Earnings & Profits determine how corporate distributions are taxed to shareholders. Under IRC §316, a distribution is a dividend to the extent of current E&P, then accumulated E&P, and only after both are exhausted does it become a return of capital or capital gain.
Current E&P
Current E&P is the corporation’s economic ability to pay dividends for the year. It starts with taxable income and is adjusted for items that do not reflect true economic income.
Add‑backs include:
- municipal bond interest
- excluded life insurance proceeds
- federal tax refunds
- dividends received deduction
These adjustments convert taxable income into a measure of actual dividend‑paying capacity.
Accumulated E&P
Accumulated E&P represents undistributed earnings from prior years. It is used only after current E&P is allocated.
How distributions are classified
When current E&P is positive but less than distributions
You must allocate current E&P proportionally across all distributions:
- Divide current E&P by total distributions
- Multiply each distribution by the ratio to determine the portion treated as a dividend from current E&P
- The remainder of each distribution is from accumulated E&P
- Once accumulated E&P reaches zero, any remaining distribution becomes:
- return of capital (reduces stock basis)
- capital gain if basis is exhausted
This rule comes directly from IRC §316(a).
When current E&P is negative (a loss year)
You must prorate the current‑year loss to each distribution date:
- Spread the loss evenly across the year
- Subtract the prorated loss from accumulated E&P at each distribution date
- Each distribution is a dividend only to the extent accumulated E&P remains positive
- Once accumulated E&P reaches zero, all later distributions become nondividend distributions
This method ensures E&P is measured as of each distribution date, not year‑end.
Tax treatment to shareholders
Distributions follow this order:
- Dividend — to the extent of current + accumulated E&P
- Return of capital — reduces basis
- Capital gain — once basis is zero
A corporation must issue Form 1099‑DIV for the dividend portion only.
Summary
E&P determines the tax character of corporate distributions. Key principles:
- Current E&P is allocated pro rata across distributions
- Negative current E&P is prorated by date
- Accumulated E&P is used only after current E&P
- Once E&P is exhausted, distributions reduce basis or create gain
These rules come directly from IRC §312, §316, and IRS corporate distribution guidance.