Computing earnings and profits (E&P) for a C corporation client is the dental cleaning of the tax world: we all know it’s in our best interest to do it every year, but damned if we do, because it’s kind of a pain in the ass. So instead, we put it off and put it off, until what would have been a small inconvenience, becomes a big, painful, emergency.
But it doesn’t have to be this way. Invest a little time learning what E&P is intended to measure and how it works, and we can actually stay up to date with our C corporation clients without too much trouble.
In this week’s Tax Geek Tuesday, we’re going to beat the heck out of the concept of E&P, and when we’re through, you’ll have no excuse for blowing off the computation.
Reasons for Computing Earnings and Profits
Determining the Taxability of Distributions
The primary purpose for computing E&P is to determine whether a distribution represents a taxable dividend, a nontaxable return of shareholder capital, or capital gain to the recipient shareholders. Section 316 defines a "dividend" as any distribution of property made by a corporation out of current or accumulated E&P. In turn, Section 301(c) provides that any distribution constituting a dividend must be included in the gross income of the shareholder, while amounts distributed in excess of those considered a dividend are first treated as a nontaxable return of capital to the extent of the shareholder's stock basis, with any remaining distribution treated as a gain from the sale of the stock, resulting in capital gain.
Ex. Corporation X is wholly owned by A, an individual. In 2013, X's first year of existence, X had $500 of E&P. As of December 31, 2013, before any adjustments for distributions made by X throughout the year, A had a basis of $300 in his X stock. X distributed $1,000 to A on December 31, 2013.
The taxability of X's $1,000 distribution to A is determined under Sections 316 and 301(c). To the extent of X's current E&P of $500, the distribution is treated as a dividend. Thus, A includes $500 in taxable income under Section 301(c)(1). Of the remaining $500 distribution, $300 is treated as a return of A's capital, and reduces A's stock basis from $300 to $0. The remaining $200 distribution is treated as the sale of the stock, generating capital gain.
Other Reasons for Computing E&P
- Certain adjustments required in computing a corporation's E&P are also required in computing a corporation's adjusted current earnings (ACE) adjustments, which in turn plays a role in determining the corporation's alternative minimum taxable income.
- The accumulated earnings tax may be imposed on a corporation for a tax year if it is determined that the corporation has attempted to avoid tax to its shareholders by allowing its E&P to accumulate beyond the reasonable needs of the business.
- Under Section 857(a)(2)(B), a real estate investment trust (REIT) must have no accumulated E&P from non-REIT years.
- In the international arena, gain from the sale or exchange of stock in a controlled foreign corporation may be treated as a dividend to the extent of its E&P. In addition, dividends paid by a domestic corporation to foreign shareholders are generally subject to a withholding tax pursuant to Sections 1441 and 1442.
- The significance of E&P extends to S corporations, as well, as the presence of accumulated E&P from prior C corporation years may be potentially harmful to an S corporation in three ways:
- An S corporation with accumulated E&P may be subject to corporate level tax on its excess passive investment income.
- If an S corporation with accumulated E&P at the end of three consecutive tax years also has passive investment income that exceeds 25 percent of its gross receipts for each of the three years, the corporation's S election will terminate.
- To the extent an S corporation with accumulated E&P from prior C corporation years makes distributions in excess of its "accumulated adjustments account," the distributions are taxed as dividends to the extent of the accumulated E&P.
The Relationship between E&P, Taxable Income, and "Retained Earnings"
A corporation's E&P is neither its accumulated taxable income nor its "retained earnings" for financial accounting purposes. Rather, E&P is an independent, economic measure of a corporation's ability to pay dividends without having to return a shareholder's contribution to capital. Thus, a corporation's E&P should include all items of income, gain, loss or deduction resulting from the economic activities of the corporation, regardless of the treatment of such items in computing taxable income or retained earnings.
A corporation's E&P and taxable income differ primarily as a result of the tax policy considerations that override many of the adjustments necessary in computing taxable income -- such as the exemption for tax-exempt interest or the disallowance of penalties or federal income taxes -- that fail to reflect the economic effect of the underlying income, gain, loss or deduction. As a result, an adjustment to the treatment of these items is often required in computing E&P.
