Pomeroy, Harlan

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Case Western Reserve University School of Law

Case Western Reserve Law ReviewVolume 17 | Issue 31966Accumulations and Distributions of Earnings andProfitsHarlan PomeroyFollow this and additional works at: https://scholarlycommons.law.case.edu/caselrevPart of the Law CommonsThis Symposium is brought to you for free and open access by the Student Journals at Case Western Reserve University School of Law ScholarlyCommons. It has been accepted for inclusion in Case Western Reserve Law Review by an authorized administrator of Case Western Reserve UniversitySchool of Law Scholarly Commons.Recommended CitationHarlan Pomeroy, Accumulations and Distributions of Earnings and Profits, 17 W. Res. L. Rev. 717 (1966)Available at: https://scholarlycommons.law.case.edu/caselrev/vol17/iss3/121966]IVAccumulations and Distributionsof Earnings and ProfitsHarlan PomeroyM HE PENALTY TAX under section 531 of the Internal Reve-nue Code is imposed only in those situations in which there isthe concurrence of an act (the accumulation of earnings and profits)with a state of mind (the intent to avoid income tax).' The re-quired state of mind has beendiscussed in a preceding article.2THE AuTHoR (B.S., Yale University, The required act is the subjectLL.B., Harvard University) is a practic-ing attorney in Cleveland, Ohio. of this article.Under section 531, the cor-poration must have permittedits earnings and profits to accumulate instead of being divided or dis-tributed during the particular year under scrutiny.' This appears tomean that (1) there must be earnings and profits, (2) the earningsand profits must have increased during the year, and (3) the earn-ings and profits must not have been divided or distributed duringthe year. Unless each of these three conditions is met, the statutoryrequirements have not been satisfied, and it is difficult to see howthe section 531 penalty tax can be imposed as a matter of law.I. EARNINGS AND PROFITSThe meaning of the phrase "earnings and profits" is a complexsubject, the details of which are beyond the scope of this article.4However, certain fundamental principles are necessary to an under-standing of the application of the penalty tax.Earnings and profits are not necessarily the same as net profitsor taxable income.5 In order to compute the corporation's earnings1 See Pomeroy, The Statutory Pattern, 17 W. RES. L. REV. 704 (1966).2 See Sullivan, Prohibited Purpose for Accumulation of Earnings, 17 W. RES. L.REV. 712 (1966).3 INT. REv. CODE OF 1954, § 532 (a) [hereinafter cited as CODE fl.4 See generally, Albrecht, "Dividends" and "Earnings Or Profits", 7 TAX L. REV.157 (1952).5 American Metal Prods. Corp., 34 T.C. 89, 104 (1960), nonacq sub nom. AdlerWESTERN RESERVE LAW REVIEWand profits, its net income is generally reduced by nondeductibleitems such as the applicable income tax and dividend distributionsto shareholders. Section 312 of the Internal Revenue Code and theregulations thereunder specify in some detail how earnings andprofits are to be determined. The following discussion includes,first, a consideration of some of the items which must be added tonet taxable income so as to cause an increase in earnings and profitsand, second, an analysis of some of the items which must be sub-tracted from net taxable income so as to result in a reduction ofearnings and profits.A. Increases in Earnings and ProfitsFor a particular year, the accumulation of earnings and profitsfrom earlier years, i.e., the earned surplus balance at the beginningof the year, is increased by the net after-tax, after-dividend income.In addition, items of exempt and nontaxable income, such as lifeinsurance proceeds and interest on municipal bonds, are added toearnings and profits.On the other hand, gain which is not recognized under the In-ternal Revenue Code' and unrealized appreciation in property donot increase earnings and profits.B. Decreases in Earnings and ProfitsNondeductible items such as income taxes and dividends re-duce earnings and profits. Income tax deficiencies may also reduceearnings and profits, although there may be a question as to whetherthe reduction should be made for the