Earnings and profits play a critical role in corporate decision-making, but they’re frequently misunderstood by the executives who rely on the metric to determine shareholder distributions. The earnings and profits (E&P) calculation measures the economic resources that a corporation has available for distribution to its shareholders. The process bears so many similarities to the financial accounting calculation of retained earnings from book income that E&P is frequently referred to as the tax equivalent of retained earnings.
The annual E&P calculation in any given year can be complicated, with many intricacies at every step. Part of the complexity stems from the fact that the Internal Revenue Code (IRC) doesn’t provide a specific definition or precise calculation for annual E&P. The calculation starts with taxable income and then adjusts for “economic realities” of a variety of transactions that are treated differently for tax and book purposes. The initial complexity of the annual calculation is compounded by the fact that cumulative historical E&P numbers can factor into the taxability of distributions, and those calculations can require examinations of annual E&P dating back to the inception of the business. Other advanced business actions taken over the life of the corporation, such as mergers, acquisitions, and combinations, can further complicate the analysis.
Most corporations tend to focus on E&P in years when they want to issue a distribution to shareholders because E&P can affect the taxability of the distribution. If there’s enough current year E&P to cover a distribution, the distribution is treated as a taxable dividend to the shareholders that receive it. If there isn’t enough current year E&P, then the company must perform a more complex analysis of prior years’ profits, taxable income, and expenses to determine a cumulative historical E&P. Generally, a corporate distribution to a shareholder will be taxable to that shareholder to the extent of current and historical E&P. If there’s insufficient current and historical E&P at the end of the calculation, the amount of the distribution that exceeds the E&P calculation will be treated as a return of capital to the shareholders, and the taxability will depend on each shareholder’s stock basis.
This article will examine a few very basic examples of a few book and tax differences that factor into the E&P calculation and provide some insights into how to track E&P accurately over multiple years. It’ll also list some of the key misunderstandings about E&P that lead to mischaracterizations of distributions and difficult conversations with shareholders. You should consult a tax advisor for details if you have an advanced situation.
The annual E&P calculation
The E&P calculation starts with taxable income and is then adjusted to reflect transactions that increase or decrease the economic resources available to be paid out as a dividend to shareholders. The general guiding principle for E&P adjustments is to ask, “Does the item increase or decrease the economic income available for the corporation to distribute to its shareholders?” If the answer to that question is “yes,” it generally needs to be reflected in the E&P calculation. There are numerous potential adjustments for E&P, but the examples below show two of the most basic ones.
- Depreciation: Most companies calculate depreciation using the MACRS method, which takes more depreciation at the start of the asset life and less depreciation later. The IRC requires taxpayers to calculate depreciation for E&P using the straight-line method, which depreciates the asset equally each year of its life. This method change usually results in an addback to taxable income in the early years and a subtraction from taxable income in later years.
- Disallowed permanent book-tax differences: Tax disallows some deductions companies can recognize as expenses in their finances. The most common of these items are meals and entertainment. Even though these expenses aren’t fully deductible in the taxable income calculation, they’re still subtracted from taxable income to reach the E&P number because they reduce the company’s economic resources.
While E&P is the tax equivalent of retained earnings, it’s doubtful that a company’s E&P would ever match the retained earnings for book purposes. However, when E&P and retained earnings are analyzed cumulatively over time, the two will likely trend in the same direction (whether the company is profitable or not). Additionally, a company can have an E&P deficit, like retained earnings, unlike stock or asset basis.
For example, the corporation “ABC, Inc.” has a taxable income of $800,000. ABC, Inc. reported depreciation of $300,000 using the MACRS method. ABC, Inc. has a depreciation expense of only $250,000 when it calculates depreciation using the straight-line method. ABC also paid $50,000 for employee meals, which were only 50% deductible for taxes. Under the E&P calculations, ABC has an E&P of $825,000. ABC’s tax depreciation is higher than the book depreciation, so ABC will add the difference back to E&P because it didn’t reduce ABC’s ability to pay dividends ($800,000 + $50,000 = $850,000). Even though the meals were only 50% deductible for taxes, the excess book expense is subtracted from taxable income because it did reduce ABC’s available resources ($850,000 - $25,000 = $825,000). Note that E&P is only adjusted by the difference between book and tax numbers because the taxable income already includes the tax numbers.
