recession), and made a distribution to its shareholders only in its second year of operations. The company is planning a distribution to shareholders this year (year 6). Exhibit 1 shows the income, tax, distribution, and other adjustments for the six years of company operations, assuming net operating losses (NOLs) will be carried forward (not back) and a federal tax rate of 34% applies.
The primary rules governing the determination of E&P and shareholder dividend treatment are contained in Secs. 301, 312, and 316. These Code sections are further elaborated upon by interpretive guidance in the form of regulations, rulings, cases, and other guidance setting forth the rules controlling what items and adjustments must be taken into account (and when) in determining E&P. Even a practitioner who knows how the computations are made should nonetheless develop an organized process for performing the E&P study to streamline what can otherwise be a time-consuming and complex project.
Determining a stand-alone corporation’s E&P takes into account the financial, transaction, and tax return information for the company since its inception. 2 The determination of E&P for any given year generally starts with the company’s final adjusted taxable income for that year, taking into account the taxable income reported on the originally filed corporate tax return and any adjustments to the original taxable income amount, including amended returns or changes resulting from an IRS audit. Any changes to a company’s taxable income are often accompanied by a change in the tax liability for that year, which must also be taken into account in the computation.
Almost every corporate transaction has the potential to affect the corporation’s E&P. Even when a single corporation’s E&P is being determined, the company’s transaction history must be analyzed to determine any changes to E&P resulting from a corporate transaction such as a merger or the liquidation of another corporation into the corporation for which E&P is being calculated. 3 The transaction history must start with the company’s formation and include all transactions from inception through the end of the year for which E&P is being computed.
Increases to E&P
Other current-year income and loss items that increase a corporation’s E&P must be accounted for in the analysis. Often, these E&P adjustments are amounts that are recognized for financial accounting purposes but are not income for income tax purposes. Adjustments that increase a corporation’s E&P include tax-exempt income. Although it is not taken into account in determining taxable income, tax-exempt income increases a corporation’s ability to make distributions to shareholders and, accordingly, must be factored into a corporation’s E&P calculations as an economic accession to wealth. 4 Another example of a positive adjustment that increases E&P but not current taxable income is the gain resulting from an installment sale, which must be recognized as if the corporation did not use the installment method of accounting. 5
Additionally, amounts the corporation received that are subject to special deduction or exclusion, such as the Sec. 243 dividends-received deduction, must be included in the E&P computation. 6
Decreases to E&P
Expenditures of various types that are recognized for financial accounting purposes, yet are nondeductible and noncapitalizable for income tax purposes, will impair a corporation’s ability to make distributions and, therefore, must be deducted in computing E&P. For example, the 50% portion of nondeductible meals and entertainment expenses 7 must be taken into account as a reduction to E&P.
Other examples of negative E&P adjustments include the payment of nondeductible fines and penalties, 8 interest expense related to tax-exempt income, 9 club dues, 10 legal lobbying expenses and political contributions, 11 excess charitable contributions, 12 and capital loss carryforwards. 13 This is just a sampling of the types of nondeductible expenses that must be deducted when computing E&P. Note that the nondeductible expenses taken into account for E&P purposes are generally those expenses that are permanently disallowed and not subject to capitalization. 14
It should be noted that the corporation’s NOL 15 will be reflected in E&P when incurred, without regard to any carryforward or carryback. 16 The NOL represents an economic loss to the corporation and correspondingly impairs, in the year incurred, the corporation’s ability to make distributions to its shareholders. A current-year NOL will generally represent, after any appropriate E&P adjustment as discussed below, a current-year E&P deficit. 17
The payment of federal income taxes must also be taken into account as a reduction to E&P. 18 Corporations reporting taxable income for any year must pay the federal government the taxes, net of credits, owed. Payments of federal income taxes reduce a corporation’s ability to make distributions to shareholders and, accordingly, must be taken into account as a negative adjustment to E&P. 19
To compute E&P, depreciation deductions generally must be determined under the alternative depreciation system (ADS). 20 Under the ADS, depreciation calculations use a straight-line method and depreciable lives that are generally longer than the accelerated depreciable lives permitted for regular tax purposes. 21 If corporations use the accelerated cost recovery system (ACRS) or the modified accelerated cost recovery system (MACRS) method in computing depreciation for regular taxable income purposes, Sec. 312(k) requires them to adjust E&P for the difference between the two methods.
