Question

Explain the tax concept of Earnings and Profits (E&P) in relation to the accounting concept of retaining earnings.

Answer 1

Explain the tax concept of Earnings and Profits (E&P) in relation to the accounting concept of retaining earnings.

• Accumulated earnings and profits are a company's net profits after paying dividends to the stockholders, and serves as a measure of the economic ability of a corporation to pay such cash distributions.End-of-year accumulated earnings and profits are the sum of beginning-of-year E&P and current period E&P less distributions to shareholders during the period.
• Since E&P is used as a metric for the capacity of a firm to pay distributions, items such as tax-exempt income or nondeductible expenses, which factor into income tax reporting, must be added back or subtracted from the E&P account.The accumulated earnings tax may be imposed on a corporation for a tax year if it is determined that the corporation has attempted to avoid tax to its shareholders by allowing its E&P to accumulate beyond the reasonable needs of the business.In general, a corporation’s current-year E&P is calculated by making adjustments to its taxable income for the year for items that are treated differently for E&P purposes.
• Even though Earning & profits and Retained earning may seem synonymous, technically they are different primarily because E&P is determinant in a corporation's ability to fund distributions but retained earnings can be reduced by stock distributions or the establishing of a contingency reserve, neither of which impair a corporation's ability to finance distributions to its shareholders.