Earnings and profits computation case study.

• Author: Kaiser, Kevin W.

It is important for businesses organized and taxed as regular corporations (so-called C corporations, from subchapter C of the Code governing corporate tax treatment) to maintain a current, accurate accounting of their earnings and profits (E&P). Almost every corporate transaction affects E&P, and many transactions require an accurate accounting of the corporation's E&P to determine the appropriate tax treatment.

Although corporations are not required to report corporate E&P on Form 1120, U.S. Corporation Income Tax Return, they are responsible for knowing the company's E&P when it is relevant to determining the correct tax treatment of a transaction. As will be seen from this case study, maintaining an up-to-date accounting of a company's E&P is much easier than preparing the calculation after many years of neglect. A company with a current E&P calculation is in the best position to respond to business transaction opportunities.

The E&P operating rules generally require an accounting of a corporation's current-year E&P and the accumulated E&P (i.e., generally the cumulative E&P balance at the end of the prior tax year). These two E&P balances must be determined and taken into account separately to determine the correct tax treatment of a corporate distribution, E&P allocation, or deemed distribution.

[ILLUSTRATION OMITTED]

When E&P Is Needed

Although the tax laws do not define E&P or provide specific rules for how to compute it, there is authority for when E&P affects a transaction and the adjustments that must be made to determine E&P. The basic HO concept is not difficult to describe and understand--it is generally viewed as a corporation's economic ability to pay dividends. Actually applying the mechanics of the existing E&P rules, however, may be challenging for many practitioners.

Determining E&P is not a simple process, or one in which the calculation can be performed quickly when and if needed. It is best performed when working from a carefully considered work plan, by a practitioner or project team with a sound understanding of the relevant authorities and with the detailed source records readily at hand (this last point often is one of the more difficult aspects of an E&P study, particularly for foreign corporations).

This case study describes, in general terms, the relevant authorities that govern the determination of E&P using a hypothetical fact pattern to illustrate how the calculations are performed and provides a process and format to facilitate the efficient calculation of E&P.

Facts

AnyCo Inc. is a midsize manufacturing company that has been in business for six years. (1) The company has a single class of nonpublicly traded common stock outstanding held by a small group of unrelated shareholders. The company has primarily domestic U.S. sales, has been profitable in all but its second year of operations (during the recession), and made a distribution to its shareholders only in its second year of operations. The company is planning a distribution to shareholders this year (year 6). Exhibit 1 shows the income, tax, distribution, and other adjustments for the six years of company operations, assuming net operating losses (NOLs) will be carried forward (not back) and a federal tax rate of 34% applies.

Exhibit 1: AnyCo tax return and E&P information Year Taxable Tax-exempt Noncapital, Federal Distributions income income nondeductible taxes expenses * paid 1 $100,000 $3,000 $6,000 $34,000 2 (20,000) 5,000 3 200,000 2,000 15,000 61,200 $10,000 4 250,000 18,000 85,000 5 100,000 10,000 34,000 6 200,000 15,000 68,000 400,000 * E.g., the disallowed portion of meal and entertainment expenditures. The primary rules governing the determination of E&P and shareholder dividend treatment are contained in Secs. 301, 312, and 316. These Code sections are further elaborated upon by interpretive guidance in the form of regulations, rulings, cases, and other guidance setting forth the rules controlling what items and adjustments must be taken into account (and when) in determining HO. Even a practitioner who knows how the computations are made should nonetheless develop an organized process for performing the E&P study to streamline what can otherwise be a time-consuming and complex project.

Determining, a stand-alone corporation's E&P takes into account the financial, transaction, and tax return information for the company since its inception. (2) The determination of E&P for any given year generally starts with the company's final adjusted taxable income for that year, taking into account the taxable income...