Although earnings and profits (E&P) have a significant impact in determining the tax status of dividend distributions, the term is not defined inside the Internal Revenue Code. Code Section 312 does provide an indication of how certain transactions will affect E&P, but it does not specifically define what E&P actually is.
Defining Earnings and Profits
Earnings and profits is basically a tax term. It has some similarities to retained earnings, but it is not equal to it. E&P is a measure of the corporation’s economic capacity to pay a dividend. Its main purpose is to measure the amount of a distribution which represents a taxable dividend to the shareholder.
This means that certain transactions that reduce or increase retained earnings may not have a similar affect on E&P. For example, a stock dividend reduces retained earnings but does not reduce E&P. This is evident in the following example:
“The XYZ Corporation pays a 20 percent stock dividend, consisting of 10,000 shares with a $1 par value and a fair market value of $5. This would cause a debit to retained earnings of $50,000, a credit to capital stock for $10,000 and a credit to paid in capital for $40,000. For tax purposes, the stock dividend is irrelevant. E&P stays the same since the stock transaction in no way has reduced the corporation’s capacity to pay a dividend in cash or property.”
How to Determine E&P
E&P is used up on a LIFO basis because distributions are considered to come from current E&P first and then from accumulated E&P. It is important to remember that a new corporation comes with zero E&P. Current E&P is determined on an annual basis.
Each year a corporation adds to accumulated E&P to the extent that it does not distribute current E&P. If a corporation distributes more than its current E&P, then the accumulated E&P is reduced by such excess, but never below zero.