PORTFOLIO

Earnings and Profits (Portfolio 762)

Tax Management Portfolio, Earnings and Profits, No. 762-3rd, discusses the principles and rules associated with earnings and profits (E&P). Since the tax treatment of a distribution of property with respect to a corporation's stock is directly related to a corporation's E&P, the correct determination of a corporation's E&P is critical. Therefore, the Portfolio also analyzes the tax effects on E&P of corporate distributions made with respect to or in exchange for stock, and the rules for carryover and allocation of E&P upon certain types of tax-free distributions and exchanges.

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DESCRIPTION

Tax Management Portfolio, Earnings and Profits, No. 762-3rd, discusses the principles and rules associated with earnings and profits (E&P). Since the tax treatment of a distribution of property with respect to a corporation's stock is directly related to a corporation's E&P, the correct determination of a corporation's E&P is critical. Therefore, the Portfolio also analyzes the tax effects on E&P of corporate distributions made with respect to or in exchange for stock, and the rules for carryover and allocation of E&P upon certain types of tax-free distributions and exchanges. Generally, every corporate distribution of property with respect to stock is conclusively presumed to have its source in E&P to the extent thereof, beginning with E&P of the current year, followed by E&P accumulated after February 28, 1913, and finally from E&P accumulated before March 1, 1913. Once E&P is depleted, distributions are presumed to be from sources other than E&P.

In the event of a tax-free transfer of property pursuant to a corporate reorganization or separation, all or part of the transferor's E&P are also transferred to the acquiring corporation as part of the transaction. If boot is transferred upon such an otherwise tax-free transaction having the effect of the distribution of a dividend, each distributee is treated as having received a dividend in an amount not in excess of his pro rata share of the undistributed E&P of the corporation accumulated after February 28, 1913.

This Portfolio covers both separate and consolidated return aspects of E&P. It provides the practitioner with analysis of the proper accounting treatment of E&P, the treatment of specific items related to the E&P account, the effects of various types of corporate distributions on E&P, and how different types of transactions affect the E&P of the distributing corporation.


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AUTHORS

DAVID FRIEDEL
David Friedel, LL.M., in Taxation, from Georgetown University; J.D. (magna cum laude) from the American University Washington College of Law; B.S. in Economics from the University of Pennsylvania Wharton School of Business and a B.S.E. from the University of Pennsylvania School of Engineering and Applied Science. Member of the District of Columbia and Virginia State bar associations. Formerly Attorney/Advisor, Office of Chief Counsel, Internal Revenue Service.

WILLIAM GALANIS
William Galanis, LL.M., in Taxation (with distinction), from Georgetown University; J.D. from the Columbia School of Law, Catholic University; B.S. in Accounting, (cum laude) from Mt. St. Mary's College. Member of the District of Columbia and Maryland State bar associations. Formerly Attorney/Advisor, Office of Chief Counsel, Internal Revenue Service.

JULIE ALLEN
Julie Allen, MPA, in Taxation, from the University of Utah; B.S in Accounting with a minor in Chemistry from the University of Utah. Licensed CPA in Utah and Washington D.C.

TABLE OF CONTENTS

Detailed Analysis

0:I. Introduction

A. Overview and Outline of Portfolio

B. General Definition of E& P

C. Areas of Application

1. Characterizing Potentially Taxable Corporate Distributions

2. Tax-Free Corporate Distributions and Exchanges

3. Other Significant Areas of Application

Part I: Rules Applicable to Separate Returns

1:II. General Principles

Introductory Material

A. Start with Taxable Income for a Particular Year

1. Start with Taxable Income

a. Borrowing Against Appreciated Property and Distributing the Proceeds to the Shareholders

b. E& P of Nonconsolidated Subsidiaries

2. E& P vs. Taxable Income and Book Income

B. The “Accounting Consistency” Rule

1. “Method of Accounting” Includes Special Accounting Treatment of a Particular Item

