When a corporation earns income, it has 2 choices as to what to do with it: it can retain the earnings so that it can invest in its business or it can distribute it as dividends to shareholders. Any distribution of cash or property to the owners of a corporation is known as a distribution. Whether that distribution is taxable depends on whether the distribution is classified as a dividend or a return of capital. A return of paid-in capital is not taxable, since it is not a profit. However, dividends are subject to double taxation, in that the corporation must pay a tax on its profits and the shareholders must pay a tax on the dividends received. A dividend is defined by IRC §316(a) as any distribution of cash or property by a corporation to its owners, but only to the extent that it was paid out of earnings and profit.
The tax code defines earnings and profits (E&P) as a company's ability to pay out profits without returning paid-in capital. Current E&P is approximately equal to the corporate taxable income minus the federal income tax assessed on it, which is then subjected to the statutory adjustments listed in IRC §312. These statutory adjustments include deductions that reduce taxable income but do not reduce the corporation's ability to pay dividends or vice versa. For example, the dividends-received deduction is deductible for income tax purposes but not for the computation of E&P, since it does not reduce the amount of money available to pay dividends. On the other hand, expenses and losses that cannot be deducted from taxable income can be deducted from E&P, such as the nondeductible expenses related to the production of tax-exempt income, since these deductions do reduce the ability to pay dividends even though they are not deductible for income tax purposes. In cases without these statutory adjustments, E&P can be approximated as the profits remaining after the payment of tax.
If a corporation has profits, then they can pay dividends with those profits, and any amount not paid out as dividends is retained by the corporation. Any amounts retained by the corporation increases accumulated E&P, which is the earnings and profits that have been retained by the corporation from previous tax years. Accumulated E&P is a tax term for what, under financial accounting, would be referred to as retained earnings. Although they are basically the same, there may be some differences because of the statutory adjustments.
A corporation can pay a dividend either out of current E&P or accumulated E&P. If the amount of the dividend paid out exceeds the sum of both current E&P and accumulated E&P, then the percentage of the payment that will be considered a dividend will be the amount paid multiplied by the total E&P divided by the total dividend paid out. The remaining percentage of the dividend will be considered a nontaxable return of capital. However, if the corporation does not earn a profit for the current year, dividends can still be paid out of the accumulated E&P, even if a corporation has a current deficit.
If the total dividend payment by the corporation exceeds its total E&P, then:
|% of Dividend Paid Out of E&P||=||Total Distribution||×||Total E&P|
% of Dividend Treated as a Nontaxable Return of Capital = 1 – % of Dividend Paid Out of E&P
Example: Effect of Distributions on Earnings and Profits Over 4 Years
Note that dividends can be paid out of current or accumulated E&P or both.
|Accumulated E&P at Start of Year||$5,000,000|
|Dividends Paid Out of Current E&P||$1,000,000|
|Addition to Accumulated E&P||$1,000,000||= Current E&P – Dividends Paid Out of Current E&P|
|Accumulated E&P at Start of Year 2||$6,000,000||= Accumulated E&P at Start of Year + Current E&P – Dividends Paid Out of Current E&P|
|Dividend Paid Out of Current E&P||$500,000|
|Dividend Paid Out of Accumulated E&P||$300,000|
|Accumulated E&P at Start of Year 3||$5,700,000|
|Dividend Paid Out of Accumulated E&P||$100,000|
|Accumulated E&P At Start of Year 4||$5,570,300||= Accumulated E&P at Start of Year 3 + Year 3 E&P – Dividends Paid Out of Year3 E&P|
If the amount paid out as dividends exceeds both E&P and accumulated E&P, then the excess is treated as a return of capital, which is not taxable to the shareholders. Any return of capital does not affect accumulated E&P. Although the stockholder is not taxed on the return of capital, the tax basis in the stock is reduced by the amount of the capital. If a return of capital is greater than the stockholders basis in the stock, then the excess must be treated as a capital gain.
