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If a corporation directly owns depreciable property, the corporation's interest in that property can cause complexity in the calculation of the corporation's earnings and profits ("E&P"); that complexity may be even greater if the corporation owns depreciable property indirectly through a partnership. In particular, if a corporation is a partner in a partnership that owns depreciable property that was contributed to the partnership by the corporation or another partner, the interaction of the E&P rules and the partnership rules under Section 704(c) raises the complexity to a new level, ultimately requiring two separate calculations of the impact of Section 704(c).
Earnings and Profits
A determination of the amount of a corporation's E&P is necessary for a number of reasons. For example, when a corporation distributes cash or other property to a shareholder, Section 301(c) treats the distribution as a dividend to the extent of the distributing corporation's E&P; any portion of the distribution that is not treated as a dividend is first applied against the adjusted basis of the stock, and, when that basis has been exhausted, is then treated as gain from the sale or exchange of property The amount of a corporation's E&P is also relevant in other contexts, including for certain international tax provisions.
Notwithstanding the importance of E&P, neither the Internal Revenue Code nor the regulations thereunder contain a comprehensive definition of the term. Instead, for federal tax purposes, E&P generally is understood to be an economic concept. Questions about whether a particular item of income or deduction should increase or decrease a corporation's E&P generally are answered by asking whether the item increases or decreases the corporation's ability to pay a dividend.
The starting point for the calculation of E&P is taxable income. However, taxable income must be adjusted under Section 312 for specified items of income, gain, loss, and deduction in order to calculate E&P Of relevance here, Section 312(k) provides that in computing E&P, an allowance for depreciation generally should be calculated as if the straight-line method of depreciation had been used.1
Prior to the enactment of the predecessor of Section 312(k), E&P was computed using the depreciation method applied for purposes of calculating taxable income. As a result, if a corporation used an accelerated cost recovery...