by A dividend is the distribution of some of a company’s earnings to a class of its shareholders as determined by the company’s board of directors. Common shareholders of dividend-paying companies are typically eligible as long as they own the stock before the ex-dividend date. Dividends may be paid out as cash or in the form of additional stock.
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.
Unlike a sole proprietor, who can take money out whenever he or she wants to, a stockholder in a corporation has to wait for the board of directors to declare and pay a dividend. In a closely held corporation, where the owner may be the chair of the board and have all decision-making ability, declaring a dividend in order to take profits out of the company can be a simple process (remembering that the corporation paid income tax on the net earnings, and the shareholder will pay income tax on the dividend). However, in a publicly-traded company, or even a non-publicly traded company with many shareholders, declaring a dividend may be much more difficult, as it takes an action of the board of directors.
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 retained by the corporation from previous tax years. Accumulated E&P is a tax term for what, under financial accounting, is called retained earnings. Though similar, they may differ 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 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 exceeds the stockholders basis in the stock, then the excess must be treated as a capital gain.
% of Dividend Paid Out of E&P = Total Distribution × Total E&P / Total Distribution
