C Corporation Taxation: E&P, Distributions and the Dividend Trap [REG Notes]

C corporation taxation means the corporation itself pays federal income tax on its profits, and shareholders pay tax a second time when those profits reach them as dividends. A C corporation files Form 1120 and pays a flat 21 percent on taxable income under IRC section 11(b). However, when it distributes cash or property, the tax result turns on earnings and profits, not on retained earnings. This note explains earnings and profits, the section 301 waterfall, and redemptions under section 302. It is part of our CPA Notes hub, where every FAR, AUD and REG note is listed in one place.

C Corporation Taxation: The Direct Answer in 49 Words

C corporation taxation taxes the same profit twice. The corporation pays a flat 21 percent on taxable income, then shareholders pay tax again when profits leave as dividends. Therefore, whether a distribution is a dividend depends on earnings and profits, not on retained earnings or the label on the payment.

How C Corporation Taxation Works: The 21 Percent Flat Rate

A C corporation is a separate taxable entity. It computes taxable income from gross income minus deductions, then applies the flat 21 percent rate the Tax Cuts and Jobs Act set for tax years beginning after 2017. In addition, there are no graduated brackets or preferential corporate capital gain rate. A corporation with $100,000 of taxable income owes $21,000, and one with $100,000 of capital gain owes the same $21,000. IRS Publication 542 states this rate plainly.

The second layer is the dividend trap. When the corporation distributes after tax profits, shareholders include the dividend in gross income. Individuals, for example, often pay the qualified dividend rates of 0, 15 or 20 percent, but the combined federal burden can still approach 40 percent with the 3.8 percent net investment income tax, before state tax. A corporation receiving dividends from another domestic corporation gets a dividends received deduction: 50 percent below 20 percent ownership, 65 percent at 20 to 80 percent, 100 percent at 80 percent or more.

C Corporation Taxation: What Earnings and Profits Really Means

Earnings and profits, usually written E and P, is a tax measure of a corporation’s capacity to pay dividends. It is not retained earnings, a book concept. E and P starts from taxable income with the section 312 adjustments: add tax exempt income, subtract federal income tax paid, and recompute depreciation on slower methods.

In fact, E and P has two buckets. Current E and P is the amount for the present tax year, figured at year end without reduction for distributions made during the year. Accumulated E and P is the running total of prior years’ current E and P, reduced by prior distributions. Current E and P is allocated pro rata across the year’s distributions; accumulated E and P applies chronologically. The nimble dividend rule: if current E and P is positive, distributions are dividends to its extent even with a large accumulated deficit.

C Corporation Taxation: The Section 301 Distribution Waterfall

Section 301 governs every nonliquidating distribution made with respect to stock. Under section 316, a dividend is any distribution out of current or accumulated E and P. Under section 301(c), every dollar passes through three tiers in strict order.

Tier	Source	Shareholder treatment
1. Dividend	Current E and P, then accumulated E and P	Included in gross income as dividend income
2. Return of capital	Amount above total E and P, up to stock basis	Tax free, reduces adjusted basis in the stock
3. Capital gain	Amount above E and P and above stock basis	Gain from a sale or exchange of property

Also, the amount distributed is cash plus the fair market value of property received. Under section 311(b), appreciated property makes the corporation recognize gain as if it sold the property at fair market value. Stock dividends are generally tax free under section 305 unless proportionate interests change. Dividends are reported on Form 1099-DIV at $10 or more; nondividend distributions go on Form 5452.

Worked Example 1: C Corporation Taxation Distribution Ordering

Harbor Inc. has current E and P of $30,000 and accumulated E and P of $50,000. Its sole shareholder, Maya, has an adjusted stock basis of $25,000. Harbor distributes $120,000 in cash.

Step 1, dividend. Total E and P is $30,000 plus $50,000, which is $80,000, and Maya includes that $80,000 in gross income. Step 2, return of capital. The distribution exceeds E and P by $120,000 minus $80,000, which is $40,000. The first $25,000 is a tax free return of capital, reducing Maya’s stock basis from $25,000 to zero. Step 3, capital gain. The remaining $40,000 minus $25,000 is $15,000, which exceeds basis, so Maya reports a $15,000 capital gain. The pieces reconcile: $80,000 plus $25,000 plus $15,000 equals the $120,000 distribution.

C Corporation Taxation: Stock Redemptions Under Section 302

A redemption is a corporation buying back its own stock. Section 302 decides whether the payment is a sale or a disguised dividend. Fail every section 302(b) test and the payment falls back to section 301: a dividend to the extent of E and P, with no basis recovery. Pass any one test and the shareholder gets sale treatment: basis offsets the proceeds and only the gain is taxed.

