Chapter 5 - Earnings and Profits and Dividend Distributions

Question 1

When a distribution is made from corporate earnings & profits, the shareholder is deemed to receive a…

Answer 1

dividend

Question 2

How are dividends taxed?

Answer 2

Ordinary income or Preferentially taxed dividend income

Question 3

Generally, corporate distributions are presumed to be paid out of E&P and are treated as dividends unless…

Answer 3

the parties to the transaction can show otherwise

Question 4

How are distributions not treated as dividends because of insufficient E&P treated?

Answer 4

Nontaxable return of capital to the extent of the shareholder’s stock basis, which is reduced accordingly

Question 5

If the distribution exceeds the shareholder’s basis, the excess is treated as…

Answer 5

a gain from sale or exchange of the stock

Question 6

Earnings and Profits (E&P)

Answer 6

Measures the economic capacity of a corporation to make a distribution to shareholders that is not a return of capital. Such a distribution results in dividend income to the shareholders to the extent of the corporation’s current and accumulated earnings and profits

Question 7

What other accounting concept is E&P similar to? And in what way?

Answer 7

Retained earnings, both are similar in that they are measures of the firm’s accumulated capital

Question 8

Accumulated E&P

Answer 8

Accumulated E&P of the corporation since its incorporation date (or February 28, 1913, if later)

Question 9

How are E&P and retained earnings different?

Answer 9

Calculation. Retained earnings is based on financial accounting rules, while E&P is determined using rules specified in the tax law

Question 10

Congress has not provided a specific calculation of E&P in the Internal Revenue Code, rather….

Answer 10

Section 312 provides adjustments that must be made to a corporation’s taxable income to arrive at E&P

Question 11

How does the treasury department, the IRS, and the courts provide additional guidance for section 312?

Answer 11

Treasury department: regulations
IRS: rulings
Courts: case law

Question 12

E&P is a measure of the dividend-paying capacity of a corporation… what is another term for this?

Answer 12

economic income

Question 13

When a corporation makes a distribution to a shareholder, E&P represents the…

Answer 13

maximum amount of dividend income that shareholders must recognize

Question 14

The effect of a specific transaction on E&P can be determined by assessing..

Answer 14

whether the transaction increases or decreases the corporation’s ability to pay a dividend

Question 15

Do cash basis and accrual basis corporations use the same approach when determining E&P?

Answer 15

Yes

Question 16

E&P Calculation - Additions to Taxable Income

Answer 16

ALL excluded income items are added back to taxable income
* tax-exempt interest
* life insurance proceeds (in excess of cash surrender value)
* federal income tax refunds from tax paid in prior years
* dividends received deduction

Question 17

Why is dividends received deduction added back to taxable income?

Answer 17

It does not impair a corporation’s ability to pay dividends. The DRD is a partial exclusion for a specific type of income (dividend income)

Question 18

E&P Calculation - Subtractions to Taxable Income

Answer 18

certain nondeductible expenses are subtracted from taxable income
* nondeductible portion of meals
* entertainment expenses
* related-party losses
* expenses incurred to produce tax-exempt income
* Federal income taxes paid
* nondeductible key life insurance premiums (net of increases in cash surrender value)
* nondeductible fines/penalties/lobbying expenses

Question 19

E&P Calculation - Timing Adjustments

Answer 19

• Charitable contributions
• net operating losses
• capital losses

Question 20

Gains and losses from property transactions generally affect the determination of E&P….

Answer 20

only to the extent they are recognized for tax purposes - gains and losses deferred under the like-kind exchange provision and gains deferred under the involuntary conversion provision do not affect E&P until recognized

Question 21

E&P Calculation - Accounting Method Adjustments

Answer 21

Accounting methods used for determining E&P generally are more conservative than those allowed for calculating taxable income

Question 22

Is the installment method permitted for E&P purposes?

Answer 22

No, as a result, an adjustment is required for the deferred gain from property sales made during the year under the installment method. All principal payments are treated as having been received in the year of sale.

Question 23

What depreciation system must be used for purposes of computing E&P?

Answer 23

The alternative depreciation system (ADS)

Question 24

ADS

Answer 24

Requires straight-line depreciation with a half-year convention over a recovery period equal to the asset depreciation rang midpoint life of the asset
Prohibits additional first-year bonus depreciation

Question 25

E&P imposes limitation on the deductibility of section 179 expense

Answer 25

Any section 179 expense must be deducted over a period of five years (20% per year) - any year that section 179 is elected 80% of the resulting expense must be added back to the taxable income to determine current E&P, in each of the following 4 years, a subtraction from taxable income equal to 20% of the 179 expense must be made

Question 26

E&P requires _________ depletion rather than ___________ depletion

Answer 26

cost, percentage

Question 27

When accounting for long-term contracts, E&P requires the ___________ method rather than the __________ method.

