Election to only withhold on corporate distributions paid to foreign persons out of earnings and profits
When a distribution is made to shareholders, only the amount that is paid out of accumulated E&P or current E&P is a “dividend” for tax purpose. A distribution is a dividend to the extent of (1) current E&P (in the year of the distribution) even if there is a cumulative deficit in E&P, or (2) accumulated E&P, even though there is a deficit in E&P in the year of the distribution.
Example: A corporation has accumulated E&P of $5 million at the end of Year 1. In Year 2, it has a loss and an E&P deficit of $2 million and distributes $3 million to its shareholders. The entire amount of the distribution is taxable as a dividend.
Example: At the beginning of Year 2, a corporation has a cumulative E&P deficit of $4 million. In Year 2, it has net income and E&P of $1 million. The corporation distributes $1 million to its shareholders in Year 2. The entire amount of the distribution is taxable as a dividend.
The portion of a distribution that is not paid out of current or accumulated E&P (i.e., is not a “dividend”) is not includible in U.S. taxable income of a foreign shareholder who has no U.S. business and is not subject to 30% (or lower treaty rate) withholding. You do not have to withhold on the portion of a distribution that you “reasonably estimate” will not be a “dividend.” If you do not withhold in this situation, you are treated as electing to reduce the amount of withholding. However, you should only elect to withhold on less than the entire amount of a distribution if you are highly confident that you can accurately project the maximum amount of the corporation's E&P through the end of the tax year, since an unexpected last minute windfall could result in underwithholding, and the company is responsible for paying any underwithheld tax if its estimate of E&P proves to be erroneous.
Example: A corporation's E&P deficit is $3 million through Year 2. Through Sept. of Year 3, there is a loss. On Oct. 1, $2 million is distributed to shareholders and no tax is withheld on payments to foreign shareholders, in the belief that there will be a loss for the entire year. In Dec., there is unexpected income of $4 million. The entire distribution is a dividend and Corporation is liable for the underwithheld tax.
In order for your estimate of E&P to be considered “reasonable,” it must be made fairly close to the date of payment and must take into account the anticipated current and accumulated E&P that the corporation will have as of the end of the tax year. It is recommended (based on an example in the regulations) that, if possible, any estimate be based on a written projection prepared by the company's accounting department that is made within one month before the distribution. The estimate may be based on previous experience taking into account the proportion of the distributions made during the most recent year for which a Form 1099 was required to be filed that was not reported as a dividend. However, previous experience may only be the basis of the estimate, if you have no reasonable basis to expect that the proportion of the distribution that is not a dividend will be substantially different for the current year.
Although the company is responsible for paying any underwithheld tax, no penalties will be incurred, if the underwithheld tax is paid to IRS by March 15, of the year after the distribution was made (the due date for filing Form 1042). If the company was a fiscal year taxpayer, it would have to file an amended Form 1042 and pay the underwithheld amount within 60 days after the close of the year in which the distribution was made.