How to Calculate Earnings and Profits (E&P)

Earnings and Profits (E&P) is a specialized tax concept that measures a corporation’s capacity to make distributions to its shareholders without impairing its capital. This calculation is fundamental for determining how corporate distributions, such as dividends, are taxed when received by shareholders. E&P serves as a proxy for the corporation’s economic income available for distribution.

It is a distinct measure from a company’s retained earnings, which are based on financial accounting principles and can differ significantly due to varying rules for recognizing income and expenses. While retained earnings reflect a company’s cumulative net income less dividends paid, E&P is specifically defined by tax law. The Internal Revenue Code (IRC) does not provide a single, all-encompassing definition of E&P, but rather outlines a series of adjustments to taxable income to arrive at this figure. This distinction is important because a corporation might have substantial retained earnings but limited E&P, or vice versa, impacting the tax consequences of distributions to its owners.

Determining Current Earnings and Profits

Calculating Current Earnings and Profits (E&P) for a given year begins with the corporation’s taxable income or net loss. This starting point undergoes specific adjustments mandated by tax regulations to reflect the true economic income available for distribution. These adjustments account for items treated differently for E&P purposes than for regular income tax calculations. The goal is to measure the corporation’s ability to pay dividends from its economic profits.

Additions to Taxable Income

Certain income items excluded from taxable income for regular tax purposes must be added back to E&P because they represent an economic increase in the corporation’s wealth. For instance, tax-exempt interest income, such as that derived from municipal bonds, is included. Proceeds from life insurance policies received by the corporation, net of any increase in the cash surrender value, are another example. Federal income tax refunds are also added back. These additions ensure that all economic inflows available for distribution are captured in the E&P calculation.

Subtractions from Taxable Income

Conversely, some expenses and losses not deductible for regular tax purposes reduce a corporation’s economic ability to pay dividends and are subtracted from taxable income when calculating E&P. Federal income taxes paid or accrued are subtracted. Non-deductible expenses, such as penalties, fines, and lobbying costs, also decrease economic resources and are subtracted. Capital losses exceeding capital gains for tax purposes reduce E&P to reflect the full economic loss.

Timing Adjustments

Timing adjustments are necessary when items are recognized for E&P purposes in a different period or manner than for regular income tax. Depreciation is a key example; E&P generally requires the Alternative Depreciation System (ADS) straight-line method over longer recovery periods. If accelerated depreciation (like MACRS or Section 179 deductions) was used for tax, E&P is increased by the excess tax depreciation over ADS depreciation. For E&P, Section 179 expenses must be deducted ratably over five years, requiring adjustment if the full amount was expensed for tax.

Income from installment sales is fully recognized for E&P in the year of sale, accelerating recognition and aligning with the economic event. For long-term contracts, E&P requires income recognition using the percentage-of-completion method as work progresses. Organizational and start-up costs, which may be amortized over several years for tax, reduce E&P in the year incurred. Gains and losses from property sales for E&P are computed using the asset’s E&P basis, adjusted for E&P depreciation.

Accounting for Accumulated Earnings and Profits

Accumulated Earnings and Profits (E&P) represents the cumulative sum of a corporation’s undistributed E&P from prior tax years, reduced by distributions. This balance carries forward the economic capacity to pay dividends built up over the corporation’s lifetime. It is a running balance, constantly updated by each year’s Current E&P and any distributions made. Maintaining accurate records of both current and accumulated E&P from year to year is important for proper tax compliance and planning.

When a corporation has a Current E&P deficit, this negative amount reduces its Accumulated E&P, reflecting a decrease in its ability to distribute profits. However, a Current E&P deficit cannot create or increase an Accumulated E&P deficit if the balance is already positive. This rule prevents a current loss from retroactively wiping out prior accumulated profits for dividend purposes.

A corporation’s Accumulated E&P balance is adjusted annually by adding the Current E&P for the year and subtracting any distributions made during that year. Even with a deficit in Accumulated E&P from prior years, any positive Current E&P for the present year is generally available for distributions. This is known as the “nimble dividend” rule, allowing distributions to be considered dividends from current profits even if historical profits are negative.

Effect of Distributions on Earnings and Profits

Corporate distributions, such as cash dividends, directly impact Earnings and Profits (E&P) and determine the tax treatment for shareholders. The Internal Revenue Code establishes specific ordering rules to classify these distributions. Understanding these rules is important for both the distributing corporation and the shareholders receiving the funds.

Distributions are first considered to come from Current E&P. If the Current E&P for the year is sufficient to cover the entire distribution, the entire amount is treated as a taxable dividend to the shareholder. This applies even if the corporation has a negative Accumulated E&P balance from prior years. If distributions made throughout the year exceed the Current E&P, the Current E&P is prorated among all distributions made during the year.

If the distributions exceed the Current E&P, or if Current E&P is negative, the remaining portion of the distribution is then considered to come from Accumulated E&P. To the extent of Accumulated E&P, these distributions are also treated as taxable dividends. The Internal Revenue Service applies a “last-in, first-out” (LIFO) approach when sourcing distributions from Accumulated E&P if there are multiple prior-year E&P accounts.

Should distributions exceed both Current and Accumulated E&P, the excess portion is treated as a tax-free return of capital. This means the shareholder reduces their adjusted basis in their stock by this amount. Once a shareholder’s stock basis is reduced to zero, any further distributions in excess of E&P are then treated as capital gains, subject to capital gains tax rates.

Distributions reduce the corporation’s E&P dollar-for-dollar, but only to the extent they are treated as dividends. A distribution cannot, however, create or increase a deficit in E&P. If a corporation has a Current E&P deficit and an Accumulated E&P surplus, the deficit is netted against the surplus at the end of the year to determine the total E&P available for distributions.