Finally, a corporation’s distribution history must be taken into account when preparing an E&P study. 22 All current- and prior-year distributions of money, property, and corporate obligations must be considered. Generally, the E&P analysis must consider the full amount of every corporate distribution; however, only the distributions made from current or accumulated E&P will reduce E&P. 23 In addition to reviewing the Schedule M-2, Analysis of Unappropriated Retained Earnings per Books , from a corporation’s annual Form 1120, a detailed analysis of year-to-year changes in the corporation’s stockholders’ equity accounts is recommended to assure that all distributions and any other adjustments to stockholders’ equity have been taken into account and analyzed for their effect on E&P. 24 The accumulated E&P determination will take into account as a negative adjustment dividend distributions made in prior years. The calculation of current-year E&P does not factor in current-year distributions as a negative adjustment. 25 Note that distributions may not create a current or accumulated E&P deficit.
AnyCo Example E&P Calculation
The dividend definition rules under Sec. 316(a)(2) provide that a distribution is treated as a dividend to the extent of the distributing corporation’s current-year E&P. If the distributing corporation has no current E&P (e.g., a current-year E&P deficit), the distribution will nevertheless constitute a dividend to the extent of the corporation’s accumulated E&P from prior years.
Exhibit 2 illustrates AnyCo’s E&P calculation for its first five years of existence.
As the dividend ordering and tracing rules reflect, if a corporation is currently profitable and its current-year distribution is less than the current-year E&P, dividend treatment will attach to the distribution without regard to a corporation’s accumulated E&P (or accumulated E&P deficit). For many taxpayers, this treatment is an unexpected result. When a corporation experiences a series of loss years, such as in the case of a startup company, then becomes profitable and makes a distribution to the shareholders in that year, the dividend rules require the distribution to be treated as a taxable dividend to the extent of current-year E&P, despite the accumulated E&P deficit (losses).
The dividend rules further clarify that E&P for the current year is determined at the close of the year without reduction for distributions paid during the year. The rules that define what a dividend is under Sec. 316 are designed to address varying distribution and E&P fact patterns to include distributing corporations with current but no accumulated E&P, no current E&P but with accumulated E&P, and no current or accumulated E&P. The distribution will be sourced to the distributing corporation’s E&P, whether current E&P, accumulated E&P, or both. A distribution a corporation makes to its shareholders is a dividend to the extent of the corporation’s current-year and accumulated E&P.
Sec. 301(c) requires a shareholder to recognize the receipt of the corporate distribution as a dividend to the extent the distribution is paid from E&P as described in Sec. 316. Distributions in excess of the corporation’s E&P are taken into account by the shareholder as a return of capital, and any excess distribution will generally be recognized as capital gain. 26
In the AnyCo example, applying the E&P rules results in the entire distribution’s being treated as a dividend. A $400,000 distribution in year 6 will be sourced first from the current-year E&P, as shown in Exhibit 3. Of the $400,000 distribution, the current-year E&P will cover the first $117,000. The remaining $283,000 distribution amount will be absorbed by the accumulated E&P balance of $356,800.
Accumulated E&P following reduction for the year 6 distribution will be $73,800, which will be the accumulated E&P balance at the beginning of year 7.
Determining a corporation’s E&P requires a detailed investigation into the corporation’s earnings and transaction history. The full scope of the rules governing corporate taxation must be taken into account when performing an E&P study. The conceptual and mechanical complexity of the analysis will often challenge even the most seasoned corporate tax adviser. Add to that the fact that many corporations do not maintain a current accounting of their E&P, and the adviser may have to go back many years to complete the E&P analysis and potentially begin the analysis with the date of incorporation (which could be many decades ago), and the task seems even more daunting. A successful E&P study requires an understanding of the relevant corporate tax rules and applying them to the large amount of data and information that must be obtained and organized.
