Corporations: Distributions Not in Complete Liquidation | CPA Exam Regulation

These lectures covers corporate distribution, earnings and profits, current earning and profit, accumulated earnings and profit and property dividend distribution.

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When a distribution is made from corporate earnings and profits (E & P), the share- holder is deemed to receive a dividend, which is taxed either as ordinary income or as preferentially taxed dividend income.1 Generally, corporate distributions are presumed to be paid out of E & P  and are treated as dividends unless the parties to the transaction can show otherwise. Distributions not treated as dividends (because of insufficient E & P) are nontaxable to the extent of the shareholder’s stock basis, which is reduced accordingly. The excess of the distribution over the share- holder’s basis is treated as a gain from the sale or exchange of the stock.

earnings and profits (E & P)
The notion of is similar in many respects to the accounting con- cept of retained earnings. Both are measures of the firm’s accumulated capital (E & P includes both the accumulated E & P of the corporation since the latter of its incorporation date or February 28, 1913, and the current year’s E & P). A difference exists, however, in the way these figures are calculated. The computation of retained earnings is based on financial accounting rules, while E & P is determined using rules specified in the tax law.
Congress has not provided a specific calculation of earnings and profits in the Inter- nal Revenue Code. Rather, in § 312, it has provided adjustments that must be made to a corporation’s taxable income to arrive at E & P. The Treasury Department (through Reg- ulations), the IRS (through rulings), and the courts (through case law) have provided additional guidance. All these must be taken into account when calculating E & P.
E & P is a measure of the dividend-paying capacity of a corporation (i.e., a measure of economic income). As a result, when a corporation makes a distribution to a share- holder, E & P identifies the maximum amount of dividend income that shareholders must recognize. As a result, the effect of a specific transaction on E & P may often be determined by assessing whether the transaction increases or decreases the corporation’s ability to pay a dividend.

Computation of E & P
The Code, Regulations, rulings, and court cases provide a series of adjustments to tax- able income that result in a measure of the corporation’s dividend-paying capacity (or economic income). Both cash basis and accrual basis corporations use the same approach when determining E & P.
Additions to Taxable Income
To determine current E & P, all excluded income items are added back to taxable income. These positive adjustments include tax-exempt interest, life insurance proceeds (in excess of cash surrender value), and Federal income tax refunds from tax paid in prior years.

The dividends received deduction  and the domestic production activities deduction are also added back to taxable income to determine E & P. Neither of these deductions impairs a corporation’s ability to pay dividends. Effectively, they are partial exclusions for specific types of income (dividend income and income from domestic production activities).

Subtractions from Taxable Income
When calculating current E & P, certain nondeductible expenses are subtracted from taxable income. These negative adjustments include the nondeductible portion of meal and entertainment expenses; related-party losses; expenses incurred to produce tax- exempt income; Federal income taxes paid; nondeductible key employee life insurance premiums (net of increases in cash surrender value); and nondeductible fines, penalties, and lobbying expenses.

Current versus Accumulated E & P
Accumulated E & P is the total of all previous years’ current E & P (since February 28, 1913) reduced by distributions made from E & P in previous years. It is important to distinguish between and because the taxability of corporate distributions depends upon how these two accounts are allocated to each distribution made during the year. A complex set of rules governs the allocation process.

Allocating E & P to Distributions
When a positive balance exists in both the current and accumulated E & P accounts, corporate distributions are deemed to be made first from current E & P and then from accumulated E & P. If there is only one distribution during the year and the distribution is less than total E & P (both current and accumulated), the distribution will be classified as a dividend.
When there are multiple distributions and total distributions exceed the amount of current E & P, it becomes necessary to allocate current and accumulated E & P to each distribution made during the year.