E&P Distribution Ordering Rules for C Corporations
The tax treatment of C corp payments to shareholders depends on a precise calculation and application of Earnings & Profits, not retained earnings.
When a C corporation distributes cash or property to its shareholders, the tax consequences depend on its Earnings and Profits (E&P). E&P is a tax concept measuring a corporation’s economic capacity to make payments to owners and is different from retained earnings or taxable income. Understanding E&P is important because it dictates whether a shareholder receives a taxable dividend, a nontaxable return of investment, or a capital gain.
The Internal Revenue Service (IRS) has specific ordering rules that corporations must follow to classify these distributions. These rules determine the source of the funds being distributed, drawing from different pools of corporate earnings in a specific sequence. This framework ensures distributions are properly characterized for tax purposes, affecting each shareholder’s tax liability.
The Three Tiers of Distribution Taxation
When a shareholder receives a distribution from a C corporation, the payment falls into one of three tax categories. The first is treatment as a taxable dividend. This portion of the distribution is considered paid from the corporation’s E&P and is included in the shareholder’s gross income. For most individual shareholders, these are often “qualified dividends,” which are taxed at lower long-term capital gains rates if certain holding period requirements are met.
If a distribution exceeds the corporation’s available E&P, the excess amount moves to the second tier and is treated as a nontaxable return of capital. This portion is not immediately taxed. Instead, the shareholder must reduce their cost basis in the corporation’s stock by the amount of the distribution. This basis reduction defers the tax consequence, as it will result in a larger capital gain or smaller capital loss when the shareholder sells the stock.
Once a shareholder’s stock basis has been reduced to zero, any further distributions fall into the third tier. These amounts are treated as a capital gain from the sale or exchange of property. The character of this gain, whether short-term or long-term, depends on how long the shareholder has held the stock.
The corporation is responsible for informing shareholders of the tax character of the distributions on Form 1099-DIV, which breaks down the total distribution into these categories. Shareholders then use this information to accurately report the income and any basis adjustments on their personal tax returns.
Calculating Current and Accumulated E&P
To apply the distribution rules, a corporation must compute both current and accumulated E&P. Current E&P is calculated annually and reflects the company’s economic performance for that year. The calculation starts with the corporation’s taxable income, which is then modified by specific adjustments to better reflect its ability to pay dividends.
Common adjustments to convert taxable income into current E&P include:
- Adding back tax-exempt income, such as interest from municipal bonds.
- Adding back the dividends-received deduction.
- Subtracting non-deductible expenses, like federal income taxes paid.
- Adjusting for the difference between accelerated depreciation (MACRS) and the slower Alternative Depreciation System (ADS).
- Adding back the Section 179 expense in the year it is taken and then deducting it ratably over five years.
Accumulated E&P is a running total of a corporation’s financial history. Calculated at the start of the tax year, it represents the total of all prior years’ current E&P, reduced by distributions made from E&P in those years. A positive balance indicates a history of profitability, while a deficit suggests past losses exceeded profits. This figure only changes at the start of the next tax year.
Applying the Distribution Ordering Rules
Under Internal Revenue Code Section 316, distributions are sourced first from the corporation’s current E&P. As long as there is positive current E&P, distributions are treated as taxable dividends up to that amount, even if there is a deficit in accumulated E&P.
If total distributions for the year exceed current E&P, the remaining portion is sourced from the accumulated E&P balance calculated at the beginning of the year. This amount is also treated as a taxable dividend until the accumulated E&P is depleted.
After both current and accumulated E&P are exhausted, any further distribution is treated as a nontaxable return of capital, which reduces the shareholder’s stock basis. Once the stock basis is reduced to zero, any additional distributions are treated as a capital gain.
Special Scenarios in E&P Allocation
When a corporation makes multiple distributions during the tax year, special allocation rules apply. Current E&P is allocated on a pro-rata basis across all distributions, regardless of when they were paid. For example, if a company with $10,000 in current E&P makes four quarterly distributions of $5,000 each (totaling $20,000), then $2,500 of each distribution is sourced from current E&P.
In contrast, accumulated E&P is applied chronologically. Using the same example, if the accumulated E&P balance was $4,000, it would cover the remaining $2,500 of the first distribution. The remaining $1,500 of accumulated E&P would then be applied to the second distribution.
Different rules apply if a corporation has a current E&P deficit but positive accumulated E&P. The two accounts are netted at the date of distribution to determine the available E&P at that time. For instance, if a corporation with $50,000 in accumulated E&P has a current deficit of $36,500, and it makes a single distribution of $20,000 on July 1, the pro-rated current deficit for half the year ($18,250) reduces the available E&P to $31,750, making the entire $20,000 distribution a taxable dividend.
When there is positive current E&P but a deficit in accumulated E&P, the two amounts are not netted. Distributions are taxable as dividends to the full extent of the positive current E&P. For example, if a corporation has $20,000 of current E&P and an accumulated deficit of $100,000, a $15,000 distribution during the year is still treated as a $15,000 taxable dividend.