Similarly, a corporation’s E&P is not synonymous with its retained earnings, as retained earnings can be reduced by stock distributions or the establishing of a contingency reserve, neither of which impair a corporation's ability to finance distributions to its shareholders. For this reason, the 2nd Circuit has held that a corporation's retained earnings is "not even prima facie evidence of E&P for income tax purposes."
Computation of Earnings and Profits
Starting Point for Determining E&P: Taxable Income
Neither Section 312--which provides the most guidance on E&P-- nor the related regulations mandate a starting point for computing E&P. Given that the Internal Revenue Code has never been accused of being parsimonious with its words, it's rather curious that the most integral part of such an important computation would go unaddressed by the statute. As a result of this ambiguity, over the last century, corporations have attempted to begin the computation of E&P with both taxable income and book income.
While a corporation's E&P can theoretically be determined by making proper adjustments to either taxable income or book income, taxable income is the logical starting point. Reg. Section 1.312-6 provides that, in general, a corporation must use its method of accounting for taxable income purposes in computing E&P. Thus, many of the adjustments mandated by the statute, regulations, administrative rulings and judicial precedent are defined in reference to the corporation's taxable income, making taxable income the logical jumping off point for determining E&P.
The “Luckman Principle”
When the existing guidance fails to address the treatment of a specific item of income, gain, loss or deduction on a corporation's E&P—which will be the case quite often-- certain overriding principles can be applied to assist in reaching a conclusion. These principles may have been best articulated by the Seventh Circuit in Luckman v. Commissioner:
As used in federal taxation, this concept [E&P] represents an attempt to separate those corporate distributions with respect to stock which represent returns of capital contributed by the stockholders from those distributions which represent gain derived from the initial investment by virtue of the conduct of business. The crucial issue is whether a given transaction has a real effect upon the portion of corporate net worth which is not representative of contributed capital and which results from the conduct of business. In order to the make this determination it is necessary to scrutinize the economic effects of the particular transaction as well as its character and relation to the corporate business.
In the absence of specific authority governing the treatment of an item in computing E&P, a corporation can apply these principles by asking the question, "Does this item increase or decrease the economic income available for a corporation to distribution to its shareholders?" before making the appropriate modifications to E&P.
Accounting Methods: Specific Treatment of a Particular Item
The term "method of accounting" includes not only a taxpayer's overall method of accounting, but also the treatment of any item.
This adds considerable complexity to a corporation's determination of E&P, as the corporation must analyze each item of income, gain, loss or deduction to determine whether a specific method of accounting is used with respect to the item. Where a specific method of accounting is used -- for example, where the gain from the sale of a capital asset is recognized on the installment method for purposes of computing the corporation's taxable income -- the corporation must look to the statute, regulations, administrative rulings or judicial precedent to determine if such a method is authorized for purposes of computing E&P.
To illustrate, assume that an accrual method corporation receives advance payments for services to be provided in the future. In general, Reg. Section 1.451-1(a) provides that for accrual method taxpayer, income is recognized on the earliest of three dates: the date the payment is earned, due, or received.
Thus, in computing taxable income, an accrual method corporation must generally include advance payments in income in the year received, despite the fact that the income may be properly deferred until it is earned under the corporation's method of accounting for financial reporting purposes.
Revenue Proc. 2004-34 provides an exception to the general treatment of advance payments under Regulation Section 1.451-1. Under the Procedure, a qualifying accrual method taxpayer may defer the inclusion of a portion of advance payments in taxable income -- subject to certain requirements and limitations -- for up to one year. Thus, a corporation that has properly adopted the deferral method provided for in Revenue Proc. 2004-34 is using a specific method of accounting with regards to its treatment of advance payments, and must consider the implications of that method of accounting in computing E&P.
