What Is E&P Tax and How Is It Calculated?
A corporation's ability to pay taxable dividends is defined by its E&P, a specific tax calculation separate from its reported income or retained earnings.
Earnings and Profits, or E&P, is a corporate tax concept that measures a company’s economic ability to pay distributions to shareholders. It is not the same as retained earnings or taxable income, as E&P is calculated using its own set of rules under the Internal Revenue Code. The function of E&P is to determine the tax treatment of payments made by a corporation to its owners. It establishes whether a distribution is a taxable dividend or a non-taxable return of capital, which directly impacts a shareholder’s personal income tax liability.
The Role of E&P in Corporate Distributions
To properly categorize payments from a C corporation to its shareholders, the company must maintain two E&P accounts. Current E&P is calculated for the current tax year, while Accumulated E&P is the sum of all undistributed E&P from previous years.
When a corporation makes a distribution, tax law applies specific ordering rules. Distributions are first sourced from Current E&P. If there is a positive balance in Current E&P, that portion of the distribution is a taxable dividend, which shareholders report as ordinary income.
If distributions exceed Current E&P, the next source is the corporation’s Accumulated E&P. The portion of the distribution covered by this accumulated amount is also treated as a taxable dividend. Any remaining distribution is treated differently only after both E&P accounts are depleted.
After both E&P accounts are reduced to zero, any excess distribution is a non-taxable return of capital. This amount is not immediately taxed but instead reduces the shareholder’s cost basis in their stock. For instance, if a shareholder with a $50 per share basis receives a $5 per share return of capital, their new basis becomes $45.
If distributions exceed a shareholder’s basis after it has been reduced to zero, any further payments are taxed as a capital gain.
To illustrate, consider a corporation with $10,000 in Current E&P and $30,000 in Accumulated E&P. It distributes $50,000 to its sole shareholder, who has a stock basis of $7,000. The first $10,000 of the distribution is a taxable dividend from Current E&P. The next $30,000 is a taxable dividend from Accumulated E&P, making the total taxable dividend $40,000. The remaining $10,000 of the distribution exceeds total E&P. The first $7,000 of this excess is a non-taxable return of capital, reducing the shareholder’s basis to zero. The final $3,000 is taxed as a capital gain.
Calculating Earnings and Profits
The E&P calculation starts with the corporation’s taxable income for the year. A series of adjustments required under Internal Revenue Code Section 312 are then made to convert taxable income into a measure of the company’s economic income. These adjustments account for items that change a company’s ability to make distributions, even if they are treated differently for tax purposes.
Some items not included in taxable income must be added back to calculate E&P because they represent economic gains. Examples include tax-exempt interest from municipal bonds and proceeds from corporate-owned life insurance policies. The dividends-received deduction, which lowers taxable income, must also be added back for E&P.
Conversely, some expenses that are not deductible for tax purposes are subtracted when calculating E&P because they represent cash outflows. Examples include federal income taxes paid or accrued, fines, penalties, and the portion of meal or entertainment expenses that are disallowed as a tax deduction.
A third category of adjustments involves timing differences, where E&P rules require a different accounting method than is used for taxable income. The primary example is depreciation. For E&P, corporations must use the Alternative Depreciation System (ADS), which uses longer recovery periods and the straight-line method.
This method results in smaller depreciation deductions for E&P in an asset’s early years compared to accelerated methods used for tax purposes. Other timing adjustments can involve installment sales and long-term contracts, which are also accounted for differently to better reflect economic reality.
Reporting Requirements for E&P
A corporation is not required to report its E&P calculation to the IRS annually. The obligation is triggered when a corporation makes a distribution that is not fully covered by its total E&P. This occurs when any part of the distribution is classified as a non-taxable return of capital or a capital gain.
In this situation, the corporation must file IRS Form 5452, Corporate Report of Nondividend Distributions. This form provides the IRS with a detailed computation of the corporation’s E&P for the year. It reconciles taxable income to the final E&P figure and shows how distributions were allocated, allowing the IRS to verify the shareholder’s tax treatment.
Form 5452 must be attached to the corporation’s income tax return, such as Form 1120, for the year the distribution occurred. The corporation must also provide this information to its shareholders on Form 1099-DIV, so they can accurately report the distribution on their personal tax returns.
E&P Considerations for S Corporations
E&P primarily applies to C corporations, as S corporations do not generate their own earnings and profits. In an S corporation, income and losses pass through directly to the shareholders and are taxed at the individual level. This system prevents the internal accumulation of earnings that would require an E&P calculation.
An S corporation can, however, have E&P from a prior period. This occurs if the company was previously a C corporation or acquired a C corporation with existing E&P. This carryover is called Accumulated E&P (AE&P) and can create tax complications.
One issue arises if an S corporation with AE&P has substantial passive investment income, such as interest, dividends, and rent. If this passive income exceeds 25% of the corporation’s gross receipts for a year, the corporation itself can be subject to a tax.
This tax is levied at the highest corporate rate on the excess net passive income. It is one of the few instances where an S corporation pays a corporate-level income tax.
A more serious consequence is tied to the same passive income threshold. If an S corporation with AE&P exceeds the 25% passive income limit for three consecutive tax years, its S election is automatically terminated. The termination is effective on the first day of the fourth year, forcing the company to revert to C corporation status.