2. Specific Examples of the Application of the Accounting Consistency Rule

a. Changes in Method of Accounting for Taxable Income

b. Estimated Taxes

c. Other Taxes

d. Bond Premiums or Discounts

e. Depletion

f. Certain Pension Liabilities

3. Method of Accounting and Insurance Companies

a. Accumulated E& P of a Life Insurance Company Acquired in a Merger

b. Unearned Premiums

c. Section 809(d) Deductions

d. Special Rules Applicable During 2005 and 2006

4. Tax Exempt Income

a. Examples

b. Effect on E& P of Gain Realized on Foreclosed Property Properly Credited to Bad Debt Reserve

5. Personal Service Corporations For Pre-1954 Tax Years

C. Nondeductible Expenses and Losses Reduce E& P

1. Section 162(c) Expenses

2. Employee Compensation

a. Cash Compensation

b. Stock or Stock Options Subject to § 83

c. Restricted Stock Options/Qualified Stock Options

3. Section 162(k): Stock Reacquisition

4. Depreciation or Amortization Subject to Anti-Churning Rules of § 197(f)(9)

5. Losses

a. Net Operating Loss Carrybacks Creating an Investment Credit Carryback

b. Effect of Accumulated Deficit on E& P.

D. A Deficit in E& P Must Be Restored by Subsequent Earnings Before Dividends Can Be Paid

E. Reduction in Capital Caused by Distribution Is Not Restored by Subsequent E& P

F. Distributions Between January 1, 1916 and August 6, 1917

1:III. Distributions of Property

Introductory Material

A. Special Rule for Debt Distributed

B. Adjusted Basis of Property

1. Distributions of Appreciated Property Under Current Law

a. Distributions of a Corporation's Own Securities

b. Section 333 Liquidations

c. Distributed Property Subject to a Liability

2. Distributions of Appreciated Property Before 1986

C. Charitable Contribution of Appreciated Property

D. Distribution of an Installment Note as a Dividend

E. Distribution of a Short-Term Transferrable Right to Acquire Stock in Another Corporation

F. Distribution by Foreign Corporations

1. General Rules

a. Section 959

b. Effect on § 1248 Computations of Dividends Paid in Year of Sale

2. Calculating the Limitation on Subpart F Income

3. Section 902

4. U.S. Shareholders Receiving Dividends from Foreign Corporations

1:IV. Distributions of Stock or Securities (§ 312(d))

A. General Rule

1. Distributions of Stock Made Under Prior Law

2. Section 305(b)(2)

3. Section 306 Stock

1:V. Effect of Gain or Loss on E& P (§ 312(f)(1))

A. General Rules

1. Limitation on Gain or Loss

2. Other Loss Situations

a. Wash Sales Rules

b. Section 311

B. Increase in Value Before March 1, 1913

1. General Rule

2. Adjustments that Result in a Loss

1:VI. Effect of Receipt of Tax-Free Distributions on E& P

1:VII. Allocation in Certain Reorganizations

A. Spin-offs

1. Spin-off Preceded by a § 368(a)(1)(D) Reorganization: the Sansome Principle

2. Spin-offs Not Preceded by a § 368(a)(1)(D) Reorganization

a. Distributing's E& P

b. Controlled's E& P

B. Other Tax-Free Exchanges Contributions to Capital (§ 351 Transfers, Transfers in Connection with a Reorganization, § 332 Liquidations, and Intercompany Transfers Between Members of an Affiliated Group)

1:VIII. Distribution of Proceeds of Loan Insured by the U.S.

A. General Rule

B. Other Details of the Provision

1:IX. Sale of Stock of Foreign Investment Company

1:X. Depreciation and Amortization

A. General Rule

1. Other Details of the Changes in § 312(k)

2. Depreciation Now Conforms to Treatment for Depletion

B. Depreciation/Depletion: Regs. § 1.312-6(c)(1)

1. Pre-1913 Tax Years

2. Post-1913 Tax Years

a. Impact of § 50(c) Adjustments on Depreciation or Depletion

b. Impact of Specific Elections on Depreciation or Depletion

c. Interests in a Partnership

d. Useful Life

C. Exception to the Straight-Line Rule

D. Tangible Property to Which § 168 Applies

E. Effect of Depreciation on Earnings and Profits

F. Certain Foreign Corporations

1:XI. Discharge of Indebtedness Income

A. General Rule

B. Bankruptcy

1:XII. Interest Paid on Certain Registration-Required Obligations Not in Registered Form

