What Is Earnings and Profits (E&P) Accounting?

Earnings and Profits (E&P) is a tax accounting measurement for C corporations that determines the tax character of distributions made to shareholders. The calculation represents a company’s economic capacity to make payments beyond a simple return of an investor’s capital. E&P is distinct from other financial metrics. It does not equal a company’s retained earnings due to different calculation rules, and it also differs from taxable income, as it requires numerous adjustments to better reflect a corporation’s true economic performance.

The Role of E&P in Corporate Distributions

A corporation’s E&P balance governs the tax consequences for shareholders receiving a distribution. The Internal Revenue Code uses a three-tier system to characterize these payments, which taxes distributions based on the corporation’s economic earnings before treating them as a return of the shareholder’s invested capital.

First, distributions are treated as a taxable dividend to the extent the corporation has positive E&P. This applies whether the E&P is from the current year or has been accumulated from prior years.

Once the corporation’s E&P is depleted, any further payment is a non-taxable return of capital. This portion of the distribution is not taxed immediately; instead, the shareholder reduces their cost basis in the company’s stock by the amount received. This basis reduction defers the tax consequence until the stock is sold.

If distributions continue after a shareholder’s stock basis is reduced to zero, any additional amount is treated as a capital gain. The gain is classified as short-term or long-term, depending on the shareholder’s holding period for the stock. For example, a shareholder with a $2,000 stock basis receives a $6,000 distribution from a corporation with $3,000 in E&P. The first $3,000 is a taxable dividend. The next $2,000 is a non-taxable return of capital, reducing the stock basis to zero. The final $1,000 is taxed as a capital gain.

Calculating Current Earnings and Profits

A corporation’s current E&P calculation begins with the taxable income from its tax return. This baseline figure is then modified with specific adjustments required by tax law. These adjustments are designed to create a measure of earnings that more accurately reflects the company’s economic performance and ability to make distributions to shareholders.

Additions to Taxable Income

Several items excluded from taxable income must be added back to calculate E&P. One example is tax-exempt income, such as interest from municipal bonds. Although not subject to federal income tax, this income increases a company’s ability to pay dividends and is included in E&P.

Another addition is the dividends-received deduction (DRD). Corporations deduct a percentage of dividends received from other domestic corporations, which lowers taxable income without being a cash expense. The full DRD must be added back when computing E&P.

Subtractions from Taxable Income

Certain expenses and losses that are not deductible for taxable income must be subtracted to determine current E&P, as they represent economic costs. These subtractions include:

• Federal income taxes paid or accrued.
• Fines, penalties, and illegal payments.
• The full amount of charitable contributions, which may be limited for taxable income purposes.
• Capital losses that exceed capital gains in the current year.
• Disallowed entertainment and meal expenses.

Timing Differences

Adjustments are also required for items recognized in different periods for tax versus E&P purposes. Depreciation is a common timing adjustment. While businesses often use accelerated methods like MACRS for taxable income, E&P requires the slower, straight-line method under the Alternative Depreciation System (ADS). This leads to a smaller E&P depreciation expense in an asset’s early years compared to MACRS.

Section 179 expenses also create a timing difference. For taxable income, a business can immediately expense qualifying property up to a limit, but this is not allowed for E&P. Instead, the Section 179 expense must be capitalized and deducted over a five-year period for E&P. Organizational expenditures must also be capitalized for E&P and are not deducted over time as they can be for tax purposes.

Accumulated E&P and Distribution Ordering

A corporation must track its accumulated E&P, which is the sum of all prior years’ current E&P, reduced by the total distributions made from E&P in those years. The resulting balance, which can be a positive amount or a negative deficit, is the accumulated E&P at the start of the tax year. Specific ordering rules dictate how current and accumulated E&P are used for distributions.

Distributions are first sourced from the current year’s E&P. Current E&P is calculated at year-end and allocated pro-rata to all distributions made during that year. If total distributions are less than or equal to current E&P, each distribution is a taxable dividend, even if the corporation has a deficit in accumulated E&P.

If total distributions exceed current E&P, the excess is sourced from accumulated E&P. These distributions are applied chronologically against the accumulated E&P balance until it is depleted.

A different rule applies if a corporation has a negative current E&P (a deficit) but positive accumulated E&P. In this case, the two E&P accounts are netted at the time of each distribution. The current year’s deficit is prorated and subtracted from the accumulated E&P balance on the date of each distribution to determine the E&P available at that moment.

Corporate Transactions Affecting E&P

Certain corporate transactions have specific rules for how they impact E&P. These events, such as stock redemptions, reorganizations, and liquidations, can cause substantial changes to the E&P account.

A stock redemption occurs when a corporation buys back its own stock. If the redemption qualifies as a sale, the corporation must reduce its E&P. The reduction is limited to the portion of E&P attributable to the redeemed shares and cannot exceed the distribution amount.

In tax-free reorganizations, such as a merger, the E&P of the acquired corporation carries over to the acquiring corporation. The target’s E&P is combined with the acquirer’s, which can increase the pool of earnings for future distributions.

When a parent corporation liquidates a subsidiary in which it owns at least 80% of the stock, the subsidiary’s E&P also carries over to the parent. In divisive reorganizations, where a single corporation splits into two or more entities, the original corporation’s E&P must be allocated among the resulting companies.

Information for Filing Form 5452

A C corporation must file Form 5452, Corporate Report of Nondividend Distributions, if it makes distributions that are not fully taxable as dividends because E&P was insufficient.

To complete Form 5452, a corporation needs the total amount of all distributions paid to shareholders during the year. The corporation must also provide its calculated current E&P for the year and the accumulated E&P balance as of the beginning of the year. Using these figures, the corporation must show a detailed allocation of the distributions, including amounts sourced from current E&P, accumulated E&P, and any portion treated as a return of capital or capital gain.