Logically, one would think that the treatment of advance payments for E&P purposes should differ from the deferral permitted by the corporation's use of Revenue Procedure 2004-34. The receipt of an advance payment increases the corporation's ability to finance a distribution to its shareholders, regardless of when the income is recognized for tax or financial accounting purposes. Thus, in keeping in line with the intent of computing E&P—the “Luckman Principle,” if you will-- the receipt of an advance payment should immediately increase a corporation's E&P. A review of the relevant authority, however, yields a counterintuitive result.
The IRS has twice held that the taxpayer's treatment of advance payments for tax purposes controls for purposes of computing E&P In Revenue Ruling 79-68 and Letter Ruling 200817029, the IRS determined that no adjustment is necessary to a corporation's taxable income in computing its E&P resulting from the receipt of advance payments; thus, a corporation using the deferral method pursuant to Revenue Procedure 2004-34 may also defer the inclusion of the advance payments for E&P purposes, despite the fact that receipt of the advance payments immediately increase the corporation's ability to make distributions to its shareholders out of earnings. Instead, the corporation will increase its E&P as the advance payments are recognized in taxable income.
As evidenced by the treatment of advance payments for E&P purposes, the method of accounting governing a specific item is not always identical to the corporation's overall method of accounting, nor is it as always a reflection of the economic impact of the item. Thus, a corporation must give careful consideration to each item of income, gain, loss or deduction to determine if the taxpayer's overall method of accounting controls for E&P purposes, or if the statute, regulations, administrative rulings or judicial precedent authorizes a different treatment.
Annual Adjustments to Taxable Income in Computing E&P
For each tax year, a corporation is required to compute its E&P by increasing or decreasing taxable income for certain adjustments mandated by statute, regulation, administrative rulings or judicial precedents. Why many of these adjustments are predicated on the desire to correlate E&P with a corporation's economic measure of its ability to finance shareholder distributions from earnings, others are a function of tax policy, and bear no relationship to the underlying economic impact. Where no specific authority for the treatment of a specific item for purposes of computing E&P exists, I would advise you to determine whether to adjust taxable income for an item by applying the general principle that E&P should reflect the economic income of a corporation.
Adjustments to Taxable Income in Computing E&P
What follows is a discussion of the common increases and decreases to taxable income made in computing a corporation's E&P. While a complete discussion of all possible adjustments to E&P is beyond the scope of this column, the following represent frequently encountered adjustments to a corporation's taxable income in computing E&P.
Items of Income and Gain
Tax-Exempt Income
In general, E&P includes income of a corporation to the extent it's recognized, regardless of whether it is included in taxable income. The regulations require that all income exempted by statute be included in a corporation's E&P in the year earned (for accrual basis corporations) or received (for cash basis corporations). This treatment has been held to include the following items:
- State and local bond interest generally tax-exempt under Section 103.
- Tax-exempt life insurance proceeds from a policy of which the corporation is the beneficiary under Section 101.
- Tax refunds of a cash-basis or accrual basis corporation.
Absent a specific authority dictating otherwise, all tax-exempt income should be included in a corporation's E&P based on the corporation's method of accounting. This is a logical result, as tax-exempt income increases the corporate earnings available for distribution, regardless of any tax policy considerations granting its exclusion from income.
Installment Sales and Completed Contract Method of Accounting
A corporation is not permitted to recognize gain on the sale of assets on the installment method for purposes of computing E&P. Thus, the corporation must recognize the entire gain in the year of sale in computing its E&P.
A corporation that use the completed contract method of accounting for purposes of computing its taxable income must use the percentage of completion method in computing its E&P. Because the completed contract method allows corporations to defer recognizing income related to the contract until it is completed, the required use of the percentage of completion method typically results in an increase to E&P during the early years of a contract.
Items of Deduction and Loss
Net Operating Losses
A corporation must reduce its E&P for a current year net operating loss in the year the loss is incurred, rather than in the year to which the loss is carried back or forward.
Ex. Corporation X generates a $100,000 loss in 2012, which it carries forward and uses to reduce X's 2013 taxable income. X is required to reflect the $100,000 loss in its E&P in 2012. Thus, when the 2012 net operating loss of $100,000 is subsequently used to reduce X's 2013 taxable income, X's E&P for 2013 must be increased by $100,000 to avoid double counting.