A. General Rule

B. Registration-Required Obligation Defined

1:XIII. Adjustments to E& P to More Accurately Reflect Economic Gain and Loss

A. Construction Period Carrying Charges

B. Intangible Drilling, Mineral Exploration, and Development Costs

1. Intangible Drilling Costs

2. Mineral Exploration and Development Costs

C. Amortization of Certain § § 173 and 248 Expenditures

D. LIFO Inventory Adjustments

1. General Rule

2. Definitions

3. Special Effective Date for Certain Foreign Corporations

E. Installment Sales and Completed Contract Method of Accounting

1. Installment Sales

a. General Rule

b. Special Effective Date for Certain Foreign Corporations

2. Completed Contract Method

a. General Rule

b. Special Effective Date for Certain Foreign Corporations

F. Special Rule for Partial Liquidation and Certain Redemptions

1. Current Law

a. Redemption of Preferred Stock

b. Multiple Classes of Stock

c. Current E& P

2. Pre-1984 Law

a. Section 312(e)

b. Rev. Rul. 70-531

c. Jarvis v. Comr.

d. Rev. Rul. 79-376

3. Redemption Cannot Create a Deficit in E& P

4. Priority of Distributions and Redemptions Occurring in the Same Tax Year

a. Distributions Reduce E& P Before Redemptions

b. Calculating the Reduction in E& P From a Redemption When Ordinary Distributions Are Also Made During the Tax Year

