4.5 Taxable Dividends of Earnings and Profits

You pay tax on dividends only when the corporation distributing the dividends has earnings and profits. Publicly held corporations will tell you whether their distributions are taxable. If you hold stock in a close corporation, you may have to determine the tax status of its distribution. You need to know earnings and profits at two different periods:

1. Current earnings and profits as of the end of the current taxable year. A dividend is considered to have been made from earnings most recently accumulated.
2. Accumulated earnings and profits as of the beginning of the current year. However, when current earnings and profits are large enough to meet the dividend, you do not have to make this computation. It is only when the dividends exceed current earnings (or there are no current earnings) that you match accumulated earnings against the dividend.

The tax term “accumulated earnings and profits” is similar in meaning to the accounting term “retained earnings.” Both stand for the net profits of the company after deducting distributions to stockholders. However, “tax” earnings may differ from “retained earnings” for the following reason: Reserve accounts, the additions to which are not deductible for income tax purposes, are ordinarily included as tax earnings.

EXAMPLES
1. During 2012, Corporation A paid dividends of $25,000. At the beginning of 2012 it had accumulated earnings of $50,000. It lost $25,000 during 2012. You are taxed on your dividend income in 2012 because the corporation’s net accumulated earnings and profits exceed its dividends.
2. At the end of 2011, Corporation B had a deficit of $200,000. Earnings for 2012 were $100,000. In 2012, it paid stockholders $25,000. The dividends are taxed in 2012; earnings exceeded the dividends.
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image Planning Reminder
Dividend Reinvestment in Company Stock
Your company may allow you either to take cash dividends or automatically reinvest the dividends in company stock. If you elect the stock plan, and pay fair market value for the stock, the full cash dividend is taxable.
If the plan lets you buy the stock at a discount, the amount of the taxable dividend is the fair market value of the stock on the dividend payment date plus any service fee charged for the acquisition. The basis of the stock is also the fair market value at the dividend payment date. The service charge may be claimed as an itemized deduction subject to the 2% of adjusted gross income floor (19.1). If at the same time you also have the option to buy additional stock at a discount and you exercise the option, you have additional dividend income for the difference between the fair market value of the optional shares and the discounted amount you paid for the shares.
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