Certain Non-Deductible Expenses Reduce E&P
Certain business expenses are rendered nondeductible in computing taxable income purely as a result of tax policy. These expenses, however, often represent real reductions in a corporation's economic income available for distribution to shareholders.
Thus, it is reasonable to assume that in the absence of a specific authority to the contrary, nondeductible expenses should reduce a corporation's E&P pursuant to its overall method of accounting. The IRS has offered its support for such a principle in Rev. Rul. 71-165, stating, " An expense of an accrual basis corporation that under the Code is never an allowable deduction in computing taxable income usually is reflected in earnings and profits in the year to which it is attributable, except where the Code specifically provides that the corporation's earnings and profits shall not be reduced by any amount which is not allowable as a deduction in computing its taxable income."
Among those items where authority exists to reduce E&P for a nondeductible expense are the following:
- Interest expense disallowed under Section 264(a)(4) related to a life insurance policy owned by a corporation covering the life of an individual.
- Premiums on a life insurance contract where the corporation is directly or indirectly the beneficiary.
- Amortizable bond premium on tax-exempt bonds, even though nondeductible under Section 171(a)(2).
- Non-deductible interest paid for tax-exempt bonds.
- Charitable contributions in excess of the 10% ceiling of Section 170(b)(2).
- Travel and entertainment expenses disallowed under Section 274.
In addition, the principles established by the IRS in Revenue Rulings 71-165 should apply in permitting a reduction for the following nondeductible expenses in computing E&P, as no contrary authority currently exists:
- Lobbying and political expenses;
- Fines and penalties;
- Nondeductible employee compensation in excess of $1,000,000 under Section 162(m) and parachute payments under Section 280G.
- Disallowed stock reacquisition expenses.
Federal Tax Liability and Credits
Federal income taxes, though nondeductible in computing a corporation's taxable income under Section 275, reduce the corporation's E&P. The reduction in E&P for a corporation's federal tax liability is net of any credit which reduces the liability, such as the general business credit of Section 38, as the reduction in tax liability provides the corporation with funds for distribution not otherwise available.
An accrual method corporation's federal tax liability should reduce the corporation's E&P as of the close of the tax year to which the tax relates.
Ex. X, an accrual method corporation, generates $1,000 of taxable income and a $300 tax liability during 2008. Assume X's E&P for 2008 is also $1,000 prior to taking into consideration X's 2008 tax liability. X must reduce its E&P of $1,000 by its $300 tax liability at the close of 2008, despite the fact that the $300 tax liability is not deductible for income tax purposes pursuant to Section 275. Thus, X's final E&P for 2008 is $700.
With regards to cash basis corporations, the circuit courts are split as to when the reduction to E&P for the corporation's federal tax liability occurs. The IRS, Tax Court, and the Third, Fifth and Eighth Circuits take the position that federal income taxes paid by a cash basis corporation reduces E&P only in the year of payment.
To the contrary, the Second, Sixth, and Seventh Circuits have held that a cash method corporation must reduce its E&P for its federal income tax liability for the year in which it relates. In each decision, the court has reasoned that the corporation was not required to use its method of accounting for purposes of computing its taxable income in determining its E&P, as the corporation's method of accounting was relevant only in determining its taxable income. As federal taxes are never deductible by either an accrual or cash method taxpayer, the courts held that the corporation's method of accounting for income tax purposes was irrelevant in computing E&P. Because the amount necessary to satisfy the corporation's federal tax liability was not available for distribution, the courts reasoned that in order to properly reflect a corporation's E&P it must be reduced in the year the federal tax liability was incurred, rather than paid.
Losses Disallowed but Recognized
The regulations provide that when a loss is recognized, but limited or disallowed in the computation of taxable income, the disallowance does not prevent a decrease in E&P for the disallowed loss.Thus, a corporation's capital losses in excess of capital gains, while subject to disallowance in computing taxable income, nevertheless reduce the corporation's E&P in full in the year the loss is recognized.
