Tony Nitti for Forbes writes: In this week’s Tax Geek Tuesday, we take a look at one of the rarest of species in the tax world: the opportunity to implement an impactful tax planning strategy after year-end. Specifically, we’re going to discuss the opportunity for a calendar-year S corporation to elect to purge its accumulated earnings and profits as of December 31, 2013 even though New Years Eve has long since passed. As discussed in detail below, ridding an S corporation of any accumulated earnings and profits may be desirous for a number of reasons.
The strategy traverses subchapters C and S and touches on several complex and misunderstood topics, but hey…that’s what Tax Geek Tuesday is for. This ain’t for the faint of heart.
Let’s get to it.
Earnings and Profits, In General
The concept of a corporation’s “earnings and profits” was first introduced into federal tax law with the Revenue Act of 1916, yet in the near century that’s followed the term has never been formally defined by statute. Instead, earnings and profits (E&P) has been indirectly defined through its application and modification by various sections of the Code to represent the measure of a corporation’s ability to make distributions to its shareholders out of earnings, rather than by returning shareholders’ contributions to capital. As opposed to a corporation’s taxable income or “book” income — which are driven by tax policy and financial accounting considerations, respectively — the computation of E&P is concerned primarily with quantifying the corporation’s economic income, without regard to such considerations.
A corporation’s E&P determines the taxability of distributions made to its shareholders. Section 316 defines a “dividend” as any distribution of property made by a corporation out of current or accumulated E&P. In turn, Section 301(c) provides that any distribution constituting a dividend must be included in the gross income of the shareholder, while amounts distributed in excess of those considered a dividend are first treated as a nontaxable return of capital to the extent of the shareholder’s stock basis, with any remaining distribution treated as a gain from the sale of the stock, resulting in capital gain.
Example: Corporation X is wholly owned by A, an individual. In 2010, X’s first year of existence, X had $500 of E&P. As of December 31, 2010, before any adjustments for distributions made by X throughout the year, A had a basis of $300 in his X stock. X distributed $1,000 to A on December 31, 2010.
The taxability of X’s $1,000 distribution to A is determined under Sections 316 and 301(c). To the extent of X’s current E&P of $500, the distribution is treated as a dividend. Thus, A includes $500 in taxable income under Section 301(c)(1). Of the remaining $500 distribution, $300 is treated as a return of A’s capital, and reduces A’s stock basis from $300 to $0. The remaining $200 distribution is treated as the sale of the stock, generating capital gain.
The Relationship Between E&P, Taxable Income, and Retained Earnings
A corporation’s E&P is neither its accumulated taxable income nor its retained earnings for financial accounting purposes. Rather, E&P is an independent measure of a corporation’s economic income for the purpose of separating those distributions which represent income derived from the conduct of business from those which represent returns of capital contributed by shareholders. Because E&P is concerned with economic effect of a particular item, E&P generally includes all items of income and expense resulting from the economic activities of a corporation, regardless of the treatment of such items in computing taxable income or retained earnings.
A corporation’s taxable income differs from its E&P primarily due to the tax policy considerations that override the determination of taxable income — such as the exemption of certain state and local bond interest income and the disallowance of expenses for federal income taxes or penalties — that fail to reflect the economic effect of the underlying item of income or expense. As the computation of E&P is generally not concerned with such tax policy considerations, adjustment are required to convert taxable income into E&P.
Example: In 2013, X, an accrual basis corporation, generated $20,000 of taxable income, giving rise to a $3,000 federal income tax liability. X also earned $10,000 of interest income on state and local bonds that was tax-exempt under Section 103. Assume X had no accumulated E&P as of December 31, 2002, and that there were no other items affecting X’s computation of E&P or taxable income in 2013. On December 31, 2013, X distributed $25,000 to its sole shareholder, A.
If E&P were synonymous with taxable income, X’s $25,000 distribution would be treated as a dividend to the extent of its taxable income of $20,000, with the remaining $5,000 distribution treated first as a reduction in A’s stock basis, then as capital gain to A.
Because a corporation’s E&P differs from its taxable income, however, certain adjustments must be made to convert X’s taxable income into E&P.
While X’s $10,000 of state and local interest income is excluded from taxable income by statute, it nevertheless increases the funds available for X to distribute to A. As a result, a $10,000 increase to X’s taxable income is required in computing E&P. Similarly, while X’s $3,000 of federal income tax liability is not deductible in computing X’s taxable income pursuant to Section 275, the liability reduces the funds available for X to distribute to A. Thus, X must reduce its taxable income by $3,000 in computing its E&P for 2013.
After modifying taxable income for the aforementioned adjustments, X had $27,000 of E&P in 2013 ($20,000 + $10,000 -$3,000) Thus, X’s entire $25,000 distribution to A is one made from E&P that is taxed as a dividend, and is included in A’s taxable income pursuant to Section 301(c)(1).
A corporation’s E&P is also not identical to its retained earnings for financial accounting purposes, as fundamental differences exist between retained earnings and a corporation’s cumulative economic income available for distribution to shareholders. For example, retained earnings can be reduced by stock distributions or the establishing of a contingency reserve, neither of which impair a corporation’s ability to finance distributions to its shareholders. For these reasons, the 2nd Circuit has stated that a corporation’s retained earnings is “not even prima facie evidence of E&P for income tax purposes.”
Example: On December 31, 2010, Corporation X had $100,000 of retained earnings for financial accounting purposes. On that day, X made a stock dividend to its shareholders that reduced its retained earnings by $40,000. Because the stock dividend did not impair X’s ability to fund a distribution to its shareholders, there is no reduction in X’s E&P.
Reasons For Computing Earnings and Profits
The primary purpose for computing ...[snip...the article continues, to read the rest of Toni Nitti visit Forbes here]
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