Legal Definitions - earnings and profits

Earnings and profits is a specific accounting measure used in U.S. corporate tax law. It represents a corporation's economic capacity to distribute funds to its shareholders that are considered taxable income (dividends) rather than simply returning their original investment (a return of capital).

This calculation helps determine how much of a distribution a shareholder receives will be taxed as a dividend. Generally, distributions made by a corporation are treated as taxable dividends to the extent of its current and accumulated earnings and profits. Any portion of a distribution that exceeds the corporation's earnings and profits is typically considered a non-taxable return of capital, which reduces the shareholder's cost basis in their stock.

Here are a few examples to illustrate this concept:

• Example 1: A Profitable Company's Regular Dividend

  Tech Innovations Inc. is a highly successful software company that has consistently generated significant profits for many years. Its current and accumulated earnings and profits total $20 million. This year, the company decides to distribute $5 million to its shareholders as a cash dividend.

  How it illustrates the term: Since the $5 million distribution is well within Tech Innovations Inc.'s $20 million in earnings and profits, the entire $5 million received by shareholders will be considered a taxable dividend for income tax purposes. The earnings and profits measure confirms the company has sufficient economic capacity from its past and current operations to make this distribution a taxable dividend.

• Example 2: A Mixed Distribution from a Growing Company

  Green Energy Corp. is a newer company that has started to generate profits, but it has also reinvested heavily. Its current and accumulated earnings and profits amount to $1.5 million. The board decides to make a larger-than-usual distribution of $2 million to reward early investors and attract new capital.

  How it illustrates the term: In this scenario, only the first $1.5 million of the distribution is covered by Green Energy Corp.'s earnings and profits. Therefore, for shareholders, $1.5 million will be treated as a taxable dividend. The remaining $500,000 ($2 million total distribution - $1.5 million E&P) will be considered a non-taxable return of capital, which reduces the shareholders' cost basis in their stock. If a shareholder's basis is reduced to zero, any further return of capital would be treated as a capital gain.

• Example 3: Distribution from Accumulated Profits Despite a Current Loss

  Heritage Manufacturing Co. has been in business for decades and has accumulated substantial profits over time, resulting in $10 million in accumulated earnings and profits. This year, due to unexpected market challenges, the company experiences a small operating loss, leading to negative current earnings and profits of -$200,000. Despite the current loss, the board decides to make a $1 million distribution to shareholders, drawing on its strong financial reserves.

  How it illustrates the term: Even though Heritage Manufacturing Co. had a loss in the current year, its significant accumulated earnings and profits from prior years are sufficient to cover the distribution. Therefore, the entire $1 million distributed to shareholders will be considered a taxable dividend. This demonstrates that both current and accumulated earnings and profits are considered when determining the taxability of a distribution.