Answer 27

Percentage of completion method, completed contract method

Question 28

E&P does not allow for the amortization of organizational expenses…

Answer 28

As a result, any expense deducted when computing taxable income must be added back to determine E&P

Question 29

If a corporation is using the LIFO method of inventory, E&P requires…

Answer 29

an adjustment for changes in the LIFO recapture amount (excess of FIFO over LIFO) during the year. Increases in LIFO recapture are added to taxable income, and decreases subtracted

Question 30

E&P requires that intangible drilling costs are amortized over a period of

Answer 30

60 months

Question 31

E&P requires that intangible mine exploration and development costs are amortized over a period of

Answer 31

120 months

Question 32

Tax-exempt Income

Answer 32

Addition to Taxable Income

Question 33

Dividends Received Deduction

Answer 33

Addition to Taxable Income

Question 34

Collection of proceeds from insurance policy on life of corporate employee (in excess of cash surrender value)

Answer 34

Addition to Taxable Income

Question 35

Deferred gain on installment sale

Answer 35

Addition to Taxable Income (ALL gain is added to E&P in year of sale)

Question 36

Future recognition of installment sale gross profit

Answer 36

Subtraction to Taxable Income

Question 37

Excess charitable contribution (over 10% limitation) and excess capital loss in year incurred

Answer 37

Subtraction to Taxable Income

Question 38

Deduction of charitable contribution, NOL, or capital loss carryovers in succeeding taxable year

Answer 38

Addition to Taxable Income
(increase E&P because deduction reduces taxable income while E&P was reduced in a prior year)

Question 39

Federal income taxes paid

Answer 39

Subtraction to Taxable Income

Question 40

Federal income tax refund

Answer 40

Addition to Taxable Income

Question 41

Loss on sale between related parties

Answer 41

Subtraction to Taxable Income

Question 42

Nondeductible fines, penalties, lobbying expenses

Answer 42

Subtraction to Taxable Income

Question 43

Nondeductible entertainment expenses

Answer 43

Subtraction to Taxable Income

Question 44

Nondeductible portion of meal expenses

Answer 44

Subtraction to Taxable Income

Question 45

Payment of premiums on insurance policy on life of corporate employee (in excess of increase in cash surrender value of policy)

Answer 45

Subtraction to Taxable Income

Question 46

Realized gain (not recognized) on an involuntary conversion

Answer 46

No effect on taxable income

Question 47

Realized gain or loss (not recognized) on a like-kind exchange

Answer 47

No effect on taxable income

Question 48

Excess percentage depletion

Answer 48

Addition to Taxable Income (only cost depletion can reduce E&P)

Question 49

Accelerated depreciation

Answer 49

Addition to Taxable Income (E&P is reduced only by straight-line, units of production, or machine hours depreciation)

Question 50

Additional first-year (bonus) depreciation

Answer 50

Addition to Taxable Income

Question 51

Section 179 expense in year elected

Answer 51

Addition to Taxable Income (80%)

Question 52

Section 179 expense in four years following election

Answer 52

Subtraction to Taxable Income (20% each year)

Question 53

Increase in LIFO recapture amount

Answer 53

Addition to Taxable Income

Question 54

Decrease in LIFO recapture amount

Answer 54

Subtraction to Taxable Income

Question 55

Intangible drilling costs deducted currently

Answer 55

Addition to Taxable Income (reduce E&P in future years by amortizing costs over 60 months)

Question 56

Mine exploration and development costs

Answer 56

Addition to Taxable Income
(reduce E&P in future years by amortizing costs over 120 months)

Question 57

Current E&P

Answer 57

Net tax-basis earnings of a corporation aggregated during the current tax year. A corporate distribution is deemed to be first from the entity’s current earnings and profits and then from accumulated earnings and profits. Shareholders recognize dividend income to the extent of the earnings and profits of the corporation. A dividend results to the extent of current earnings and profits, even if there is a larger negative balance in accumulated earnings and profits.

Question 58

Accumulated E&P

Answer 58

Net undistributed tax-basis earnings of a corporation aggregated from March 1, 1913, to the end of the prior tax year. Used to determine the amount of dividend income associated with a distribution to shareholders. (section 316 and Reg. 1.316-2)

Question 59

Current E&P at the time of the distribution: Positive
Accumulated E&P at the time of the distribution: Positive

Answer 59

Current E & P is applied first to distributions on a pro rata basis; then accumulated E & P is applied (as necessary) in chronological order beginning with the earliest distribution.
Unless the parties can show otherwise, it is presumed that current E & P covers all distributions.

Question 60

Current E&P at the time of the distribution: Positive
Accumulated E&P at the time of the distribution: Deficit

Answer 60

Current and accumulated E & P are NOT netted. Distributions are dividends to the extent of current E & P. If the distribution exceeds the current E & P, the excess first reduces the stock basis to zero and then generates a taxable gain.

Question 61

Current E&P at the time of the distribution: Deficit
Accumulated E&P at the time of the distribution: Positive

Answer 61

Current and accumulated E & P are netted. Any loss in current E & P is deemed to accrue ratably throughout the year unless the corporation can show otherwise.
1. If net amount is positive: Distribution is a dividend to the extent of the balance. If the distribution exceeds the net E & P, the excess first reduces the stock basis to zero and then generates a taxable gain.
2. If net amount is negative: Distribution is treated as a return of capital, first reducing the stock basis to zero, then generating taxable gain.

Question 62

Current E&P at the time of the distribution: Deficit
Accumulated E&P at the time of the distribution: Deficit

Answer 62

Distribution is treated as a return of capital, first reducing the basis of the stock to zero, then generating taxable gain.

Question 63

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. (Formula)

Answer 63

Current E&P * (Amount of distributions/Total distributions) = Current E&P allocated to a distribution

Question 64

How is accumulated E&P applied?

Answer 64

In chronological order beginning with the earliest distribution

Question 65

When the tax years of a corporation and its shareholders are not the same, it may be impossible to determine the amount of current E&P on a timely basis. What is the solution?

Answer 65

The allocation rules presume that current E&P is sufficient to cover every distribution made during the year until the parties can show otherwise