Chapter 5 - Earnings and Profits and Dividend Distributions Flashcards
When a distribution is made from corporate earnings & profits, the shareholder is deemed to receive a…
dividend
How are dividends taxed?
Ordinary income or Preferentially taxed dividend income
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
How are distributions not treated as dividends because of insufficient E&P treated?
Nontaxable return of capital to the extent of the shareholder’s stock basis, which is reduced accordingly
If the distribution exceeds the shareholder’s basis, the excess is treated as…
a gain from sale or exchange of the stock
Earnings and Profits (E&P)
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
What other accounting concept is E&P similar to? And in what way?
Retained earnings, both are similar in that they are measures of the firm’s accumulated capital
Accumulated E&P
Accumulated E&P of the corporation since its incorporation date (or February 28, 1913, if later)
How are E&P and retained earnings different?
Calculation. 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 E&P in the Internal Revenue Code, rather….
Section 312 provides adjustments that must be made to a corporation’s taxable income to arrive at E&P
How does the treasury department, the IRS, and the courts provide additional guidance for section 312?
Treasury department: regulations
IRS: rulings
Courts: case law
E&P is a measure of the dividend-paying capacity of a corporation… what is another term for this?
economic income
When a corporation makes a distribution to a shareholder, E&P represents the…
maximum amount of dividend income that shareholders must recognize
The effect of a specific transaction on E&P can be determined by assessing..
whether the transaction increases or decreases the corporation’s ability to pay a dividend
Do cash basis and accrual basis corporations use the same approach when determining E&P?
Yes
E&P Calculation - Additions to Taxable Income
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
Why is dividends received deduction added back to taxable income?
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)
E&P Calculation - Subtractions to Taxable Income
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
E&P Calculation - Timing Adjustments
- Charitable contributions
- net operating losses
- capital losses
Gains and losses from property transactions generally affect the determination of E&P….
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
E&P Calculation - Accounting Method Adjustments
Accounting methods used for determining E&P generally are more conservative than those allowed for calculating taxable income
Is the installment method permitted for E&P purposes?
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.
What depreciation system must be used for purposes of computing E&P?
The alternative depreciation system (ADS)
ADS
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
E&P imposes limitation on the deductibility of section 179 expense
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
E&P requires _________ depletion rather than ___________ depletion
cost, percentage
When accounting for long-term contracts, E&P requires the ___________ method rather than the __________ method.
Percentage of completion method, completed contract method
E&P does not allow for the amortization of organizational expenses…
As a result, any expense deducted when computing taxable income must be added back to determine E&P
If a corporation is using the LIFO method of inventory, E&P requires…
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
E&P requires that intangible drilling costs are amortized over a period of
60 months
E&P requires that intangible mine exploration and development costs are amortized over a period of
120 months
Tax-exempt Income
Addition to Taxable Income
Dividends Received Deduction
Addition to Taxable Income
Collection of proceeds from insurance policy on life of corporate employee (in excess of cash surrender value)
Addition to Taxable Income
Deferred gain on installment sale
Addition to Taxable Income (ALL gain is added to E&P in year of sale)
Future recognition of installment sale gross profit
Subtraction to Taxable Income
Excess charitable contribution (over 10% limitation) and excess capital loss in year incurred
Subtraction to Taxable Income
Deduction of charitable contribution, NOL, or capital loss carryovers in succeeding taxable year
Addition to Taxable Income
(increase E&P because deduction reduces taxable income while E&P was reduced in a prior year)
Federal income taxes paid
Subtraction to Taxable Income
Federal income tax refund
Addition to Taxable Income
Loss on sale between related parties
Subtraction to Taxable Income
Nondeductible fines, penalties, lobbying expenses
Subtraction to Taxable Income
Nondeductible entertainment expenses
Subtraction to Taxable Income
Nondeductible portion of meal expenses
Subtraction to Taxable Income
Payment of premiums on insurance policy on life of corporate employee (in excess of increase in cash surrender value of policy)
Subtraction to Taxable Income
Realized gain (not recognized) on an involuntary conversion
No effect on taxable income
Realized gain or loss (not recognized) on a like-kind exchange
No effect on taxable income
Excess percentage depletion
Addition to Taxable Income (only cost depletion can reduce E&P)
Accelerated depreciation
Addition to Taxable Income (E&P is reduced only by straight-line, units of production, or machine hours depreciation)
Additional first-year (bonus) depreciation
Addition to Taxable Income
Section 179 expense in year elected
Addition to Taxable Income (80%)
Section 179 expense in four years following election
Subtraction to Taxable Income (20% each year)
Increase in LIFO recapture amount
Addition to Taxable Income
Decrease in LIFO recapture amount
Subtraction to Taxable Income
Intangible drilling costs deducted currently
Addition to Taxable Income (reduce E&P in future years by amortizing costs over 60 months)
Mine exploration and development costs
Addition to Taxable Income
(reduce E&P in future years by amortizing costs over 120 months)
Current E&P
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.
Accumulated E&P
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)
Current E&P at the time of the distribution: Positive
Accumulated E&P at the time of the distribution: Positive
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.
Current E&P at the time of the distribution: Positive
Accumulated E&P at the time of the distribution: Deficit
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.
Current E&P at the time of the distribution: Deficit
Accumulated E&P at the time of the distribution: Positive
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.
Current E&P at the time of the distribution: Deficit
Accumulated E&P at the time of the distribution: Deficit
Distribution is treated as a return of capital, first reducing the basis of the stock to zero, then generating taxable gain.
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)
Current E&P * (Amount of distributions/Total distributions) = Current E&P allocated to a distribution
How is accumulated E&P applied?
In chronological order beginning with the earliest distribution
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?
The allocation rules presume that current E&P is sufficient to cover every distribution made during the year until the parties can show otherwise