1 This case study involves a single corporation. The consolidated return regulations include special rules for E&P calculations involving members of an affiliated group of corporations filing a consolidated U.S. federal income tax return, treating the affiliated group as a single entity (see Regs. Sec. 1.1502-33). These regulations are complex and must be studied carefully when preparing an E&P determination for a consolidated group member. A detailed discussion of consolidated return E&P is beyond the scope of this article.
2 An E&P study must generally take into account all earnings and profits of the corporation from the earlier of Feb. 28, 1913, or inception of the corporation. See Sec. 316(a)(1).
3 Sec. 381(c)(2) identifies E&P as a corporate attribute that will transfer to the acquiring corporation and must generally be taken into account in a carryover basis transaction described in Sec. 381—generally a merger or liquidation. Where either the acquirer or target in a Sec. 381 transaction has a deficit in E&P (i.e., negative E&P), special rules may apply to account for the deficit. Further discussion of the E&P carryover rules and related restrictions is beyond the scope of this article.
4 Regs. Sec. 1.312-6(b).
5 Sec. 312(n)(5). Generally, except where specifically provided for otherwise, a corporation determines its E&P using its regular method of accounting. See Regs. Sec. 1.312-6(a).
6 Regs. Sec. 1.312-6(b). For example, the receipt of a $100 portfolio dividend would be reflected in taxable income only to the extent of $30 ($100 dividend income less a $70 dividends-received deduction), but E&P must be increased by the $70 dividends-received deduction amount to accurately reflect that the company has a full $100 economic accession to wealth.
7 Sec. 274(n) generally restricts deductions for meals and entertainment expenses incurred in a trade or business activity to 50% of the otherwise allowable amount.
8 See generally Secs. 162(f) and 162(g).
9 See generally Sec. 265 (tax-exempt income must be taken into account when computing E&P and should be accompanied by any related expenses or interest costs incurred to acquire or hold the tax-exempt asset).
10 See generally Sec. 274.
11 See generally Sec. 162(e).
12 See generally Sec. 170(b)(2).
13 See generally Sec. 1211(a).
14 Generally, many E&P adjustments taken into account as increases and decreases to E&P can be found in the corporation’s annual tax returns, Form 1120, on Schedules M-1, Reconciliation of Income (Loss) per Books With Income per Return, and M-3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More.
15 See generally Sec. 172.
16 Regs. Sec. 1.312-6(d).
17 Assuming that any net positive and negative E&P adjustments do not result in the current-year NOL becoming current-year positive E&P.
18 Regs. Sec. 1.312-6(a).
19 Note that foreign tax paid generally should be taken into account as a reduction to E&P whether or not the corporation claimed the foreign taxes as a credit under Sec. 901 or 902.
20 Secs. 312(k)(3) and 168(g)(2).
21 For example, personal tangible property with a seven-year MACRS depreciable life may be subject to a 10- or 12-year ADS depreciable life.
22 Sec. 312(a).
23 It should be noted that while corporate distributions are taken into account when determining E&P, corporate capital contributions are not. Capital contributions generally do not increase E&P.
24 For example, another equity-related adjustment that may be revealed by reviewing the stockholder equity accounts is the exercise of company stock options issued as compensation for personal services. See Rev. Rul. 2001-1, 2001-1 C.B. 726. The revenue ruling clarifies that the E&P of a corporate employer is reduced to reflect the deduction the corporation takes when an employee receives stock upon exercise of a nonstatutory stock option.
25 Sec. 312(a).
26 Secs. 301(c)(1), (2), and (3).
Kevin W. Kaiser is a partner with the law firm Lindquist & Vennum LLP in Minneapolis. The author would like to acknowledge the contributions of Michelle Albert of EY LLP, David Hering of KPMG LLP, and Bart Stratton of PwC LLP. Mr. Kaiser, Ms. Albert, Mr. Hering, and Mr. Stratton are members of the AICPA Corporations & Shareholders Technical Resource Panel, and its Earnings and Profits Computation Practice Guide working group. For more information about this article, contact Mr. Kaiser at firstname.lastname@example.org.