Ex. Corporation X generates $100,000 of taxable income in 2012 before considering its capital gains and losses. During 2012, X recognizes $20,000 of capital gain and $40,000 of capital loss. Under Section 1211, X may only deduct its capital losses to the extent of its capital gains in computing its 2010 taxable income. Thus, X's 2012 taxable income is $100,000 ($100,000+$20,000-$20,000).
In computing its 2012 E&P, X's capital losses are not subject to limitation. Thus, X is required to reduce its 2012 taxable income by the $20,000 of disallowed capital losses, resulting in current E&P of $80,000.
Similarly, any related party loss that is disallowed by Section 267(a)(1) should also reduce the corporation's E&P in the year the loss is incurred.
Tax Deductions That Increase E&P
Congress allows for certain deductions in computing a corporation's taxable income that do not reduce a corporation's economic income available for distribution. Such artificial deductions generally should not reduce E&P and thus require an adjustment increasing taxable income. Included in this category of deductions are the following:
- The dividends received deduction of Section 243. In computing its E&P, a corporation must include the full amount of any dividends received in income.
- The Section 199 deduction related to qualified production activities taking place within the United States. As this deduction does not reduce a corporation's economic income, presumably the deduction should be added back in computing E&P, though no authority on the matter exists at this time.
- Percentage depletion is not permitted in computing E&P; a corporation must use cost depletion.
Depreciation
Section 312(k)(1) provides that for purposes of computing E&P, depreciation and amortization must be computed on the straight-line method.
Tangible property is permitted to be depreciated under the alternative depreciation system (ADS) as defined by Section 168(g)(2). The ADS system requires straight-line depreciation be taken under the applicable convention over the ADS life of the asset, generally ranging from four to 50 years.
In computing E&P, first-year bonus deprecation as provided by Section 168(k) is not permitted. Any amount deducted by a corporation under Sections 179, 179A, 179B, 179C, 179D or 179E must be deducted ratably over a five year period.
Upon the disposition of asset, the assets E&P basis (basis as reduced by E&P depreciation) must be used in computing the resulting gain or loss for E&P purposes. The regulations provide the following illustrative example:
Ex. On Jan. 1, 2008, Corp X purchased for $10,000 a useful-life depreciable asset with an estimated useful life of 5 years and no salvage value. In computing depreciation on the asset, X used the applicable declining balance method with a rate twice the straight line rate. On Dec. 31, 2012, the asset was sold for $9,000. Under Section 1016(a)(2), the basis of the asset is adjusted for depreciation allowed for the years 1 through 4, or a total of $3,439. Thus, X realizes a gain of $2,439 (the excess of the amount realized, $9,000, over the adjusted basis, $6,561). However, the adjustment to basis for the purpose of determining E&P is only $2,000, i.e., the total amount which was applied in the computation of E&P for the years 1 through 4. Hence, upon sale of the asset, E&P is increased by only $1,000 i.e., the excess of the amount realized, $9,000, over the adjusted basis for E&P purposes, $8,000.
Deferred Gains and Losses
Section 312(f) provides in general that gains and losses from the disposition of property are not taken into account in computing E&P until recognized for tax purposes. Thus, in situations where gain or loss is deferred because a corporation takes a carryover or substituted basis in property received in exchange for the property disposed, the corresponding gain or loss is also deferred for purposes of computing the corporation's E&P. Though not expressly provided in the statute, regulations, administrative rulings or judicial precedent in all cases, included among those nonrecognition transactions creating deferral for both E&P and taxable income purposes are those within the purview of Sections 351, 354, 361, 1031, 1033 and 1091.
Distributions
On the distribution of property by a corporation with respect to its stock, the corporation reduces its E&P by:
1) the amount of money distributed;
2) the principal amount of any obligations of the corporation (or, in the case of obligations having original issue discount, the aggregate issue price of such obligations), and;
3) the adjusted basis of the other property (but see exception below for appreciated property).
A corporation cannot create a deficiency in E&P through a distribution; thus, a corporation only reduces E&P for the appropriate amount of the distribution to the extent of the E&P balance prior to the distribution.
