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Posted by Jim McClaflin, EA, NTPI Fellow, CTRC

Understanding Accumulated Earnings & Profits (E&P) Taxes

Understanding Accumulated Earnings & Profits (E&P)  Taxes

Accumulated earnings and profits (E&P) are the earnings accumulated by a company after the payment of dividends to shareholders. It measures a company's ability to pay cash distributions. E&P, as it is widely referred to, is an accounting term used to refer to the shareholders of companies. These retained earnings, which are not paid out to shareholders in the form of dividends, appear in the shareholders' equity section of the company's financial report. Companies use these deferred profits to finance their operations and facilitate expansions.


The purpose of the tax

The purpose of accumulated earning tax is to discourage the accumulation of profits if the purpose of such accumulation is to enable shareholders to avoid paying taxes on those profits by not paying them dividends. Keep in mind that this is not a self-imposed tax; an IRS review of a business can impose it.


Exemption Amounts

C corporations can earn up to $250,000 without incurring accumulated earning tax. A Personal Services Company (PSC) can make profits of up to $150,000 without having to pay these fees.


Calculation of Accumulated Earnings

The formula for computing retained earnings (RE) is:

RE = initial retained earning + dividends on net profits.

For example, suppose a certain company has $100,000 in retained earnings at the beginning of the year. The company made a net profit of $700,000 and paid $300,000 in dividends in the same year. The profit brought forward will be ($100,000 + $700,000) - $300,000 = $500,000. This amount is recorded in the financial statement at the end of the year as deferred income.


Net Income

When the net profit of a company increases, the reported profit also increases. The company pays the deferred income account to increase it and debits if the deferred income decreases because this account has a credit balance. The reason companies prepare the cash flow statement from the income statement is that the net profit from the income statement needs to be transferred to the cash flow statement to calculate retained earnings.


Cash Dividends

When a company's board of directors declares a cash dividend, the retained earnings are reduced. When these dividends are declared in cash, it creates a current liability that must be settled. Because of this statement, the company usually pays the dividend payable account and debits the retained earnings account. When cash dividends are paid, the dividend payable account is debited, and the cash account is credited.


Dividends Per Share

Sometimes stakeholders are rewarded with additional shares instead of cash. Although this reduces the deferred result, equity, total assets, and total liabilities are not affected. When establishing a dividend account, the company debits the deferred income account and then pays the distributable dividend account and the paid-in capital account from the nominal account. Upon distribution, the company debits the distributable dividends from the stock account and pays them to the common stock account.


Tax on Accumulated Earnings

This is a federal tax levied on businesses that are considered invalid and have above-average incomes. This tax was created to discourage companies from withholding profits and paying dividends. When a company's value of deferred profit exceeds a certain amount and is not distributed as a dividend to shareholders, the company pays taxes on the deferred profit. The US tax service considers an amount greater than this amount to exceed reasonable business needs. 20% of the rent is deductible from the surplus. If the company does not distribute profits, the government issues taxes to ensure that the decision to distribute dividends to a company without investment has a negative impact. For-profit corporations have a higher stock rating, which is good for shareholders, but since capital gains tax is lower than dividend tax, taxes go down and are not good for the government. When extra taxes are added to the company's undistributed profits, taxpayers persuade the company to pay more or not pay taxes or pay dividends to the company. The government can then try to raise funds from stakeholders.

For a business to avoid this tax, it must demonstrate that the profits carried forward do not exceed the limits of reasonable business needs. Corporations do not tax accrued income because the income of such corporations is subject to tax for shareholders and investors whether the corporation is distributed or not.


Taxes and interest rates

If a business makes profits in excess of the exempt amounts, a 20% retained earnings tax may be levied on the excess profits. In addition, tax interest is collected from the expiration date of the company's return without extensions.


A ray of light:

Even if the exemption amount is exceeded, regardless of the amount, if the earnings are accrued based on what the IRS considers the business to be reasonable, then the accrued income tax will not be imposed.

The question is, what are the reasonable business needs of the IRS?

Here's what the IRS says a business' reasonable needs are:

  • Specific, defined, and achievable plans for utilizing the accrual of profits in the business.

  • The amount required to redeem the shares of the company is included in the gross assets of a deceased shareholder if this amount does not exceed the reasonably foreseeable total of estates and inheritance rights and funeral and administrative expenses borne by the estate of the shareholder.

Expanding the business, building a new facility, and investing in newer, more productive equipment are all reasonable business needs.

S corporations have no problem with accumulated earnings because profits are taxed for S corporation shareholders even though they are not distributed to them.


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Jim McClaflin, EA, NTPI Fellow, CTRC
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