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Note: This explanation is not applicable
to an “S” corporation.
Whether a distribution is a dividend is determined by the
corporation“s “earnings and profits (E&P).”
To the extent the corporation has E&P, the distribution
is taxed as a dividend. Dividend income is taxed at capital
gains rates. If the amount distributed exceeds E&P, it
is a nontaxable return of the shareholder“s capital rather
than a dividend and is applied against the shareholder“s basis
in stock. Any remaining amount of the distribution (in excess
of the amount applied against the basis) is taxed as gain
from the sale of stock.
 Example:
Sam is the sole shareholder of XYZ, Inc. and has a $10,000
basis in his stock. XYZ has $5,000 in earnings and profits
and distributes $8,000 to Sam. Sam is taxed on a dividend
of $5,000 (XYZ“s E&P) and the remaining $3,000 reduces
his basis in his stock from $10,000 to $7,000.
Example:
Sally is the sole shareholder of ABC, Inc. and has a $10,000
basis in her stock. ABC has $5,000 in earnings and profits
and distributes $17,000 to Sally. Sally is taxed on a dividend
of $5,000 (ABC“s E&P) and the remaining $12,000 reduces
Sally“s basis in her stock from $10,000 to zero and also results
in her being taxed on $2,000 of gain (the excess of the $12,000
nondividend portion of the distribution over her $10,000 basis).
In the above examples, the corporation was wholly owned by
one shareholder. If there is more than one shareholder, the
corporation“s E&P is allocated proportionately among the
distributions to the shareholders.
Accumulated or current E&P.
E&P will cause a distribution to be taxed as a dividend
whether they are “current” or “accumulated.”
The current E&P (E&P earned in the year of the distribution)
is drawn upon first. If the distributions made during the
year exceed current E&P, the current E&P is allocated
among the distributions proportionately to the amount of each
distribution. If the distribution exceeds the corporation“s
current E&P, it will be a dividend to the extent of the
corporation“s accumulated E&P (undistributed E&P
from earlier years). Accumulated E&P is allocated among
distributions by the corporation in the order in which they
are made (unlike distributions out of current E&P which
are allocated in proportion to the distributions).
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Example:
DEF Corp has $6,000 in current E&P and $5,000 in accumulated
E&P. It distributes $10,000 to its shareholders on April
1st and $20,000 on October 1st. The current E&P is allocated
to the distributions first. The April distribution is one-third
of the total distributed during the year ($10,000/$30,000).
Therefore, 1/3 of current E&P, or $2,000, is allocated to
the April distribution. In similar fashion 2/3 of current E&P,
or $4,000, is allocated to the October distribution. Of the
remaining $8,000 of the April distribution ($10,000 distribution
- $2,000 from current E&P), $5,000 is treated as coming
from accumulated E&P, thus using up accumulated E&P
entirely. Thus, a total of $7,000 of the April distribution
is a dividend ($2,000 from current E&P and $5,000 from accumulated
E&P) while only $4,000 of the larger October distribution
is a dividend (from current E&P).
The different rules for allocating current and accumulated
E&P among corporate distributions should not have an impact
on an individual who is a shareholder for the entire year.
However, a prospective shareholder who will acquire his stock
after a distribution has already been made during the corporation“s
tax year may be affected by these rules. Such shareholder
should seek to determine both the amount and nature of the
corporation“s E&P. Accumulated E&P will attach
to the earliest distributions (which are not covered by current
E&P) and, if it“s used up, later distributions will
not be dividends. Conversely, the existence of current E&P
(which is allocated proportionately to all distributions)
would make it more likely that distributions later in the
year will be treated as dividends. Of course, if the corporation
has E&P in excess of total expected distributions for
the year, all distributions will be dividends and the distinction
between current and accumulated E&P will have no impact.
Please note that a deficit in accumulated E&P will not
reduce current E&P. Thus, for example, if a corporation
with a history of losses finally has earnings and makes a
distribution in that year, the current E&P, even if dwarfed
by the accumulated losses, will cause the distribution to
be taxed as a dividend. On the other hand, a deficit in current
E&P does reduce accumulated E&P and can prevent a
distribution from being a dividend.
Finally, please note that “earnings and profits”
is a special tax concept and is determined under rules different
from those for determining retained earnings or taxable income.
It is important to get the relevant data from the corporation
in order to address E&P issues. (This would include, among
other things, information about mergers to which the corporation
was party and redemptions of its stock.)
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