Example: Effect of Distributions When the Company Has a Net Deficit
|Dividend Paid Out of Current E&P||$125,000|
|Addition to Accumulated E&P||$175,000||= Current E&P – Dividend Paid Out of Current E&P|
|Since the current distribution is less than the current E&P, the entire distribution is considered to be a dividend.|
|Accumulated E&P at Start of Year 2||($625,000)||Note that even though the company still has a net deficit, the distribution in Year 1 is entirely a dividend — no part is a return of capital.|
|Dividend Paid Out of Current E&P||$500,000||Note that this is a dividend even though the net deficit is larger than the current E&P, since the distribution is 1st considered paid out of current E&P.|
|Addition to Accumulated E&P||$0|
|Additional Distribution||$300,000||= Current Distribution – Dividend Portion = $800,000 – $500,000 This is a return of capital, since the accumulated E&P has a deficit.|
|Accumulated E&P At End of Year||($625,000)|
Based on the above table, you, as a shareholder who owns 10% of the company, will receive 10% of the $800,000 total distribution. Your taxable dividend and your nontaxable return of capital are calculated thus:
|Amount of Distribution||$80,000|
|Dividend||$50,000||= $80,000 × Part of Distribution Paid Out of E&P / Total Distribution|
= $80,000 × $500,000 / $800,000 = $80,000 × $50,000 / $80,000
|Return of Capital||$30,000||= Amount of Distribution – Dividend|
|Ordinary Income||$50,000||= Amount of Dividend|
|Original Stock Basis||$100,000|
|Basis after Return of Capital||$70,000||= Original Stock Basis – Return of Capital|
Sometimes a corporation will distribute property rather than cash, in which case the fair market value (FMV) of the property is the amount that is distributed. If the FMV is greater than the corporation's tax basis in the property, then it must recognize the distribution as a constructive sale, where the FMV minus the tax basis is equal to the corporation's profit, which is added to current E&P. However, the distribution of the property reduces E&P by the fair market value of the property.
If the FMV of the distribution is less than the corporation's tax basis, it cannot claim a loss because of the property distribution. Instead it must decrease current E&P by the adjusted basis of the property.
When the shareholder receives the property, then the adjusted basis in the property is the property's FMV, not the corporation's basis.
Sometimes, instead of cash or property, a corporation may distribute stock dividends, which represents a capitalization of retained earnings by increasing the number of outstanding shares.
A stock dividend is a proportional distribution of additional stock to its shareholders. Because there is no distribution of cash or property, the firm's assets and liabilities, and therefore the stockholders' equity, are not changed.
There are several reasons why the Board of Directors may declare a stock dividend:
- to give some indication that the company is successful, but without paying out working capital
- to make a tax-free distribution to the shareholders, since stock dividends are not usually taxable
- to increase its permanent capital, since stock dividends transfer amounts from the retained earnings account to the contributed capital account
- to reduce the market price because it increases the number of shares outstanding, even though the firm's assets and liabilities have not changed
So, to summarize: stock dividends do not:
- change stockholders' equity;
- reduce corporate assets, since the distribution is not cash or property; and
- stockholders maintain proportionate ownership of the company.
However, if a corporation allows the shareholders to choose between the stock dividend or cash, then the distribution is taxable. If the stockholder elects to receive cash, then obviously that distribution is taxable to the shareholder. If the shareholder elects to receive the stock dividend, then his proportionate ownership of the corporation increases at the expense of those who choose to take cash. Therefore, the shareholders who received the stock dividend must recognize it as income equal to the FMV of the new shares, which is also equal to the tax basis in the shares.
While the payment of the nontaxable stock dividend does not change corporate E&P, taxable stock dividend distributions decrease E&P by the FMV of the stock.
Besides dividends, shareholders can receive compensation as employees of the corporation, or they may receive loans from the corporation in which they have to pay a reasonable interest rate.
However, some shareholders of closely held corporations may attempt to benefit by using property of the corporation without compensating the corporation for the use of the property. In such cases, the IRS will treat the FMV of the property as a constructive dividend. A shareholder may also engage in activities that are a personal interest of the shareholder, but not much of a benefit to the corporation. In these cases, the expenses that were deducted by the corporation because of the personal interest will be treated as a constructive dividend to the shareholder.