Recognizing when an S corporation has accumulated earnings and profits.

• Author: Ellentuck, Albert B.

BOTH A C CORPORATION AND AN S CORPORATION can distribute taxable dividends to the extent that the corporation has accumulated earnings and profits (AE&P). An S corporation cannot generate earnings and profits (E&P) but, as discussed in the following paragraphs, a C corporation's AE&P transfers to the S corporation when the S election is made (Sec. 1371(c)).

Defining Dividends

Dividends are distributions of current E&P or AE&P of a C corporation (See. 316(a)). An S corporation can pay a dividend only when AE&P that arose when the corporation was in C status is distributed (See. 1371(c)). Therefore, a corporation that has been an S corporation since inception and has not acquired another corporation with AE&P cannot issue a dividend.

For federal income tax purposes, a "distribution" is a payment in cash or property from a corporation to a shareholder based on stock ownership. A "dividend" is a distribution from AE&P (See. 316). Therefore, a distribution may or may not include a dividend. State law and corporate minutes often refer to distributions to shareholders as dividends with out regard to whether AE&P is actually distributed.

Calculating C Corporation E&P

C corporations generate positive or negative E&P each year, calculated by making annual adjustments to taxable income. Depreciation, for example, can cause one such adjustment. For purposes of calculating taxable income, assets generally can be depreciated under the modified accelerated cost recovery system (MACRS), but they must be depreciated under the alternative depreciation system (ADS) when computing E&P (See. 312(k)(3) (A)). In addition, the Sec. 179 expense is deducted for regular tax purposes in the year the asset is placed in service but is deducted pro rata over five years when determining E&P (See. 312(k)(3)(B)). Furthermore, the Sec. 179 expense may be handled entirely differently for book purposes in arriving at retained earnings.

The term "retained earnings" refers to a corporation's undistributed earnings; its computation is normally governed and determined by generally accepted accounting principles (GAAP). AE&P is also a measure of the undistributed earnings of a corporation, but from a tax point of view. In other words, accounting rules govern the determination of retained earnings, while AE&P is calculated under tax law. Because of these differences, AE&P seldom matches retained earnings.

Some S Corporations Will Not Have AE&P

AE&P is significant because its...