Cumulative E&P
Companies should calculate E&P every year, even in years when they’re not relying on the number to determine taxability of a distribution. Any E&P the company doesn’t use in the current year gets added to the E&P that has accumulated in earlier years, which is referred to as “cumulative E&P.” While it’s often possible to perform an E&P calculation retroactively to determine a company’s current and cumulative E&P, it shouldn’t be a company’s preference. A retroactive E&P study can be costly, laborious, and potentially less accurate than yearly calculations because older information may not be available.
Determining distribution and dividends
As was mentioned earlier, when a company has enough E&P in the current year to absorb the full amount of a distribution, the entire distribution is a taxable dividend. When a company doesn’t have enough current E&P to cover the distribution, the company will use cumulative E&P to absorb the distribution, again resulting in treatment of the distribution as a taxable dividend. If the company doesn’t have enough E&P (current or accumulated), then the shareholders who receive the distribution will have to pay taxes or adjust their basis in the company. The ability to make dividends in loss years is why the performance of yearly E&P calculations and the ongoing tracking of cumulative E&P can provide significant value to the company. A company may not be profitable in the current year, but it’s still eligible to issue taxable dividends instead of basis-reducing distributions.
Considering ABC corporation again — The corporation wants to distribute $600,00. The entire distribution will be a taxable dividend because ABC has more E&P ($825,000) than the distribution.
Now, consider if ABC corporation has cumulative E&P of $500,000 in addition to the current year E&P of $825,000, and ABC wants to distribute $1,000,000. ABC will first use the current year E&P and can then use the cumulative E&P. This is still a taxable dividend because the total E&P ($1,325,00) exceeds the total value of the distribution ($1,000,000).
IRS Forms 1099-DIV, 5452, 8937, and the “reporting” of E&P
The IRS doesn’t require companies to report their E&P yearly. However, if there is a distribution in excess of E&P, the corporation must file Form 5452, “Corporate Report of Nondividend Distributions,” and include support that the distribution isn’t from E&P. In most cases, if a company makes a distribution in excess of E&P, it will also need to file a Form 8937, “Report of Organizational Actions Affecting Basis of Securities.” The key documents for reporting shareholder distributions to the recipients and the IRS include:
- Form 1099-DIV, “Dividends and distributions” — Reports to shareholders (with a copy to the IRS) the amount of ordinary taxable dividends and a variety of other distributions from the company throughout the year. There is space on this form to report nondividend distributions, which would include distributions in excess of E&P that might affect shareholder basis. When nondividend distributions are reported on a 1099-DIV, the corporation may not be required to share a form 8937 with the shareholder. However, there are some circumstances that may require nondividend reporting to a shareholder on an 8937, including:
- Shareholders that aren’t required to get a 1099-DIV should be notified of basis impact on an 8937.
- Distributions made in the absence of any E&P that are entirely nondividend amounts are typically not reported on a 1099-DIV and would usually trigger an 8937.
- Form 5452, “Corporate Report of Nondividend Distributions” — Reports to the IRS nondividend distributions made to shareholders.
- Form 8937, “Report of Organizational Actions Affecting Basis of Securities” — Filed with the IRS when an issuer of a security takes an organizational action that affects the basis of that security (such as a distribution made in the absence of any E&P). A company that’s required to file Form 8937 with the IRS is also required to give a copy of the form to each security holder of record as of the date of the organizational action. Companies that make distributions without E&P are expected to notify all shareholders whose basis may be affected.
Common misconceptions about earnings and profits
The calculation of E&P and the decision-making based on the amount presumed to be available can be affected by some common misconceptions about the process. For instance:
- Companies operating with a cumulative deficit in E&P can still issue a distribution that may be at least in part a taxable dividend if they have even $1 of current year positive E&P.
- Redemptions require appropriate reductions to E&P, even if there’s not a taxable dividend involved.
- Corporations leaving a consolidated group need to understand that their preconsolidation E&P that has been “trapped” or “frozen” will spring to life at exit.
- Restructurings can cause reduction or reallocation of E&P across members of a group.
- S corporations that converted from C corporations need to know what the C corporation’s E&P was at the time of the conversion. Certain post-conversion distributions could be taxable dividends if there’s carryover E&P.
Asking for help
Calculating E&P is a technical and complicated process with many potential pitfalls. The examples above are the simplest cases with many intricacies removed. Additionally, there are further complications and requirements for consolidated corporations, companies that have undergone any restructuring, and newly formed companies. Given all of the complexities of the annual calculation that can be compounded when cumulative E&P goes untracked for years, it’s easy to see the value of investing in E&P tracking on an annual basis. When in doubt, contact a tax advisor who can help guide you through this process.
