How to Calculate Earnings and Profits | QuickBooks

As per the United States tax law, the taxation of the income distributed to corporate shareholders will depend on the nature and structure of such distribution (Dharmapala & Riedel, 2013). Therefore, the corporate profit distributed to equity owners is treated as their dividends, and they are taxed on the shareholders themselves since they are not deductible on the corporation (Ordower, 2013). The dividends distributions are made to the shareholders as a return on their initial capital investment in the company or a share of reinvested earnings (E&P). However, the distributions which are paid from the corporation E&P are the only ones which are taxable as dividends. According to Dharmapala & Riedel, (2013), in the case where both the current and the accumulated E&P are generally negative, such distributions are considered to be a non-taxable return on capital. 

Therefore, based on the ABC Corporation scenario, there is no any part of the distributions to shareholders which is treated as dividends since both current E&P and accumulated E&P are negative. The computation of the ABC Corporation non-taxable return on capital is as follows: 

According to Dharmapala & Riedel, (2013), the proportion of the corporate distributions that is not usually considered as dividends to shareholders is first applied to minimize the basis of the shareholders in the corporation’s stock. However, the remaining portion is treated as the capital gains from the sale or exchange of capital property. In this case, when a shareholder takes a particular property or assumes a certain liability then, the amount of distribution to such shareholder is generally reduced by the amount of liability assumed or property taken (Ordower, 2013). Therefore, in the case of ABC Corporation’s stock, the shareholder’s tax basis will be $100,000. The tax basis is considered to be the less of the beginning tax basis for the year less the lesser between the distribution more than accumulated earnings and profit and the tax basis in the ABC Corporation stock for the year. Therefore, the shareholders’ tax basis after the stock distribution in the ABC Corporation will be computed as follows: 

Since there was no any dividend distribution which was made to the shareholders for the year ended because both beginning and current earnings and profits were negative, therefore, the balance of earning and profits of $300,000 will, thus, be treated as a capital gain. The earnings and profits of $350,000 received from ABC Corporation will be considered as a return on capital; hence, it is not taxable on the shareholders because the corporation does not have any accumulated distributable profits at the beginning of the year or even during the current year. Therefore, the earnings and profits balance after the distribution will be ($550,000) worked out as follows: 

According to Ordower, (2013), earnings and profit entail the measure of corporation ability to pay dividends to its shareholders. In accounting sector, a timely computation of earnings and profit is very vital for many corporate transactions which include determination of the nature of the dividends issued to the shareholders. Therefore, the primary objective of computing earnings and profit is to be able to determine whether distributions issued to shareholders are either taxable dividends, capital gain to shareholders or non-taxable return of shareholders capital. According to Ordower, (2013), any distribution made by a corporation to its shareholders out of its current E&P or accumulated earnings and profits will be considered taxable dividend and should, thus, be included in the shareholder's gross income. The distributions deemed to be taxable are taxed on the receiving shareholder and not the issuing corporation (Ordower, 2013). Further, any distribution more than those considered as shareholders dividends will be therefore considered to be a non-taxable return on investment to the extent of the equity owners stock basis. Any remaining of the distribution will be considered as a capital gain arising from the sale of corporation stocks. 

Further, computing earnings and profits help in developing certain computation adjustments which companies require in order to compute adjusted current earnings which are important in determining the alternative minimum taxable income of a company. For a particular financial year, a corporation that computes its earnings and profits will be in a position to determine its accumulated earning tax for that particular year which may be of great help in the case where the corporation wishes to reduce the tax burden to its shareholders. In such case, the company will allow its earnings and profits to accumulate up to a certain set limit, and this will safeguard its shareholders against excess taxes. 

Also, exchange gains from the sale of stock by controlled multinational corporations are usually treated as shareholders dividends to the extent of the firms’ earnings and profits (Dharmapala & Riedel, 2013). Further, the dividends paid to foreign shareholders by a domestic corporation will only be subjected to withholding tax without any further taxation in their country of the recipient. Earnings and profits computation is also of great significance to S corporations which have accumulated E&P level as this will ensure that such corporations are subjected to corporate level tax only on any of its excessive passive investment income (Dharmapala & Riedel, 2013). 

Based on the above case, it is appropriate for any corporation to ensure that earnings and profits are computed accurately. Therefore, in the case of the ABC Corporation, non-measurement of the earnings and profits may result in some potential problems. In the case the earnings and profits were not measured, the negative stock dividends could have been considered to be taxable to the shareholders. However, this is not supposed to be the case because both the current and opening earnings and profits were negatives, hence, the stock dividends were not subjected to tax which could have increased the taxpayers’ liability. Additionally, non-computation of earnings and profits of ABC Corporation would have made it impossible to determine the value of the dividends amounts which could have been treated as a non-taxable return. 

References 

Dharmapala, D., & Riedel, N. (2013). Earnings shocks and tax-motivated income-shifting: Evidence from European multinationals.    Journal of Public Economics ,    97 , 95-107. 

Ordower, H. (2013). Schedularity in US income taxation and its effect on tax distribution.    Nw. UL Rev. ,    108 , 905.