Business Entities · Corporations in general

Earnings and profits

Earnings and profits has no definition in the Code. Section 312 says how it changes and section 316 says what it does, but neither says what it is. What it functions as is a measure of the corporation’s capacity to make a distribution that is genuinely a return on the shareholders’ investment rather than a return of it — which is why it includes income the tax system exempts, excludes deductions that do not represent an economic outlay, and looks nothing like either the retained earnings on the balance sheet or the taxable income on the return.

The rule

What a dividend is. a dividend is any distribution of property made by a corporation to its shareholders out of earnings and profits accumulated after 28 February 1913, or out of the earnings and profits of the taxable year computed as of the close of that year without diminution by reason of distributions made during it and without regard to the amount on hand when the distribution was made. Every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits (IRC § 316(a))^TY2026

What a distribution does to it. on a distribution of property with respect to its stock a corporation earnings and profits are decreased, to the extent thereof, by the money distributed, the principal amount of its own obligations distributed — or the aggregate issue price where they carry original issue discount — and the adjusted basis of other property distributed (IRC § 312(a))^TY2026

Appreciated property. where a corporation distributes property other than its own obligation whose fair market value exceeds its adjusted basis, earnings and profits are first increased by that excess and the reduction is then measured by fair market value rather than adjusted basis (IRC § 312(b))^TY2026

Depreciation. for earnings and profits purposes the allowance for depreciation and amortisation for a taxable year beginning after 30 June 1972 is the amount that would be allowable if the straight line method had been used, with an exception where a unit-of-production or other method not expressed in a term of years was properly used (IRC § 312(k)(1), (2))^TY2026

And the economic adjustments. further adjustments are required so that earnings and profits reflect economic gain and loss more accurately — among them the disallowance of construction period carrying charges with a matching basis increase, the use of the completed contract and installment methods being overridden, and the spreading of intangible drilling and mineral exploration costs (IRC § 312(n))^TY2026

The computation follows the books. the amount of earnings and profits depends on the method of accounting properly employed in computing taxable income — a corporation on the cash basis may not use the accrual basis for earnings and profits — and mere bookkeeping entries increasing or decreasing surplus are not conclusive (Reg. § 1.312-6(a))^TY2026

Including what is not taxed. among the items entering into the computation of earnings and profits are all income exempted by statute and all income not taxable by the federal government under the Constitution, as well as everything includible in gross income under IRC § 61 — so tax-exempt income increases earnings and profits even though it never enters taxable income (Reg. § 1.312-6(b))^TY2026

Current figures

How it works in practice

Two pools, and the order between them is fixed. Current earnings and profits are computed as of the close of the taxable year, without reduction for distributions made during it. Accumulated earnings and profits are what has built up since 28 February 1913. A distribution is a dividend to the extent of current earnings and profits first, then accumulated, and the statute directs that it comes from the most recently accumulated pool (IRC § 316(a)).

The consequence practitioners find counter-intuitive is that a corporation with a large accumulated deficit can still pay a dividend. Current-year earnings and profits are tested on their own, so a corporation that has lost money for a decade and makes a profit this year has current earnings and profits to distribute out of, and the accumulated deficit does not absorb them. The reverse is also true: a corporation with a current-year deficit and a large accumulated surplus is generally still distributing a dividend, out of the accumulated pool.

The adjustments that separate earnings and profits from taxable income run in both directions. Upward, for income that never reached taxable income: municipal bond interest, life insurance proceeds, the excess of gain realised over gain recognised where a provision defers it. Downward, for economic outlays that never produced a deduction: federal income tax paid, non-deductible fines and penalties, the disallowed portion of meals, the excess of capital losses over capital gains. The organising question in each case is whether the corporation is actually richer or poorer, not whether the Code allowed a deduction.

Timing differences are handled by overriding the Code’s own accelerations. Depreciation is recomputed on the straight line method under IRC § 312(k), so a corporation taking a large first-year cost recovery deduction reduces taxable income far more than it reduces earnings and profits — and may therefore have ample earnings and profits to make a dividend in a year it reports a loss. The IRC § 312(n) adjustments do the same work for construction period carrying charges, long-term contracts, installment sales and mineral costs.

Distributions reduce earnings and profits by money, by the principal amount of the corporation’s own obligations, and by the adjusted basis of other property. Appreciated property is the exception worth knowing: IRC § 312(b) first increases earnings and profits by the appreciation and then measures the reduction by fair market value, so the net effect is a reduction equal to the property’s value rather than its basis. That reflects the fact that the corporation recognises gain on the distribution and has parted with something worth more than it cost.

