Corporate earnings are taxed twice under the current Federal income tax system. First, the earnings are taxed once at the corporate level when the corporation files its own income tax return, reports its earnings, and pays taxes according to the corporate Federal tax rate. The earnings are then taxed a second time when they are distributed to the shareholders as dividends. As we’ve learned, dividends are included in an individual’s taxable income. That doesn’t mean, however, that every distribution of property from a corporation to a shareholder is a taxable dividend. For example, the corporation could be distributing a shareholder’s original capital contribution to the corporation back to the shareholder – or, for that matter, some other shareholder’s original capital contribution. These clearly aren’t corporate earnings, so they shouldn’t be taxed twice. The obvious question, therefore, arises: how do we determine whether a distribution to a shareholder is out of corporate profits, and therefore, a tax [Audio Skip]? The simple answer is that every corporation is required to keep a running total of its earnings and profits, or E&P. If any distribution is out of the E&P, then it is a taxable dividend to the shareholder receiving it. By contrast, if any distribution is not out of E&P, then it is a return of capital, which – depending upon the individual shareholder’s circumstances – may or may not be tax [Audio Skip]. The primary issue to note is that E&P is derived from a corporation’s taxable income for the year. As we’ve noted, taxable income is defined differently from accounting income. Earnings and profits, however, are probably more akin to an accounting concept of income than one of taxable income. Accordingly, we start with the corporation’s taxable income for the year, and then make various adjustments to that taxable income so that it more closely approximates the corporation’s econo – [Audio Skip], or its earnings, during a particular taxable period. Under the code and the associated regulations, we are required to divide E&P into two pools. The first pool is current E&P, or the corporation’s earnings and profits for the current tax year. The second pool is, essentially, everything else. The accumulated E&P consists of the cumulative earnings and profits for all prior tax years. This distinction is significant because E&P from the two pools is allocated differently to distributions occurring during the year.
Let’s focus first on how we calculate E&P. Concept Summary 10-1 in your textbook does an excellent job of summarizing the various adjustments to taxable income to yield E&P. In a nutshell, we are adjusting taxable income so that it more accurately reflects the actual earnings of the corporation during the year.
The first line in the Concept Summary requires us to increase taxable income by any tax-exempt income the corporation earns during the year. Hopefully this makes sense. Although tax-exempt income is, by definition, tax-exempt – and therefore not included in the corporation’s taxable income for the year – it is still money earned by the corporation during the year. It’s part of the corporation’s profits.
Accordingly, we need to increase the taxable income by the amount of any tax-exempt income earned on our way to approximating the corporation’s actual earnings and profits for the year. All of these adjustments – both increases and decreases – reflect this underlying concept. It would behoove you to become familiar with the adjustments in Concept Summary 10-1.
Once we’ve calculated the corporation’s E&P for a given tax year – and, of course, know the accumulated E&P from prior years – we can determine how distributions made during any given year should be taxed. Simply put, we allocate the corporation’s current and accumulated E&P to distributions made during the year. Any E&P allocated to a distribution makes that distribution a dividend.
Two consequences result: first, the distribution is not deductible to the corporation, and the corporation might be required to recognize gain on the distribution. Second, the shareholder receiving the distribution has received a dividend and, accordingly, must include that dividend in income. This general process is outlined in Concept Summary 10-2, another summary you would be well advised to learn.
This general process essentially encompasses four different steps, or tiers, of E&P allocation. First, we allocate any current E&P to distributions made during the year. If the current E&P is insufficient to cover the total amount of the year’s distributions, it’s allocated pro rata.
If all of the current E&P has been allocated, and distributions without E&P remain, accumulated E&P is then allocated to these remaining distributions. Accumulated E&P, however, is allocated chronologically. The first distribution made during the year receives all of the accumulated E&P until the accumulated E&P is either exhausted or the distribution is completely filled with E&P. If any accumulated E&P then remains, then the next occurring distribution receives accumulated E&P under the same rules, and so on, until either the accumulated E&P is completely exhausted, or all of the distributions during the year are covered. Any distributions in excess of E&P to a particular shareholder are treated as return of that shareholder’s basis until that shareholder runs out of [Audio Skip].
Finally, any amounts distributed to a shareholder in excess of his basis in his stock are treated as gain from the sale or exchange of the underlying stock that we must analyze virtually made during the years under these rules, other than stock dividends or some limited exceptions, to determine whether they constitute a dividend. For example, property could be distributed to a shareholder instead of cash. The amount of the dean distribution is the fair market value of the property at the time of distribution.
It is also important to note, however, that property distributions will also generally affect the corporation’s E&P. Accordingly, when a corporation has made property distributions during the year, you must adjust the E&P to account for these property distributions before proceeding through the E&P allocation process.
Let’s look at Example 8 in your textbook. This problem provides that Black Corporation has accumulated E&P of $10,000 at the beginning of the year, and the current year’s E&P – calculated at the end of the year, is $30,000. Megan and Matt are equal shareholders from January 31st to July 31st, after which time, Megan sells her one-half interest to Helen. Black makes two distributions during the year: $20,000 [Audio Skip] to Megan and Matt on July 1st, and $20,000 each to Matt and Helen on December 1st. Following our rules, we can see how these distributions will be treated by the shareholders.
First, we allocate current E&P to the distributions. There is a total of $80,000 in distributions during the year, and we only have $30,000 of current E&P. Accordingly, there’s not enough current E&P to cover all of the distributions. Our rules tell us that, in such circumstances, we allocate current E&P pro rata, or in proportion to the value of the distributions made. Here, the July 1st distribution is 50% of the total value of the distributions made during the year. Accordingly, it receives 50% of the current E&P, or $15,000. The same goes for the December 1st distribution. Accordingly, we know that $15,000 of each of the two distributions is out of E&P and it will be treated as a dividend to the receiving shareholders.
Step 2 is to allocate any accumulated E&P that we have. The rules tell us, however, that we allocate accumulate E&P chronologically. Accordingly, we go to the July 1st distribution and begin allocating accumulate E&P. We have a total of $25,000 of the distribution remaining to fill up with E&P, but we only have $10,000 of accumulated E&P left. Accordingly, the July 1st distribution gets all of it, making an additional $10,000 of the July distribution a dividend. We’re now entirely out of E&P. That means the remaining amount of each distribution is a return of capital to the shareholders.
We haven’t been given enough information about each of the shareholder’s basis in his or her stock to ascertain whether the remainder is taxable to them. Accordingly, we can’t proceed through the remaining two steps.
I leave it to you to review the rest of this example, and the remaining examples in the chapter.
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