year to which the deficiencyrelates or for a later year, such as the year in which the deficiencyis paid. Even the section 531 penalty itself may reduce earningsand profits.7Where the corporation has a deficit in earnings and profits, noaccumulation can occur, and hence no penalty can be imposed untilthe deficit has been cured.8 Thus, for example, a corporation withMetal Prods. Corp., 1963-2 CuM. BULL. 6, aft'd, 287 F.2d 860 (8th Cir. 1961); W. S.Farish & Co., 38 B.T.A. 150, 157-58 (1938), nonacq., 1938-2 CUM. BULL. 43, aIf'd,104 F.2d 833 (5th Cir.), cert. denied, 308 U.S. 559 (1939); Treas. Reg. § 1.312-6(1955) [hereinafter cited as Reg. Q].6 See generally CODE § 1002.7 American Metal Prods. Corp., 34 T.C. 89, 104, nonacq. sub nom. Adler MetalProds. Corp., 1963-2 CUM. BULL. 6, aff'd, 287 F.2d 860 (8th Cir. 1961).8 W. S. Farish & Co., 38 B.T.A. 150, 157-59 (1938), nonacq., 1938-2 CUM. BULL.43, affJd, 104 F.2d 833 (5th Cir.), cert. denied, 308 U.S. 559 (1939); accord, Rev.Rul. 71, 1954-1 CUM. BULL. 71.[VoL 17: 717ACCUMULATIONS AND DISTRIBUTIONSvery substantial current earnings, such as 500,000 dollars after taxes,could not be subject to the penalty as a matter of law where priorto the current year it had a deficit of at least 400,000 dollars.As in the case of increases in earnings and profits, unrealizeddepreciation in the value of assets does not affect accumulated earn-ings and profits.'Shareholder distributions will generally decrease earnings andprofits. Thus, under section 312(a), any distribution of propertyby a corporation with respect to its stock reduces the earnings andprofits of the corporation. More specifically, such a distribution firstreduces earnings and profits of the year of distribution."° This maynot be the result, however, where the distribution is effected as partof a stock redemption. Thus, in a stock redemption qualifying forcapital gain treatment under sections 302 or 303, that part of thedistribution "properly chargeable to capital account shall not betreated as a distribution of earnings and profits."" Where the re-demption involves stock the capital of which is represented by thecapitalization of prior earnings, a question may arise as to whetherthe redemption effects a distribution or division of current earningsand profits. This requires a determination of whether any part ofthe distribution is properly chargeable to capital account and, if not,whether the amount not charged to capital account is charged firstagainst earnings and profits of the current year.The distribution of a nontaxable stock dividend does not reduceearnings and profits.' Moreover, Revenue Ruling 65-68,". in re-jecting the holding of Harry A. Koch Co. v. Vinal, 4 requires thatearnings capitalized upon the payment of a nontaxable stock divi-dend remain available for distribution as dividends for purposes ofsection 531. Where stock representing capitalized earnings is re-deemed, the portion of the distribution in redemption not chargeableto such stock's share of paid-in capital is charged to and reducesearnings and profits. 5 In addition, under section 316(a), in theabsence of a contrary provision in the Code, every distribution of9 Helvering v. National Grocery Co., 304 U.S. 282 (1938). However, such de-predation, like appreciation, may be relevant in determining whether the corporationhas sufficient capital to meet its business needs.10 CODE § 316(a)."1 CODE § 312(e). The same rule applies to distributions in partial liquidation.12 Reg. § 1.312-1(d) (1955).13 1965-1 CuM. BULL. 246..4 228 F. Supp. 782 (D. Neb. 1964).15August Horrmann, 34 B.T.A. 1178, 1186-87 (1936).1966]WESTERN RESERVE LAW REVIEWearnings and profits is charged against the most recently accumu-lated earnings and profits. This general rule is applicable in de-termining the effect of a distribution in redemption of stock; thusa redemption distribution, to the extent that it is not charged topaid-in capital, will generally reduce current earnings and profits."II. YEAR OF INCREASE OR DECREASE IN EARNINGSAND PROFITSA considerable body of case law has developed around the ques-tion of when items affecting earnings and profits are to be reflectedin earnings and profits. This question can