A corporation can pay dividends out of its undistributed profits whenever the board of directors determines that accumulated earnings are sufficient to fund the payment and the company will still pass two legal tests after the money goes out: its assets must cover its liabilities (plus any senior liquidation preferences), and it must be able to pay its debts as they come due. Federal tax law treats any distribution from current or accumulated earnings and profits as a dividend, while state corporate statutes add the solvency and balance sheet gates on top of that definition.
What Undistributed Profits Are
Undistributed profits go by several names: retained earnings, earned surplus, or accumulated earnings and profits. They refer to the running total of a corporation’s net income over its lifetime, minus whatever has already been paid out as dividends or reclassified into capital accounts. The figure sits on the balance sheet under shareholders’ equity.
The math is simple. Take last period’s retained earnings, add current net income, subtract dividends declared. What’s left is available for distribution or reinvestment. A negative balance (a deficit) means the corporation has lost more over time than it has earned, which sharply limits its ability to pay dividends.
Earned surplus is not the same as capital surplus. Earned surplus comes from profitable operations. Capital surplus comes from capital transactions, like the premium investors pay above a stock’s par value. Most state corporate laws restrict dividends from capital surplus, and when a company does distribute from it, the payment is usually treated as a return of invested capital rather than a distribution of profits.
The Two Tests the Board Must Pass
State corporate statutes generally impose two tests that must be satisfied before any distribution. Both get evaluated at the time the board authorizes the payment, not during earlier planning. Directors who skip the analysis expose themselves to personal liability.
The Balance Sheet Test
After giving effect to the distribution, the corporation’s total assets must equal or exceed total liabilities plus the liquidation preferences of any senior equity holders. If the payment would push liabilities above assets or leave the company unable to satisfy preferred shareholders’ priority claims in a hypothetical dissolution, the distribution is illegal. The board can base the determination on financial statements prepared using accounting practices and principles that are reasonable under the circumstances, which allows some flexibility beyond strict GAAP.
The Solvency Test
Even if the balance sheet looks fine, the board must also confirm that the corporation will be able to pay its debts as they come due in the ordinary course of business after the distribution. Companies with large retained earnings but illiquid assets run into trouble here. A real estate holding company might show substantial accumulated profits yet fail the solvency test because it can’t convert those assets to cash fast enough to cover near-term obligations. The test forces directors to look at projected cash flow and upcoming debt maturities, not just historical profitability.
Both tests must be passed. A company that clears one but fails the other cannot legally make the distribution.
The Nimble Dividend Exception
Some states allow a “nimble dividend,” which lets a corporation pay dividends despite an accumulated deficit in retained earnings, as long as it earned net profits in the current or immediately preceding fiscal year. The reasoning is that a company with a weak historical track record but recent profitability shouldn’t be permanently locked out of rewarding shareholders.
Federal tax law takes a parallel approach. Under the Internal Revenue Code, a distribution qualifies as a taxable dividend if it comes from either accumulated earnings and profits or the current year’s earnings and profits. A company with a $15,000 accumulated deficit but $10,000 in current-year earnings can make a $10,000 distribution that the IRS treats entirely as a dividend sourced from the current year’s profits. The accumulated deficit stays unchanged.
The state-law rule and the federal tax treatment don’t always align. A payment can be legal under a state’s nimble dividend rule but treated partly as a return of capital for federal tax purposes, or the reverse. Directors and tax advisors have to track both frameworks independently.
Rules by Type of Dividend
The source-of-funds requirements apply differently depending on what the corporation is actually distributing.
Cash Dividends
Cash dividends are the most common and the most straightforward. They must come from earned surplus, and the board must confirm both the balance sheet and solvency tests are satisfied before declaring the payment. The full amount flows directly out of retained earnings.
Property Dividends
When a corporation distributes non-cash assets such as securities or real estate, the same earned surplus requirement applies. Valuation is the complication. Under generally accepted accounting standards, a pro rata property distribution is recorded at the fair value of the assets distributed, not their book value. If fair value exceeds book value, the company recognizes a gain. If the resulting charge against retained earnings exceeds the available balance, the distribution may be illegal.