Ex. Corporation X generates $10,000 of E&P in its first year of existence. X distributes $12,000 to its shareholders on December 31, Year 1. The distribution reduces X's E&P only to $0, it does not create a $2,000 deficit in X's E&P. Thus, $10,000 of the distribution is treated as a dividend pursuant to Section 316, while the remaining $2,000 is either a tax-free return of capital or generates capital gain to the receiving shareholders.
If a corporation distributes appreciated property, two adjustments to E&P are required. The corporation first increases its E&P to account for the excess of the property's fair market value over its E&P basis to determine its E&P immediately prior to the distribution. E&P is then reduced by the fair market value of the distributed property.
Ex. Corporation X distributes to its sole shareholder property with a fair market value of $100,000 and a basis of $40,000. Prior to the distribution, X has $70,000 in E&P. Pursuant to Section 312(b), X first increases its E&P from $70,000 to $130,000 to account for the $60,000 of appreciation inherent in the distributed asset. X then reduces its E&P by the asset's $100,000 fair market value, resulting in an ending E&P of $30,000.
When loss property is distributed, no loss is recognized for tax or E&P purposes, and the corporation reduces its E&P by the adjusted basis of the property. The amount of the distribution treated as a dividend by the shareholders, however, is limited to the property's fair market value.
Ex. Corporation X distributes to its sole shareholder property with a fair market value of $10,000 and a basis of $20,000. Prior to the distribution, X had $40,000 of E&P. X does not recognize a loss on the distribution of the asset. X is required to reduce its E&P by $20,000, the adjusted basis of the asset.
Sourcing Rules Related to Dividend Distributions
Distributions are made out of E&P in the following order:
1) First, to the extent of the E&P of the current year (current E&P), computed as of the close of the year and without reduction for any distributions made during the year and without regard to the amount of interim E&P at the time of the distribution; then
2) To the extent of the E&P accumulated since February 28, 1913 (accumulated E&P); then
3) To the extent of E&P accumulated before March 1, 1913.
Only after these three sources of E&P are depleted can a distribution generate a return of capital or capital gain to a shareholder.
From a practical perspective, these ordering rules require a corporation to concern itself with its accumulated E&P only when its current year distributions exceed its current year E&P.
Current E&P Exceeds Total Distributions
If current E&P is sufficient in amount to cover all distributions made during that year, then each distribution made during the year is a dividend. There is no need to take into account any accumulated E&P as of the beginning of the year.
Ex. X, a calendar year corporation, had $20,000 of accumulated E&P as of the beginning of 2013. During 2013, X had $12,000 in current E&P and made four quarterly distributions of $2,500 each to its shareholders. Because X's current E&P of $12,000 exceeds the total amount of distributions, the entire $10,000 of distributions is taxed as a dividend.
Current E&P is determined without diminution by reason of any distributions made during the year, and is made without regard to the actual E&P on hand at the time of a distribution. Only current E&P as of the close of the tax year is relevant in determining whether a sufficient amount of E&P exists to classify all distributions made during the year as dividends.
Ex. X a calendar-year corporation, had an E&P deficit of $15,000 for the period January 1 through June 30, 2013 and positive E&P of $25,000 for the period July 1 through December 31, 2013. On July 1, 2013, X made a distribution of $8,000.
Though X had a deficit in E&P on July 1, 2013 (the date of the distribution), X's interim E&P on the distribution date is irrelevant. X's current E&P must be determined at the end of 2013, regardless of when distributions were made throughout the year. Thus, X has current E&P in 2013 of $10,000, making X's entire $8,000 distribution a dividend.
Because all distributions are deemed to come first out of current E&P, when current E&P is sufficient to cover all distributions made during the year, the presence of a positive or deficit balance in accumulated E&P as of the beginning of the year is irrelevant. Thus, when a corporation has a deficit in accumulated E&P, current E&P is not reduced throughout the year to "absorb" the deficit in accumulated E&P.
