Earnings and Profits
Earnings and Profits (E&P) is a tax term that refers to the economic capacity of a corporation to make a distribution to shareholders in the form of dividends that are not considered a return of capital. Distributions from E&P are taxable to shareholders as dividends up to the amount of current and accumulated earnings and profits.
Examples
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Example 1: A company’s E&P Calculation
Suppose a corporation starts the year with $1,000,000 in accumulated earnings and profits. During the year, it earns another $200,000 and distributes $150,000 to its shareholders. Its ending E&P would be calculated as follows:
- Starting E&P: $1,000,000
- Current Earnings: $200,000
- Distributions: $150,000
- Ending E&P: $1,050,000
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Example 2: Distribution as Taxable Dividend
If a corporation has $500,000 in E&P and distributes $100,000 to its shareholders, this $100,000 will be considered a taxable dividend to the shareholders.
Frequently Asked Questions (FAQs)
Q1: How do you calculate Earnings and Profits?
A1: Earnings and Profits are calculated starting with taxable income and then adjusting for specific tax and economic factors such as tax-exempt income, nondeductible expenses, federal income taxes paid, and other items impacting the inflow and outflow of corporate wealth.
Q2: What is the difference between Earnings and Profits and Retained Earnings?
A2: While similar in nature, the key difference lies in their calculation and application. Retained Earnings are based on accounting income, whereas E&P start with taxable income and are adjusted to reflect economic income, aligning more closely with the economist’s approach to income.
Q3: Why is E&P important for corporations and shareholders?
A3: E&P is crucial for determining whether distributions to shareholders are taxable dividends or returns of capital. Taxable dividends can affect shareholders’ tax liabilities significantly.
- Retained Earnings: The portion of net income that is retained by the corporation rather than distributed to its shareholders as dividends. It is recorded under shareholders’ equity on the balance sheet.
- Taxable Income: The amount of income used to calculate the corporation’s tax due, arrived at by subtracting allowable deductions from gross income.
- Dividends: Distributions made by a corporation to its shareholders, usually in the form of cash or additional stock.
- Accumulated Earnings Tax: A tax on corporations that accumulate earnings beyond the reasonable needs of the business to avoid paying dividends to shareholders and thereby avoid shareholder taxation on those dividends.
Online References
Suggested Books for Further Studies
- “Federal Taxation of Corporations and Shareholders” by Boris I. Bittker, James S. Eustice
- “U.S. Master Tax Guide” by CCH Tax Law Editors
- “Earnings and Profits Computations” by Cathy V. Sommers
Fundamentals of Earnings and Profits: Taxation Basics Quiz
### What forms the starting point for calculating Earnings and Profits?
- [ ] Gross Profit
- [ ] Operating Income
- [x] Taxable Income
- [ ] Net Profit
> **Explanation:** Earnings and Profits calculation starts with taxable income, then adjustments are made to account for numerous tax and economic factors to determine the corporation's capacity to pay dividends.
### When a distribution exceeds Earnings and Profits, what is it considered?
- [ ] Tax Deduction
- [ ] Ordinary Income
- [x] Return of Capital
- [ ] Additional Earnings
> **Explanation:** When a distribution exceeds Earnings and Profits, it is considered a return of capital and is not taxable to shareholders up to their basis in the stock.
### What type of income closely resembles the economist's approach to the inflow and outflow of wealth when calculating Earnings and Profits?
- [ ] Operating Income
- [ ] Financial Accounting Income
- [x] Taxable Income
- [ ] Gross Income
> **Explanation:** Earnings and Profits closely resemble the economist's approach to income, focusing on the inflow and outflow of wealth, starting from taxable income and adjusting for various factors.
### What is the potential tax status of distributions to shareholders from E&P?
- [ ] They are tax-exempt.
- [ ] They are deductible from corporate income.
- [x] They are taxable as dividends.
- [ ] They reduce corporate capital gains.
> **Explanation:** Distributions to shareholders from E&P are taxable as dividends, up to the extent of current and accumulated E&P.
### Why is it important to distinguish between taxable dividends and return of capital?
- [ ] To maximize dividends.
- [x] To determine shareholders' tax liabilities.
- [ ] To list them in financial statements.
- [ ] To evaluate operating efficiency.
> **Explanation:** It is crucial to distinguish between taxable dividends and return of capital to accurately determine and manage shareholders' tax liabilities.
### What main factor differentiates Earnings and Profits from Retained Earnings?
- [ ] Accounting treatment
- [ ] Depreciation methods
- [ ] Expense categorization
- [x] Basis of calculation (taxable income vs. net income)
> **Explanation:** E&P and Retained Earnings differ primarily in their basis of calculation—E&P starts with taxable income and adjusts for tax and economic factors, while Retained Earnings are based on accounting net income.
### To whom are taxable dividends primarily relevant?
- [ ] Creditors
- [ ] Employees
- [x] Shareholders
- [ ] Suppliers
> **Explanation:** Taxable dividends are primarily relevant to shareholders, as they impact shareholders' tax liabilities on received distributions.
### How often must corporations assess their Earnings and Profits?
- [ ] Annually
- [ ] Quarterly
- [x] Both Annually and as needed for distributions
- [ ] On a project basis
> **Explanation:** Corporations assess their E&P annually for tax reporting, as well as whenever they make distributions to determine their taxability.
### What happens to distributions that are not covered by E&P?
- [x] They are considered a return of capital.
- [ ] They become part of gross income.
- [ ] They incur additional taxes.
- [ ] They increase retained earnings.
> **Explanation:** Distributions not covered by E&P are considered a return of capital and are not taxable up to the shareholders' basis in the stock.
### What are Earnings and Profits primarily used for in tax terms?
- [ ] Calculating corporation tax rates
- [ ] Assessing operational effectiveness
- [x] Determining the taxability of shareholder distributions
- [ ] Approving financial statements
> **Explanation:** E&P is primarily used to determine the taxability of shareholder distributions, informing whether they are taxed as dividends or treated as a return of capital.
Thank you for exploring the intricate tax term of Earnings and Profits. Test your understanding with the quiz and enhance your knowledge in the realm of taxation.