Stock Dividends
Stock dividends are fundamentally different because no corporate assets leave the company. The business simply issues additional shares to existing shareholders. Nothing is distributed, so stock dividends don’t implicate the solvency test, and they aren’t “distributions” in the legal sense that triggers the balance sheet analysis. The transaction is an internal reclassification on the balance sheet rather than a depletion of assets, with amounts moved from retained earnings to the capital stock and additional paid-in capital accounts.
Liquidating Dividends
Liquidating dividends are the explicit exception to the rule that distributions come from profits. These payments return the shareholders’ original investment and typically occur when a company is winding down or selling off substantial assets. On the corporate side, all creditor claims must be satisfied or adequately provided for before capital goes back to shareholders. Creditors always stand ahead of equity holders in the priority line, even in a planned dissolution. For tax purposes, a liquidating distribution follows the same ordering rules as any other: dividend to the extent of remaining earnings and profits, then return of capital reducing basis, then capital gain on anything above basis.
Preferred Stock Comes First
If the corporation has both preferred and common stock outstanding, preferred shareholders’ dividend rights must be honored before any common dividends can be paid. The board cannot allocate any portion of undistributed profits to common shareholders until all required preferred dividends have been addressed.
What “addressed” means depends on the type of preferred stock. With cumulative preferred, any skipped dividend accumulates as dividends in arrears, and the company must pay all accumulated arrearages plus the current year’s preferred dividend before common shareholders see a dollar. A company that skipped three years of a 5 percent preferred dividend would owe 20 percent (four years’ worth) before paying anything on the common. With non-cumulative preferred, skipped dividends are gone forever, and the company only needs to pay the current year’s preferred dividend before distributing to common holders.
Arrearages on cumulative preferred are recorded on the balance sheet. They don’t reduce retained earnings until actually declared, but they effectively lock up a portion of undistributed profits that cannot flow to common shareholders.
How the IRS Taxes the Distribution
Whatever the board calls the payment, the IRS applies a three-tier ordering rule to every corporate distribution, and that ordering determines what the shareholder owes.
- The portion that comes from current or accumulated earnings and profits is taxed as dividend income.
- Any portion above that is applied against the shareholder’s adjusted basis in the stock, reducing it dollar for dollar. No tax is owed on this portion as long as basis stays above zero.
- Once basis hits zero, any remaining amount is treated as gain from the sale of property, typically taxed at capital gains rates.
The ordering is automatic. A distribution qualifies as a return of capital only when the corporation has no current or accumulated earnings and profits.
The Accumulated Earnings Tax
While state corporate law restricts premature distributions, federal tax law pushes the other way. The accumulated earnings tax under IRC Section 531 imposes a 20 percent tax on earnings that a corporation retains beyond the reasonable needs of the business, when the purpose of the accumulation is to help shareholders avoid individual-level tax on dividends.
The IRS generally treats up to $250,000 in accumulated earnings as within the reasonable needs of most corporations ($150,000 for certain personal service corporations). Accumulations beyond that invite scrutiny. The tax sits on top of regular corporate income tax, so sitting on profits without a legitimate business reason, like planned expansion, debt retirement, or working capital needs, gets expensive. Boards need to document the business justification for retaining earnings above the threshold, or the corporation risks an additional 20 percent bill on the excess.
Liability When a Dividend Is Illegal
Directors who authorize a dividend that violates the statutory tests face personal liability. Under the laws of most states, directors who vote for an unlawful distribution are jointly and severally liable for the amount that exceeded the permissible limit, plus interest. In many jurisdictions, that liability can be pursued for up to six years after the improper payment.
A director who was absent from the vote or formally dissented and recorded the dissent in the meeting minutes can generally avoid liability. The more common defense is good-faith reliance. A director who relies in good faith on financial statements prepared by competent officers, outside accountants, or a board committee is protected, provided the director didn’t have personal knowledge that made the reliance unreasonable.
Shareholders can also be on the hook. Under the model act framework adopted by most states, a director held liable for an unlawful distribution can seek pro rata recoupment from each shareholder, but only from those who accepted the distribution knowing it violated the law. Good-faith shareholders with no reason to suspect the payment was improper are generally protected. In practice, clawback actions target insiders and controlling shareholders who participated in the decision or had access to the financials. A passive outside investor who deposited a dividend check without any red flags is unlikely to face a repayment demand.