Section 302(b)(1) covers redemptions not essentially equivalent to a dividend, where the shareholder’s proportionate interest falls meaningfully. The section 302(b)(2) test is mechanical: after the redemption the shareholder must own under 50 percent of voting power and under 80 percent of the percentage owned before. Section 302(b)(3) is a complete termination of interest. Section 318 attribution can defeat these tests, since family and entity owned stock is attributed to the shareholder. Liquidations differ: under section 331 the shareholder treats the distribution as a sale of stock, and under section 336 the corporation recognizes gain or loss as if it sold its assets at fair value.

Worked Example 2: C Corporation Taxation Stock Redemption Test

Summit Corp. has 1,000 voting shares outstanding, and Dana owns 400, or 40 percent. Summit redeems 200 of Dana’s shares for $60,000 cash. Her basis in the redeemed shares is $30,000. Test the redemption under section 302(b)(2).

After the redemption, 800 shares remain and Dana owns 200, which is 25 percent. That passes the first test, under 50 percent after the redemption. It also passes the second test: 80 percent of her old 40 percent is 32 percent, and 25 percent is less than 32 percent. The redemption is substantially disproportionate, so Dana gets sale treatment. Her gain is $60,000 minus her $30,000 basis, which is a $30,000 capital gain. By contrast, if only 50 shares had been redeemed, Dana would own about 36.8 percent, above 32 percent, so the test would fail.

C Corporation Taxation vs S Corporation Taxation

The S corporation contrast is a reliable REG question.

Feature	C corporation	S corporation
Entity level tax	Yes, flat 21 percent on Form 1120	None; files Form 1120-S
Shareholder tax	Only on distributed dividends	Yearly on the K-1 share
Distribution order	E and P dividend, then basis, then gain	AAA first, then E and P, then basis
E and P role	Decides dividend treatment	Only for former C corporations
Eligibility limits	None	100 or fewer shareholders, one stock class
Losses	Stay at the corporate level	Flow through, limited by basis

C Corporation Taxation: Exam Traps to Avoid

1. Netting current E and P against an accumulated deficit. Positive current E and P means a dividend despite a deficit. 2. Giving basis recovery before E and P is used up. Return of capital starts only after the dividend tier. 3. Forgetting section 318 attribution. Family and entity shares count toward the percentage. 4. Treating a failed redemption as a sale. It is a section 301 distribution with no basis offset. 5. Confusing E and P with retained earnings or taxable income. It is its own computation under section 312. 6. Taxing corporate capital gains at a preferential rate. Corporations pay 21 percent on gains. 7. Forgetting the corporate gain on appreciated property under section 311(b).

One-Page Revision Box: C Corporation Taxation

• 21 percent flat rate, IRC 11(b); Form 1120; no preferential corporate capital gain rate.
• Double taxation: corporate tax, then dividend tax; qualified dividends 0, 15 or 20 percent.
• Dividend, section 316: any distribution out of current or accumulated E and P.
• Section 301 waterfall: dividend, then return of capital to basis, then capital gain.
• Current E and P pro rated; accumulated E and P chronological; nimble dividend rule when current E and P is positive.
• E and P adjustments: add tax exempt income, subtract federal income tax, slower depreciation.
• Section 302(b): not essentially equivalent, substantially disproportionate (under 50 percent after, under 80 percent of before), complete termination; section 318.
• Example 1: $120,000 distribution, $80,000 E and P, $25,000 basis: $80,000 dividend, $25,000 return of capital, $15,000 gain.
• Example 2: Dana at 25 percent, under 32 percent: $30,000 gain on $60,000 proceeds, $30,000 basis.
• REG Area V 23 to 33 percent; REG 4 hours, 72 MCQs, 8 TBSs, pass 75.

FAQ: C Corporation Taxation

Is a distribution a dividend just because the corporation calls it one?

No. A dividend exists only to the extent of E and P under section 316. Without E and P, it is a return of capital, then capital gain.

Can a corporation with an accumulated deficit still pay a taxable dividend?

Yes, under the nimble dividend rule. In fact, positive current E and P makes distributions dividends even when accumulated E and P is negative.

In short: 21 percent at the corporation, E and P deciding dividends, section 301 ordering every dollar, section 302 judging buybacks. For more, see our CPA Notes hub.

Sources

IRS Publication 542, Corporations (Rev. January 2019), flat 21 percent corporate rate, distributions to shareholders, Form 1099-DIV and Form 5452 reporting. AICPA Uniform CPA Examination Blueprints, effective January 2025, approved September 12, 2024: REG Area V Federal Taxation of Entities 23 to 33 percent; REG 4 hours, 72 multiple choice questions, 8 task based simulations, 50 percent multiple choice and 50 percent simulations, passing score 75. IRC sections 11(b), 301, 302, 311(b), 312, 316, 318, 331 and 336, via the U.S. Code text on govinfo.gov. IRS Topic No. 404, Dividends and Other Corporate Distributions, qualified dividend rates of 0, 15 and 20 percent. StudyFromNotes S corporation taxation note, https://www.studyfromnotes.com/s-corporation-taxation-reg-notes/, read live November 7, 2026, for the contrast table.