Accumulated Earnings, Profits, and Tax Explained
Accumulated earnings and profits (E&P), are the profits retained by a company after it pays dividends to stockholders. It measures the ability of a company to pay cash distributions. E&P is an accounting term that is used to refer to the stockholders of corporations.
These retained earnings, which are not paid to shareholders as dividends, appear in the equity section of the shareholder in the financial report of the company. These retained profits are used by companies to finance their operations and facilitate expansions.
Calculating the Accumulated Earnings
The formula for calculating retained earnings (RE) is:
RE = Initial RE + net income – dividends.
For example, let’s assume a certain company has $100,000 in accumulated earnings at the beginning of the year. The company made $700,000 in net profits and paid dividends worth $300,000 in the same year. The retained earnings will be,
($100,000 + $700,000) – $300,000 = $500,000
This figure is recorded in the financial report at the years end in the accumulated earnings item.
When the net profits of a company increase, the accumulated earnings also increase. The company pays the accumulated earnings account to increase it and charges it if the accumulated earnings decrease since this account has a favorable balance. The reason why companies prepare the financial report after the income report is because the net income of the income report has to be transferred to the financial statement to calculate retained earnings.
When a board of directors declares a cash dividend, accumulated profits reduce. When these dividends are declared in cash, they create a current liability that must be settled. In account for this declaration, a company typically pays the dividend payable account and charges the retained earnings account. When the dividends in cash are paid, the dividend payable account is charged and the cash account credited.
Dividends in shares
Sometimes, shareholders are rewarded with additional shares instead of cash. Even though this reduces the accumulated earnings, the total shareholder capital, assets and total liabilities are not affected. When a declaration of dividends is made, the company debits the accumulated earnings account and then pays the distributable dividend account and the paid-in capital account of the nominal account. When the distribution is done, the company charges the dividend account distributable in shares and pays the ordinary shares account.
Accumulated Earnings Tax
This is a federal tax charged to companies considered invalid and which have excess earnings that exceed the average rate. This tax is used to discourage companies from retaining profits but to pay dividends. When the amount of retained earnings in a company exceed a certain amount and is not distributed as dividends to shareholders, the company is taxed on the accumulated income
The US Internal Revenue Service allows for companies to accumulate profits of up to $250,000 without paying tax since it believes that an amount exceeding this goes over the reasonable requirements of the company.
20% of the income is deductible from the surplus. If the company fails to distribute profits, the government issues taxes to ensure that dividends decision to a non-investment company will have a negative impact. Companies retaining profits have a higher stock rating which is good for shareholders but because the capital gains tax is lower than the dividend tax, the tax decreases and this is not good for the government.
When additional taxes are added to the company’s retained earnings, the company is convinced by tax officers to pay more or not to pay tax or pay dividends from the company. The government can then attempt to raise funds from shareholders. For a company to avoid this tax, it must prove that the retained earnings do not exceed the reasonable business requirement limits. Companies do not tax accumulated income because the income of these companies is taxable to shareholders and investors in spite of whether the company is distributed.
References for Accumulated Earnings Tax
Academic Research for Accumulated Profits Tax
- Stock Redemptions and the Accumulated Earnings Tax, Herwitz, D. R. (1960). Harv. L. Rev., 74, 866. This paper attempts to examine if a closely held corporation can finance a stock redemption by accumulated earnings even though the status of accumulation under these earnings is unclear.
- Out of Its Earnings and Profits”: Some Reflections on the Taxation of Dividends, Andrews, W. D. (1956). Harvard Law Review, 69(8), 1403-1439.’ This study examines how the earnings and profit concept have not been subjected to the same strain as the provisions that deal with random distribution means.
- The Role of Taxes in Organizational Choice: S-Conversions After the Tax Reform Act of 1986, Plesko, G. (1994). Boston, MA: Northeastern University. Mimeo. This study provides detailed information on the role that is played by taxes in influencing the choice of an organization.
- The New Accumulated Earnings Tax: A Survey of Recent Developments, Ziegler, S. S. (1966). Tax L. Rev., 22, 77. This paper surveys the recent developments in firms to find out the new tax obligations that pertain to accumulated earnings.
- The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, Plumb Jr, W. T. (1970). Tax L. Rev., 26, 369. This paper expounds on the significance that the federal income tax has on corporate debt.
- Practical Aspects of Accumulated Earnings Tax, Latham, R. S. (1963). W. Res. L. Rev., 15, 363. This study centers on examining the aspects of accumulated earnings tax and its significance.
- Dividends and taxes, Miller, M. H., & Scholes, M. S. (1978). Journal of financial economics, 6(4), 333-364. Regardless of tax differentials being in favor of capital gains, the paper provides sufficient conditions for taxable investors to be indifferent from dividends.
- Earnings management, corporate tax shelters, and book-tax alignment, Desai, M. A., & Dharmapala, D. (2009). National Tax Journal, 169-186. This paper examines the evidence that analyzes the link between earnings management and corporate tax avoidance and then considers the impacts for how policymakers are supposed to evaluate the financial reporting of environment facing firms.
- Internal finance and investment: Evidence from the undistributed profits tax of 1936-1937, Calomiris, C. W., & Hubbard, R. G. (1993). (No. w4288). This study uses a tax experiment, the Surtax on Undistributed Profits (SUP) to identify firms’ relative costs of internal and external funds and then analyze the effects on the firm’s investment decisions.
- An empirical analysis of tax court decisions in accumulated earnings cases, Madeo, S. A. (1979). Accounting Review, 538-553. This study contains the statistical analysis results of post-1954 accumulated earning cases that are prosecuted in the Tax Court to identify the variables that are drawn from regulations and IRS audit guidelines. These guidelines have separated cases won by taxpayers from those lost by them.
- The accumulated earnings tax and the reasonable needs of the business: A proposal, Elliott, H. L. (1970). Wm. & Mary L. Rev., 12, 34. This paper explains the accumulated earnings tax concerning the reasonable needs of a business
- Accumulated Earnings Tax Aspects of Business Expansions and Investments, Case, G. L. (1976). Tax L. Rev., 32, 1. This paper explains how projected business expansions and investments are affected by the aspects of accumulated earnings tax.
- Dividends and Earnings or Profits Under the Income Tax Law: Corporate Nonliquidating Distributions, Rudick, H. J. (1940). U. Pa. L. Rev., 89, 865. The paper investigates how individuals assume that after receiving dividends, the federal government tax authorities will demand their share, but in some cases, this does not happen since the dividend might be ruled a return on capital and this is non-taxable.
- Last‐chance earnings management: Using the tax expense to meet analysts’ forecasts, Dhaliwal, D. S., Gleason, C. A., & Mills, L. F. (2004). Contemporary Accounting Research, 21(2), 431-459. This study emphasizes on the tax expense being a powerful context for studying earnings management since it’s among the accounts closed last just before the earnings are announced.
- Tax rates and tax revenues in a model of growth through human capital accumulation, Pecorino, P. (1995). Journal of Monetary Economics, 36(3), 527-539. In this paper, the existing relationship between tax rates and the current value of tax collections is analyzed in a growth setting where the growth is driven by human capital accumulation.
- The growth rate impacts of tax reform, Pecorino, P. (1994). 492-501. In this article, a growth model is set through human capital accumulation and simulation of tax reforms by using the US economy in 1985 as the benchmark parameterization.
- The Accumulated Earnings Tax: The Relationship Between Earnings and Profits and Accumulated Taxable Income in a Redemption Transaction, Doernberg, R. L. (1981). U. Fla. L. Rev., 34, 715. This study uses a redemption transaction to determine the relationship between earnings, profits and accumulated taxable income.