While there is general agreement on extending the tax cuts for the “middle class,” there is no consensus yet on whether to extend the cuts for high income individuals, or what would be considered “high income.”
The 2001-2003 tax cuts that expire at the end of 2012 include the 15% preferential tax rate on non-corporate capital gains and qualified dividends.
The tax rate on capital gains and dividends will be part of the negotiations on a compromise package to address the fiscal cliff. It is possible that capital gains may continue to be taxed a preferential rate (although possibly higher than the current 15%). Dividends may be taxed at the same rate as capital gains or at the same rate as ordinary income. If no compromise is reached, dividends will automatically be taxed at ordinary income rates.
Some companies are considering accelerating distribution of dividends into 2012—or have already made early distributions—to avoid the possibly higher tax rates on dividends in 2013.
Tax treatment of distributions
As a reminder, it is necessary to evaluate the tax character of distributions to shareholders. The distribution may be a dividend, return of basis, or capital gain. When a distribution is made to a company’s shareholders, the distribution:
- First reduces the company’s earnings and profits (E&P), resulting in a taxable dividend
- If the distribution is in excess of E&P, then it reduces stock basis resulting in a tax free return of capital
- If the distribution is in excess of both E&P and stock basis, then the remainder is capital gain income
What is E&P?
- The function of E&P is to measure a corporation’s economic income or its dividend paying capacity.
- E&P shares some of the attributes of taxable income and some of the attributes of corporate retained earnings, but is identical to neither.
- E&P is not defined in the Internal Revenue Code. There are a number of factors listed which affect E&P, but there is no statutorily defined starting point.
- The term “dividend” means any distribution of property out of accumulated E&P or E&P of the tax year.
- E&P is relevant in determining the tax consequences of certain related-party stock sales and intragroup reorganizations, both domestic and foreign.
Determining E&P can be a substantial undertaking. The sheer number of rules and limitations require not only a very thorough technical understanding of the statutory, regulatory, and judicial provisions, but also a comprehensive means to calculate their effect correctly and expeditiously. Conducting an E&P study may be the most efficient and effective way of determining E&P.
For more information, contact a KPMG tax professional:
- Concerning legislative developments: Hank Gutman, (202) 533-3044
- Concerning mechanisms for executing an actual or deemed distribution: Mark Hoffenberg,
- Concerning E&P studies: Alan Barton, (713) 319-2430