also be important inother contexts, such as where the issue is the amount of earningsand profits for purposes of measuring either the presence or theamount of a dividend to shareholders.The year for which earnings and profits are adjusted may alsobe important in a section 531 case. If, in a particular year, a corpo-ration's accumulated earnings and profits have decreased, one of thestatutory conditions to application of the section 531 penalty is miss-ing for that year.'The rules as to which year's earnings and profits are reducedby taxes, tax deficiencies, penalties, and interest, or are increased byrefunds of such taxes, penalties, and interest, have been distilledfrom a seemingly endless series of cases. The reported income taxliability of a corporation on the accrual basis of accounting general-ly reduces earnings and profits in the year to which the tax relates. 8In the case of a deficiency in the income tax or in other taxes wherethe corporation is on the accrual basis of accounting, the deficiencygenerally reduces the earnings and profits for the year to which itrelates, whether or not the deficiency is contested.'"Where the corporation is on the cash basis of accounting, someauthorities follow the same rule as that applied to corporations on16 For the possible significance of the fact that current earnings and profits are re-duced because of the effect of items decreasing earnings and profits see text accompany-ing notes 23-27 infra. For the impact of a redemption of stock upon the question ofreasonable needs of the business and the purpose to avoid shareholders' income taxes,see Pomeroy, The Effect of Stock Redemptionr Upon Tax Avoidance and the Reason-able Needs of the Business, 17 W. REs. L REV. 754 (1966).17 See text accompanying notes 23-27 infra.18 James Armour, Inc., 43 T.C. 295, 310 (1964).19 Stern Bros., 16 T.C. 295, 322-23 (1951), acq., 1951-2 CUM. BULL. 4. A con-trary result has been suggested where the deficiency is contested. Estate of Halley Tart,21 P-H Tax Ct. Mem. 1029 (1952).[Vol. 17: 717ACCUMULATIONS AND DISTRIBUTIONSthe accrual basis,2" while the Commissioner and other authoritiesrequire the earnings and profits to be reduced for the year in whichthe tax deficiency is paid.2' Under the latter view, it might beargued that the tax paid with the return reduces earnings and profitsfor the year when the return is filed. This, in fact, is the rule ap-plied to a penalty imposed in connection with the filing of a re-turn.22 Unlike the situation involving the proper year for deductinga contested item for income tax purposes, the above rules do notas yet seem to turn upon whether the tax or the penalty is beingcontested.Dividends, and presumably other distributions to shareholders,reduce earnings and profits for the year of actual payment.23III. SIGNIFICANCE OF THE ABSENCE OF CURRENTEARNINGS AND PROFITSUnder section 531, the surtax penalty for improper accumula-tion of earnings can be imposed only if the corporation's earningsand profits have been permitted "to accumulate instead of beingdivided or distributed."24  The penalty tax is imposed annually aspart of the income tax.25 Thus, unless there has been an accumula-tion of earnings and profits during the year in question, the thresholdcondition for the imposition of the penalty has not been satisfied,and it would appear that the tax cannot be imposed for that year.It has been so held in one case. " A more recent case pointing, butnot holding, to the contrary does not cite the earlier case which re-fused to apply the penalty on similar facts.27 Regrettably, the latercase is not dear as to the reasons for its contrary condusion.20 Demmon v. United States, 321 F.2d 203 (7th Cir. 1963); Drybrough v. Commis-sioner, 238 F.2d 735 (6th Cir. 1956).2 1 Helvering v. Alworth, 136 F.2d 812 (8th Cir.), cert. denied, 320 U.S. 784(1943); Paulina duPont Dean, 9 T.C. 256, 266-67 (1947), acq., 1947-2 Ctum. BULL.2; G.C.M. 2951, VII-1 CuM. BULL. 160 (1928).22 Estate of Esther M. Stein, 25 T.C. 940, 965-66 (1956), acq., 1957-2 CuM. BULL.7, aff'd per curiaem, 250 F.2d 798 (2d Cir. 1958); Rev. Rul. 332, 1957-2 CUM. BULL.231.2 3 Rev. Rul. 131, 1962-2 CuM. BuLL. 94.2 4 CODE § 532 (a). "Accumulate" is