Ex. Assume the same facts as in the previous example, except X had a deficit in accumulated E&P as of the beginning of 2010 of $50,000. This deficit in accumulated E&P has no bearing on the computation of X's current E&P for 2010; thus, X's $8,000 distribution is deemed to have come from X's current E&P of $10,000, making the entire distribution a dividend.
Distributions Exceed Current E&P, Corporation has Positive Accumulated E&P
If the total of a corporation's distributions made during a tax year exceed current E&P, a portion of the current E&P must be allocated to each distribution based on the proportion that the current E&P bears to the total of all distributions made during the year. Next, the corporation's accumulated E&P is applied to the distributions in chronological order.
Ex. X, a calendar year corporation, had $28,000 of accumulated E&P as of the beginning of 2013. X had $40,000 in current E&P in 2013 and made four quarterly distributions of $20,000 each.
Because X's total distributions ($80,000) exceed current E&P ($40,000), X must first allocate current E&P to each distribution. As a result, $10,000 of each distribution is deemed to have come from current E&P. This is the portion of each distribution that bears the same proportion that X's current E&P ($40,000) bears to X's total distributions ($80,000).
The remaining $10,000 of each distribution is treated as a dividend only to the extent of the accumulated E&P as of the beginning of 2013, applied in chronological order. Thus, $10,000 of X's $28,000 of accumulated E&P is applied to each of X's first and second distributions, with the remaining $8,000 of accumulated E&P applied to X's third distribution.
The treatment of X's quarterly distributions can be summarized as follows:
| Distributions during 2013 | Portion out of current E&P | Portion out of accumulated E&P | Taxable amount of each distribution | |
| April 1 | $20,000 | $10,000 | $10,000 | $20,000 |
| July 1 | $20,000 | $10,000 | $10,000 | $20,000 |
| October 1 | $20,000 | $10,000 | $8,000 | $18,000 |
| December 31 | $20,000 | $10,000 | $0 | $10,000 |
| $40,000 | $28,000 | |||
Deficit in Current E&P
When a corporation has a deficit in current E&P for the tax year in which distributions are made, the characterization of the distributions are dependent upon the accumulated E&P available on the date of distribution. As opposed to when a corporation has positive current E&P, this requires an interim allocation of the current year E&P deficit to the date or dates of distribution.
The regulations provide that in determining this interim amount, if the exact amount of current E&P through a distribution date cannot be shown, the current E&P must be prorated to the date of distribution (not counting the date on which the distribution was made).
Ex. X had $60,000 of accumulated E&P at the beginning of 2013. X had a $36,000 deficit in current E&P during 2013 and made a $20,000 distribution on April 1 and October 1, 2013.
If X does not elect to -- or cannot -- show the amount of accumulated E&P available on each distribution date, X must allocate the $36,000 deficit in current E&P evenly throughout the year. Under Reg. Section 1.316-2(b), the $36,000 deficit in current E&P is prorated and determines the taxability of the distributions as follows:
| Accumulated E&P January 1, 2013 | $60,000 | |
| Current deficit for the entire year ($36,000) prorated through April 1 | ($9,000) | |
| Accumulated E&P April 1 | $51,000 | |
| Distribution April 1 | ($20,000)* | |
| *entire $20,000 distribution taxable as dividend | ||
| Remaining accumulated E&P April 1 | $31,000 | |
| Current deficit for the entire year ($36,000) prorated from April 1 through October 1 | ($18,000) | |
| Accumulated E&P October 1 | $13,000 | |
| Distribution October 1 | ($13,000) ** | |
| Remaining accumulated E&P October 1 | $0 | |
| **$13,000 of the distribution comes out of accumulated E&P on September 1, and is taxed as a dividend. The remaining $7,000 distribution is not taxed as a dividend, and is treated as a nontaxable return of capital to the extent of the shareholder's stock basis, then capital gain. | ||
X's $36,000 deficit in current E&P would continue to accrue for the period October 1 through December 31, 2013. Thus, X would end the year with an accumulated deficit in E&P of $9,000.
Hopefully, this discussion takes some of the intimidation factor out of determining E&P for your C corporation clients.
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