How IRS Section 312 Defines Corporate Earnings & Profits

“Earnings and Profits,” or E&P, is a tax measurement defined under Internal Revenue Code Section 312 that gauges a C corporation’s economic capacity to make distributions to its shareholders. While similar to the accounting concept of retained earnings, E&P is calculated using a distinct set of federal tax rules. Its primary function is to determine the tax character of distributions. Whether a payment is a taxable dividend, a non-taxable return of investment, or a capital gain is dictated by the corporation’s E&P, ensuring distributions are sourced from economic income before being considered a return of capital.

The Role of Earnings and Profits in Corporate Distributions

The tax treatment of a corporate distribution hinges on two E&P accounts: current E&P and accumulated E&P. Current E&P is calculated annually, reflecting the company’s economic income for that tax year. Accumulated E&P is the sum of all prior years’ current E&P, reduced by any distributions made in those years. When a corporation makes a distribution, it is first sourced from current E&P.

This sourcing rule creates a three-tiered system for taxing a distribution. First, the distribution is a taxable dividend to the extent the corporation has either current or accumulated E&P, and this amount is included in the shareholder’s gross income. If the distribution is larger than the total available E&P, the excess amount moves to the second tier.

At the second tier, the portion of the distribution exceeding the corporation’s E&P is a non-taxable return of capital. This payment is not immediately taxed; instead, it reduces the shareholder’s adjusted basis in their stock. The stock basis is what the shareholder originally paid for the shares, plus or minus certain adjustments. A return of capital means the shareholder is recouping part of their initial investment.

Should the distribution be so large that it exceeds both the corporation’s E&P and the shareholder’s entire stock basis, the third tier of the system is triggered. Any remaining amount is taxed as a capital gain, as if the shareholder sold a portion of their stock. The character of the gain, whether long-term or short-term, depends on how long the shareholder has held the stock.

To illustrate, consider a shareholder who owns 100% of a corporation and has a stock basis of $20,000. The corporation has $15,000 in current E&P and a deficit of $8,000 in accumulated E&P. If the corporation distributes $25,000, the first $15,000 is a taxable dividend covered by current E&P. The next $10,000 is a return of capital, reducing the shareholder’s stock basis from $20,000 to $10,000. No portion of the distribution is taxed as a capital gain.

Calculating Current Earnings and Profits

The calculation of a corporation’s current E&P begins with its taxable income from its annual tax return, such as Form 1120. From this starting point, a series of adjustments are made to more accurately reflect the company’s economic ability to pay dividends. The logic behind these modifications is that taxable income is often reduced by deductions that do not involve a cash outlay or includes income deferrals that do not align with the company’s actual cash flow.

The accounting method used for tax purposes must also be used for E&P calculations. For instance, a corporation using the cash basis for its tax return cannot use the accrual basis to determine E&P.

Additions to Taxable Income

Several types of income excluded from taxable income must be added back to calculate E&P because they represent an increase in the corporation’s wealth. An example is tax-exempt interest from municipal bonds, which increases the company’s capacity to make distributions. Another addition relates to tax deductions that do not represent an economic outflow, such as the dividends-received deduction.

Any federal income tax refunds received during the year are also added to E&P. An adjustment is also required for depreciation. For tax purposes, companies often use accelerated methods like the Modified Accelerated Cost Recovery System (MACRS), but for E&P, depreciation must be recalculated using the straight-line Alternative Depreciation System (ADS). The difference between the larger MACRS deduction and the smaller ADS deduction must be added back.

Subtractions from Taxable Income

Conversely, certain expenses that are not deductible for taxable income are subtracted to determine E&P, as they reduce a company’s economic resources. The most common subtraction is for federal income taxes paid or accrued during the year. Other non-deductible expenses that reduce E&P include fines, penalties, and lobbying expenses.

Charitable contributions are also treated differently; for E&P, the full amount of the contribution is deductible in the year it is made, unlike the percentage limit for taxable income. Furthermore, capital losses that exceed capital gains cannot be deducted by a corporation in the current year for tax purposes but can be deducted in full when calculating E&P.

Impact of Specific Corporate Transactions on E&P

Beyond the annual calculation, certain corporate events trigger special adjustments to E&P. These transactions are often non-routine and have distinct rules governing their effect on the corporation’s ability to make distributions. One common transaction is the distribution of appreciated property to a shareholder.

If a corporation distributes property with a fair market value higher than its adjusted basis, E&P is first increased by the amount of appreciation. Then, E&P is decreased by the fair market value of the distributed property. This two-step process ensures the unrealized gain on the property is captured in E&P before the distribution is recorded.

Stock redemptions, where a corporation buys back its own stock, also impact E&P. If the redemption qualifies as a sale or exchange under IRC Section 302, the corporation reduces its E&P by an amount not to exceed the ratable share of the E&P attributable to the redeemed stock. If the redemption does not qualify, it is treated like a regular distribution, reducing E&P by the amount distributed.

In a qualifying corporate reorganization, such as a tax-free merger under IRC Section 368, the E&P of the acquired corporation carries over to the acquiring corporation. This prevents corporations from using reorganizations as a tool to eliminate their E&P and avoid dividend treatment on future distributions. The accumulated E&P of the target corporation is combined with that of the acquiring corporation.

Reporting and Tracking E&P

All C corporations must maintain an accurate and ongoing calculation of Earnings and Profits. The IRS requires every corporation to keep a permanent record of its E&P, often called an E&P study. This record is not filed annually but must be available for inspection during an IRS audit. This study should document the starting taxable income and detail every adjustment made to arrive at E&P for each year of the corporation’s existence.

When a corporation makes a distribution that is not fully a taxable dividend, it must file Form 5452, Corporate Report of Nondividend Distributions. The purpose of Form 5452 is to inform the IRS of these nondividend distributions and to provide the underlying E&P calculation that justifies this tax treatment. Form 5452 must be attached to the corporation’s income tax return for the year of the distribution.

The form requires the corporation to report its beginning accumulated E&P, its current E&P for the year, and the total distributions paid. It also requires a breakdown of how much of the distribution is taxable from E&P and how much is a nontaxable return of capital.