Earnings and Profits

[Edsel]

Mortimer puts $400,000 into a C Corp.  The assets are quite cash-producing, and by 12/31/18 Mortimer withdraws more cash than the corporation has profits by $10,000.  However the corporation's fiscal year ends on June 30th, and by year-end the corporation has produced $50,000 in profits and Mortimer has withdrawn only $48,000.  Which of the following is true?

1. Mortimer has invaded equity by $10,000, reduces his capital balance accordingly prior to year-end, and is able to claim non-taxable return-of-capital on his 1099-DIV of $10,000.
2. The calculation of Earnings and Profits ignores the calendar year and must wait until year-end, and E&P are $50,000 prior to Mortimer's withdrawal of $48,000.  Capital balance is unchanged from the original $400,000, and there are Retained Earnings of $2,000.

[jklcpa]

Your example appears to use $50K of E&P and retained earnings interchangeably, and that is rarely the case that these would be the exact same figure.  Have you calculated current and accumulated E&P?  It is more complicated and time consuming to calculate current year and accumulated E&P than merely looking at taxable income and retained earnings balances because it takes into account non-taxable items such as tax-exempt income, reductions for non-deductible expenses, and recalculation of depreciation using the ADS method. It is a corporate level calculation at its year end without regard for distributions, and is also not controlled by the owner's year-end.

Second, is this a new corporation as it seems in your example?  In general, in determining whether a distribution is considered a dividend or a return of capital, current year earnings and profits are considered first so that any distributions not exceeding current E&P would be considered a dividend only. Any current distribution that exceeds current E&P would still be considered a dividend to the extent the corporation has accumulated E&P available. It is only after current and any accumulated E&P has been distributed that the return of capital is determined.

https://www.thetaxadviser.com/issues/2013/oct/kaiser-oct2013.html

Edited September 9, 2018 by jklcpa
removed one dup word

[jklcpa]

I wanted to add a few more adjustments to arrive at E&P, list still not meant to be all-inclusive.  Other adjustments to taxable inome to arrive back at E&P would be to disallow and add back artificial deductions that do not require cash outlay such as sec 199 DPAD, div recd deduction, and carryforwards (NOLs, contribs, cap losses), and to reduce E&P for income taxes paid or payable because these do no reduce taxable income but do require cash outlay. This reduction for taxes would not include any state or local taxes that are deducted as an expense on the return to arrive at taxable income.  

Remember, E&P is an economic measure of the corp's ability to pay out the dividends, and taxable income isn't fully reflective of that. 

 

[Edsel]

2 hours ago, jklcpa said:

Second, is this a new corporation as it seems in your example?  In general, in determining whether a distribution is considered a dividend or a return of capital, current year earnings and profits are considered first so that any distributions not exceeding current E&P would be considered a dividend only.

Yes - new corporation and you have directly answered the question.  The determination of dividends versus return of capital is made at the end of the year when E&P are calculated.  Thank you.