The Difference Between E&P and Tax Depreciation
Learn how depreciation for Earnings & Profits uses distinct rules from tax methods, impacting dividend taxation and the gain or loss recognized on asset sales.
A corporation’s “Earnings & Profits,” or E&P, is a tax accounting concept that measures its economic ability to make distributions to shareholders. The balance in a corporation’s E&P account determines the tax treatment of those distributions. A payment from a positive E&P balance is a taxable dividend to the shareholder, while a distribution made when there is no E&P is treated as a non-taxable return of the shareholder’s original investment.
To calculate E&P, a company must make several adjustments to its regular taxable income. These adjustments transform taxable income into a more precise measure of the company’s financial performance. One of the most common adjustments is for depreciation expense, which differs between the calculation for income tax and the one for E&P.
The Core Difference Between Tax and E&P Depreciation
The different depreciation treatments stem from their distinct purposes. For income tax, businesses use the Modified Accelerated Cost Recovery System (MACRS), which is designed to encourage investment. MACRS allows companies to take larger depreciation deductions in the early years of an asset’s life, accelerating tax savings and reducing taxable income more quickly.
In contrast, the E&P calculation aims to reflect a corporation’s economic reality. For E&P purposes, companies must use the Alternative Depreciation System (ADS). This system requires the straight-line method of depreciation over a longer recovery period than allowed under MACRS.
Tax depreciation under MACRS is an incentive for rapid cost recovery, while E&P depreciation under ADS measures an asset’s gradual economic decline. Spreading the expense over a longer timeframe provides a more realistic picture of a company’s ability to pay dividends from actual earnings. This prevents a company from showing an artificially low E&P and making tax-free distributions that are not economically a return of capital.
Calculating Depreciation for E&P Purposes
When calculating E&P, depreciation must be handled using the Alternative Depreciation System (ADS) instead of accelerated methods. ADS recovery periods are often longer than standard MACRS periods. For example, an asset classified as 5-year property under MACRS might have a 9-year or 12-year life under ADS.
For E&P calculations, the Section 179 immediate expense deduction is disallowed. While this rule allows a business to expense the full cost of an asset for income tax, it is not permitted for E&P. Instead, the cost of the asset must be capitalized and depreciated on a straight-line basis over a five-year period.
Bonus depreciation is also disregarded for E&P purposes. For tax purposes, this provision allows a business to deduct a portion of an asset’s cost in the first year (40% for property placed in service in 2025). This accelerated deduction is not permitted when computing E&P, and the asset’s entire cost must be depreciated using the straight-line method over its ADS recovery period.
E&P Adjustments for Asset Sales and Dispositions
Using different depreciation methods for tax and E&P directly impacts the sale of an asset. Because the amount of depreciation claimed differs, the asset’s adjusted basis will also be different for each calculation. The adjusted basis is the asset’s original cost minus accumulated depreciation, and a lower basis results in a higher gain upon sale.
The gain or loss from a sale must be calculated separately for tax and E&P. For tax purposes, the gain or loss is the sale price minus the basis adjusted for MACRS, Section 179, and bonus depreciation. For E&P, the gain or loss is the sale price minus the basis adjusted for the straight-line ADS depreciation.
Consider an asset purchased for $50,000. For tax purposes, total accelerated depreciation (including bonus) might be $40,000, leaving a tax adjusted basis of $10,000. For E&P, the straight-line ADS depreciation might only be $15,000, resulting in an E&P adjusted basis of $35,000. If the asset is sold for $45,000, the gain for tax purposes would be $35,000 ($45,000 – $10,000), while the gain for E&P purposes would be only $10,000 ($45,000 – $35,000).