One structural point that decides a surprising number of questions: earnings and profits cannot be reduced below zero by a distribution. A distribution can exhaust the pool but cannot create a deficit in it. A deficit arises only from operations. So a corporation with modest earnings and profits that distributes far more has a dividend to the extent of the pool, a return of capital to the extent of the shareholders’ basis, and capital gain beyond that — and its earnings and profits are nil, not negative.

Scenarios

How this has changed

The framework is old and stable. IRC § 316 dates from 1954 in substantially its present form, and the “most recently accumulated” ordering has not moved.

What has changed is the size of the gap between taxable income and earnings and profits, which has widened considerably as cost recovery has accelerated. The IRC § 312(k) straight-line override was enacted for years beginning after 30 June 1972, when the gap it addressed was modest. With the expensing and bonus depreciation regimes now available, a corporation can reduce taxable income to nothing while its earnings and profits barely move — so the situation in which a corporation reports a loss and pays a fully taxable dividend is far more common than it was when the provision was written. Anything that treats a taxable loss as evidence of no earnings and profits is reasoning from a world in which the two figures tracked each other.

The IRC § 312(n) adjustments were added later and for the same reason: each identifies a place where the Code’s timing rules had diverged from economic reality far enough that earnings and profits needed to be computed differently. Their number has grown over time and the direction of travel is consistent — more adjustments, not fewer.

Exam focus

The reliable question gives current earnings and profits, accumulated earnings and profits, a distribution and a shareholder basis, and asks for the character of the distribution. Work the tiers in order: dividend to the extent of current earnings and profits, then to the extent of accumulated, then return of capital against basis, then capital gain.

Watch for the two sign traps. A corporation with an accumulated deficit and current earnings and profits still pays a dividend. A corporation with a current deficit and accumulated earnings and profits usually does too, though the current deficit is allocated to the date of distribution.

Where a question mentions a taxable loss, do not treat that as the answer. Check whether the loss came from accelerated depreciation, which IRC § 312(k) reverses for this purpose.

And where a question lists items of income and expense and asks for earnings and profits, sort them by whether the corporation is richer or poorer, not by whether the item was taxable or deductible.

Check yourself

1. A corporation has accumulated earnings and profits of negative $800,000 and current earnings and profits of $150,000. It distributes $150,000. What is the character of the distribution?

Answer: a dividend in full. IRC § 316(a)(2) makes a distribution a dividend to the extent of the earnings and profits of the taxable year, and current earnings and profits are not reduced by an accumulated deficit. The shareholders have $150,000 of dividend income notwithstanding that the corporation has an $800,000 accumulated deficit.

2. A corporation receives $50,000 of tax-exempt municipal bond interest and pays $30,000 of federal income tax. Neither figure appears in taxable income as an item of income or deduction. How do they affect earnings and profits?

Answer: up $50,000 and down $30,000. Reg. § 1.312-6(b) includes all income exempted by statute in the computation, and federal income tax is an economic outlay that reduces the corporation’s capacity to distribute even though no deduction is allowed for it. Earnings and profits track economic position, not taxable income.

3. A corporation distributes land worth $500,000 with an adjusted basis of $120,000. By how much do its earnings and profits change on account of the distribution?

Answer: a net reduction of $500,000. Under IRC § 312(b)(1) earnings and profits are first increased by the $380,000 excess of fair market value over adjusted basis, and IRC § 312(b)(2) then measures the reduction by fair market value rather than by the $120,000 adjusted basis. The net movement is a reduction equal to the property’s value.

4. A corporation claims $900,000 of accelerated cost recovery in 2026, producing a taxable loss. What depreciation figure is used in computing earnings and profits?

Answer: the straight line amount. IRC § 312(k)(1) provides that for earnings and profits purposes the allowance for depreciation for a taxable year beginning after 30 June 1972 is deemed to be what would be allowable had the straight line method been used. The accelerated deduction reduces taxable income far more than it reduces earnings and profits, which is why a taxable loss and a dividend can coexist.

5. A corporation with $60,000 of earnings and profits distributes $400,000. What are its earnings and profits afterwards?

Answer: nil. IRC § 312(a) decreases earnings and profits on a distribution only “to the extent thereof”, so the pool is exhausted but not driven negative. The balance of the distribution is a return of capital to the extent of shareholder basis and capital gain beyond it, but none of that creates a deficit in earnings and profits. Only operating losses do.