defined as "To increase in quantity or num-ber." WEBSTER, COLLEGrATE DiCrIONARY (1961).2 5 Corporate Inv. Co., 40 B.T.A. 1156, 1171-72 (1939), nonacq., 1940-1 CuM.BuLL. 6.20 American Metal Prods. Corp., 34 T.C. 89, 104, afl'd, 287 F.2d 860 (8th Cir.1961), inonacq. sub nom., Adler Metal Prods. Corp., 1963-2 CuM. BULL. 6.27 See Ted Bates & Co., P-H 1965 TAx CT. REP. & MEM. DEc. (34 P-H Tax Ct.Mem.) 5 65251 (Sept. 17, 1965). Since the judge concluded (p. 1363) that there1966]WESTERN RESERVE LAW REVIEWIf the current earnings and profits have decreased, it is difficultto see how there can have been the accumulation of earnings forthat year which is penalized by the statute. Moreover, refusal toimpose the penalty in this situation would seem to be consistentwith the statutory purpose of discouraging, on an annual basis, un-warranted accumulations of surplus. If the penalty tax is avoidedin a particular year because of a net decrease in surplus, the Com-missioner is entirely free to assert the penalty for prior and subse-quent years.28It must be remembered that there is an important distinctionbetween determining whether there has been an accumulation ofearnings and profits, on the one hand, and determining the amountof the corporation's accumulated taxable income on the other. Thepresence of an accumulation of earnings and profits is "jurisdic-tional" to the application of the penalty. In contrast, the amountof accumulated taxable income is the tax base or the income againstwhich the penalty tax is applied. The penalty tax base - accumu-lated taxable income - is specifically and precisely defined in Sub-chapter G of the Code. The act of permitting an accumulation ofearnings and profits, however, is determined by reference to generaltax and accounting principles entirely outside Subchapter G andthe provisions relating to the penalty tax on improper accumulationsof earnings.IV. CONCLUSIONThis article has been confined to the determination of whetherthe act of permitting earnings to accumulate has been committedand does not relate to the determination of the amount of the ac-cumulated taxable income and the penalty tax thereon. Thus, unlessthe decreases in earnings and profits during a particular yearhave the effect of entirely eliminating that year's earnings andprofits, so that the act of permitting earnings to accumulate has notbeen committed, the decreases are not significant to our presentproblem. Even a slight net increase in earnings and profits duringwas a small net accumulation for the year of the redemption, his comments pertainingto the reduction of earnings and profits to reflect the stock redemption are dicta andthe decision itself cannot be regarded as contrary to that in American Metal Prods. Corp.,supra note 26.2 8 Ted Bates & Co., supra note 27. If the penalty is to be imposed for years inwhich earnings and profits have decreased, it would seem such action should be pre-ceded by an appropriate amendment to the statute.[VoL 17: 7171966] ACCUMULATIONS AND DISTRIBUTIONS 723the current year (and hence commission of the act of permittingearnings to accumulate) will not prevent the assertion of the penaltytax against the full amount of the corporation's accumulated taxableincome for the current year.The foregoing discussion suggests a useful planning tool toavoid, or at least to be able to argue against, assertion of the penaltytax on legal grounds totally apart from the often complex factualarguments based upon the reasonable needs of the business and thesubjective matter of intentions. In short, the impact on earningsand profits of items such as taxes, distributions to shareholders, andthe like, may be to eliminate or substantially reduce current earn-ings and profits. However, if it appears that current earnings andprofits will be substantially reduced, but not entirely eliminated,consideration should be given to additional items, such as distribu-tions to shareholders, which will eliminate current earnings andprofits.

Accumulations and Distributions of Earnings and Profits

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Accumulations and Distributions of Earnings and Profits

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