Key Takeaways
- E&P measures a corporation's economic ability to pay dividends.
- E&P differs from taxable income—adjustments required.
- Distributions are dividends to extent of current + accumulated E&P.
- Tax-exempt income increases E&P; nondeductible expenses decrease E&P.
- Current E&P is allocated first, then accumulated E&P.
- Distributions exceeding E&P are return of capital, then capital gain.
Earnings & Profits (E&P)
Why This Matters for the Exam
E&P determines whether distributions are dividends, return of capital, or capital gain. This is one of the most tested C corporation topics.
Expect at least 3-4 questions on E&P.
What Is E&P?
Earnings & Profits (E&P) measures a corporation's economic ability to pay dividends.
| Concept | Description |
|---|---|
| E&P | Economic profit measure |
| Taxable income | Tax-computed income |
| Retained earnings | Book/GAAP measure |
These three amounts are usually different.
Why E&P Matters
E&P determines how distributions are classified:
| Classification | When Applies |
|---|---|
| Dividend | To extent of E&P |
| Return of capital | Exceeds E&P, reduces basis |
| Capital gain | Exceeds E&P and basis |
Two Types of E&P
| Type | Description |
|---|---|
| Current E&P | E&P for the current tax year |
| Accumulated E&P | E&P from prior years |
E&P Calculation
Start with taxable income and make adjustments:
| Add to Taxable Income | Subtract from Taxable Income |
|---|---|
| Tax-exempt interest | Federal income taxes paid |
| DRD add-back | Nondeductible penalties/fines |
| Federal tax refunds | Life insurance premiums |
| Excess % depletion over cost | Charitable contributions >10% |
E&P Formula
E&P = Taxable Income
+ Tax-Exempt Income
+ DRD (add back)
- Federal Taxes Paid
- Nondeductible Expenses
Distribution Ordering Rules
| Order | Source | Treatment |
|---|---|---|
| 1st | Current E&P | Dividend |
| 2nd | Accumulated E&P | Dividend |
| 3rd | Stock basis | Return of capital |
| 4th | Excess | Capital gain |
Distribution Example
| Item | Amount |
|---|---|
| Distribution | $100,000 |
| Current E&P | $30,000 |
| Accumulated E&P | $40,000 |
| Shareholder basis | $20,000 |
Tax Treatment:
| Source | Amount | Treatment |
|---|---|---|
| Current E&P | $30,000 | Dividend |
| Accumulated E&P | $40,000 | Dividend |
| Basis reduction | $20,000 | Return of capital |
| Excess | $10,000 | Capital gain |
Current E&P Deficit
If current E&P is negative but accumulated E&P is positive:
| Scenario | Treatment |
|---|---|
| Current E&P: ($20,000) | Deficit |
| Accumulated E&P: $50,000 | Positive |
| Net E&P for distributions | $30,000 |
| Distribution: $40,000 | $30,000 dividend, $10,000 ROC/CG |
Real-World Scenario
Scenario: A corporation has current E&P of $25,000 and accumulated E&P of $15,000. It distributes $60,000 to its sole shareholder, whose stock basis is $12,000.
| Source | Amount | Treatment |
|---|---|---|
| Current E&P | $25,000 | Dividend |
| Accumulated E&P | $15,000 | Dividend |
| Basis ($12,000) | $12,000 | Return of capital |
| Excess | $8,000 | Capital gain |
On the Exam
Expect 3-4 questions on E&P, typically:
- Increase/Decrease Questions: "What increases E&P?"
- Distribution Questions: "How much of the distribution is a dividend?"
- Ordering Questions: "What is the order of distribution classification?"
The key is to remember: E&P ≠ taxable income. Current E&P first, then accumulated. Dividend to extent of E&P, then ROC, then CG.
Which of the following increases E&P?
A corporation has current E&P of $50,000 and accumulated E&P of $30,000. It distributes $100,000. Shareholder basis is $10,000. How much is dividend?
What is subtracted from taxable income when calculating E&P?