G. Death Benefits

1:XIV. Section 304 Redemptions Using Related Corporations

1:XV. Special Rules for RICS and REITS

1:XVI. Corporate Distributions With Respect To Stock

Introductory Material

A. Timing of Corporate Distribution for E& P Purposes

1. Payment Date

2. Date of Declaration

3. Date of Actual or Constructive Receipt

4. Date of Record

B. Sourcing Rules

1. Distributions Exceed Current Year E& P

a. Determining Current E& P

b. Deficit in Current E& P

2. Distributions out of E& P Inherited under § 381

C. Distributions of Property Other Than Money

D. Characterization as a Distribution Under § 316

E. Exceptions to § 316(a)

1:XVII. E& P Carryover in Corporate Acquisitions: Section 381 Transactions

A. General Rule

B. Deficits in E& P

1. Target Deficit

2. Acquiring Deficit

C. Simultaneous Acquisition of Multiple Targets

D. Successive Acquisitions

E. Impact of “Boot” Distributions in a Reorganization or Liquidation

1. Reorganizations

2. Liquidations with Minority Shareholders

F. Carryover Rules in Effect Before the Enactment of § 381(c)(2)

1. Background

2. Types of Transaction

a. Corporate Reorganizations

b. Liquidations

c. Insolvency Reorganizations

3. “Deficits” in Earnings and Profits

a. Corporate Reorganizations and Liquidations

b. Insolvency Reorganizations

(1) IRS Position

(2) Position of the Courts

4. Corporate Separations

Part II: Consolidated Return Aspects of E& P

2:XVIII. Earnings and Profits of Consolidated Group Members - In General

A. A Word about Vocabulary

B. Overview of Effective Date Issues

C. Relationship to Separate Return Computations

1. Myths About Consolidated Group Member's E& P

2. Similarities Between Consolidated and Separate Return Computations

3. Special Adjustments to Separate Return E& P Computations

D. Relationship to Stock Basis Adjustments

2:XIX. History of Consolidated Return E& P Rules

A. Pre-1966

B. 1966-1994

1. Introduction of Investment Adjustment System1

2. Ten-Year Phase-In of Annual E& P Adjustments

3. Pre-1991 Intra-Group § 304 Transactions

4. Improper Duplication of E& P; Improper Failure to Duplicate E& P

a. Preventing Over-Inclusion: Anti-Duplication for § 381 Transactions

b. Preventing Under-Inclusion: The Group Structure Change Rules

(1) Scope of Group Structure Change Rule

(2) Effective Date

5. Deemed Dividend Election

6. Dividend Stripping: One Problem, Four Solutions

a. 1966 – 1987: Immediate Stock Basis Decreases

b. Tax Years Beginning After Nov. 30, 1987: Basis Reduction Accounts

c. Tax Years with Returns Due After March 14, 1989: Dividend Acceleration Rule

d. Tax Years Beginning On or After January 1, 1995: E& P Elimination

7. Anomalies Under the 1966 Investment Adjustment Regime

a. Failure to Timely Reflect Current E& P Deficits

b. Stock Basis Distortions Caused by Code Amendments

8. Enactment of § 1503(e)

C. 1995 Revisions

2:XX. Application of 1995 Regulations

Introductory Material

A. Overview of Effective Date

B. Tiering up of Adjustments

1. Tiering up Post-1976 E& P

2. Tiering up Pre-1976, Pre-1966 E& P

C. Timing of Adjustments

D. Effect of Distributions

1. E& P Accumulated in Prior Consolidated Return Year

2. E& P Accumulated in Prior Separate Return Limitation Year

3. E& P Accumulated in Prior Affiliated but Separate Return Year

E. Allocating Adjustments

1. Percentage Ownership

2. Varying Interests

F. Anti-Duplication Rule

2:XXI. Treatment of Particular Transactions

A. Basis in Member Stock for E& P Purposes

B. Application of Loss Disallowance / Stock Basis Reduction Rules

1. Loss Disallowed under Regs. § 1.1502-20(a)

2. Stock Basis Decrease Required under Regs. § 1.1502-20(b)

3. Loss Disallowed under Regs. § 1.1502-13(f)(6)

4. Stock Basis Decrease Required under Regs. § 1.1502-13(f)(6)

C. Intercompany Transactions

D. Group Structure Change Rules

1. General Rule

2. Special Effective Date Issues

a. Group Structure Changes Before September 7, 1988

b. Group Structure Changes Between September 7, 1988 and 1994

c. Change in Location of Subsidiaries

E. Departing Members

1. Elimination of E& P Accumulated During Consolidated Return Years

2. Exceptions to Elimination Rule

a. Acquisition of Group

b. Group Remains in Existence

c. Special Uses of E& P

d. Spin-Offs

F. Allocation of Tax Liability

1. Reasons for Allocating Taxes

2. Overview of Tax Allocation Methods

a. General Operation of § 1552 and Regs. § 1.1502-33(d) Methods

b. Specific Application of § 1552 Methods

c. Specific Application of Regs. § 1.1502-33(d) Complementary Methods

3. Electing and Changing Tax Allocation Methods

4. Comparison with Tax Allocation for Stock Basis Adjustments

G. Subsidiary Liquidations

2:XXII. Predecessors and Successors

2:XXIII. Anti-Avoidance


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, Prepared by the Staff of the Joint Committee on Taxation, 176–177, 181 (1984). (Excerpt - Earnings and Profits (Redemptions))

Worksheet 2 General Explanation of the Technical Corrections to the Tax Reform Act of 1984 and Other Recent Tax Legislation, Prepared by the Staff of the Joint Committee on Taxation, 25–26 (1987). (Excerpt - Earnings and Profits)

Worksheet 3 Filled–in Form 5452 and Example of Current Year E& P Calculation (Including Calculation of E& P Depreciation)

Worksheet 4 Allocation of Earnings and Profits in Connection with Corporate Separation

Worksheet 5 Rev. Rul. 79-376, 1979-2 C.B. 133

Worksheet 6 Rev. Rul. 74-266, 1974-1 C.B. 73

Worksheet 7 Rev. Rul. 82-72, 1982-1 C.B. 57 (Modifying Rev. Rul. 74-266)

Worksheet 8 Rev. Rul. 74-338, 1974-2 C.B. 101

Worksheet 9 Rev. Rul. 74-339, 1974-2 C.B. 103

Worksheet 10 Rev. Proc. 75-17, 1975-1 C.B. 677

Worksheet 11 Rev. Proc. 79-47, 1979-2 C.B. 528

Bibliography

OFFICIAL

Statutes:

Legislative History:

Regulations:

Treasury Rulings:

Cases:

UNOFFICIAL

Treatises:

Periodicals:

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1952

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1965

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