Earnings and Profits – C Corps
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
Earnings and profits (E&P) is the tax concept that decides one specific question: when a corporation pays a shareholder a distribution, how much of it is a taxable dividend versus a tax-free return of capital? It's conceptually close to retained earnings, it grows with income and shrinks with distributions, but it's computed with its own tax adjustments and used for a different purpose than the number on the balance sheet.
What's the difference between current and accumulated E&P?
Current E&P covers everything earned in the current year. Accumulated E&P covers everything earned in every prior year. The ordering rule that decides how a distribution is characterized: current E&P is always used up first.
How does each combination of current and accumulated E&P change the answer?
There are four possible combinations, and each one produces a different split between taxable dividend income and non-taxable return of capital.
| Current E&P | Accumulated E&P | Result |
|---|---|---|
| Positive | Positive | The entire distribution is dividend income |
| Positive | Negative | Dividend income limited to current E&P; anything above that is return of capital |
| Negative | Positive | Net the two together; the net positive amount, if any, is the dividend income limit |
| Negative | Negative | The entire distribution is return of capital, no dividend income |
Worked through with a $50,000 distribution in each case:
- Current $30,000, accumulated $80,000 (both positive): the full $50,000 distribution is dividend income.
- Current $20,000, accumulated ($40,000): dividend income is capped at the $20,000 current E&P; the remaining $30,000 is a return of capital.
- Current ($10,000), accumulated $35,000: net E&P is $25,000, so $25,000 of the distribution is dividend income and $25,000 is a return of capital.
- Current ($15,000), accumulated ($20,000): the entire $50,000 is a return of capital.
The scenario that trips people up is a positive current year sitting on top of an accumulated deficit. A corporation that's been unprofitable for years can still generate real dividend income in a year it turns a profit, up to that year's current E&P, even while its accumulated E&P stays negative. Current E&P is evaluated on its own; it is never blocked by a negative accumulated balance.
A return of capital isn't free money. It reduces the shareholder's stock basis dollar for dollar, and only becomes taxable (as a capital gain) once basis is reduced to zero.
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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 95 on FAR. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.
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