Now, let’s talk about earnings and profits. Earnings and profits are retained earnings for a C Corp. It increases with the company’s earnings and decreases with the dividends.

Every C Corp has current earnings and profits and accumulated earnings and profits. Current earnings and profits is for everything earned in the current year, and accumulated earnings and profits is for everything earned before the current year.

The key is that we always deplete current earnings and profits first. Why does it matter? Depending on whether there are positive or negative balances, we have different rules for how the shareholder recognizes the dividend. Will the shareholder record dividend income and pay taxes, or will it merely be a return of capital, which is a non-taxable event?

Let’s examine the four situations involving current earnings and profits and accumulated earnings and profits:

The first possible situation is when both current earnings and profits and accumulated earnings and profits are positive. In this case, the entire dividend paid is dividend income.

Next, consider if current earnings and profits are positive and accumulated is negative. The dividend income in this case will be limited to the current earnings and profits. Everything paid as a dividend up to that amount is dividend income, and everything in excess will be considered a return of capital (non-taxable).

Third, what happens when current earnings and profits are negative and accumulated is positive? In this instance, we net the two together, and that’s the limit for the dividend income.

Lastly, what if both are negative? In this case, the entire dividend is considered a return of capital, meaning there will not be any dividend income.