 Hello, and welcome to the session in which we will discuss current earnings and profit and accumulated earnings and profit which are known as CEP and AEP now, what is the big idea of CEP and AEP why do we need to know about those two? Well because we need to determine the amount of dividend From the corporate distribution. So when the company distributed dividend to us make a distribution Not dividend when they make a distribution We say that as long as the distribution is coming from CEP and AEP Then distribution is considered dividend and that's important now how to compute CEP current earnings and profit we learn about this in the prior session So if you are not familiar with how to compute CEP you want to make sure you are because in this session I assume, you know how to do so and basically it's taxable income Plus or minus certain adjustments, but that's very important because in this session I assume, you know how to compute CEP What is AEP? Well AEP is accumulated earnings and profit. It's the total of all current years CEP since 1913 when the first corporation was incorporated reduced by any distribution of EEP So AEP is an accumulated account of CEP. The first thing we're gonna look at are the general rules For AEP and CEP when we have those how do we treat the distribution assuming we have a distribution? Let's go ahead and get started Before we proceed any further. I have a public announcement about my company farhat-lectures.com Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles My accounting courses are aligned with your accounting courses broken down by chapter and topics My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises Go ahead start your free trial today The general rule is to distinguish between CEP and AEP because the taxability of corporate distribution depends on how much Current and earnings are allocated to each distribution made throughout the year Now we're gonna have four different scenarios when it involves CEP and AEP So we need to understand what they are the first rule is or the first scenario is you have a positive CEP and a positive Accumulated earnings and profit. So I'm just gonna refer to them as CEP and AEP. What does that mean? It means this year you have a positive taxable income plus and minus the adjustment So basically the corporation made a profit and they have dividend ability for this current year and from prior year They do have prior year dividend ability. So any distribution made it will be considered dividend to the extent of EMP The second scenario you could have a positive current earnings and profit. So this year you have a positive taxable income and Plus or minus the adjustment so you have the ability to pay dividend from the current year But the front from the prior year you have a deficit and AEP in other words You made you don't have a positive AEP from prior year. You made a distribution again, what do you have to do here the amount of the distribution is dividend to the extent of CEP and You don't net AEP to CEP. So you have to be very careful here first. What you do you would say here's my distribution To the amount of CEP it's dividend and that's it Well, what if you pay more if you pay more? Well, if you pay more we learn this then it's gonna be return of capital which is Tax-free it's not taxable and if you pay more and you no longer have basis return of capital to the extent of basis It's considered capital gain and don't worry. We're gonna work many many examples in this session The third scenario you have a negative CEP. It means this year you're you're taxable plus or minus the adjustments is negative So this year you did not generate any dividend ability and you have a positive AEP However from prior years you have a reserve an AEP When you have a negative CEP and positive AEP under those circumstances you can net them Now why can you net them? Because what is CEP? CEP eventually closed to AEP what we're saying here is you don't have CEP CEP is negative Therefore if you don't have CEP go ahead and close it to AEP So you net them and the net amount you net the two number and if the number is negative if it's positive Well dividend to the extent of that positive number if the negative if you net them and you have a negative in other words You have a larger CEP negative than the positive AEP. You don't have any dividend well You don't have any dividend. It's ROC to the extent of basis then capital gain The fourth scenario and you know what the fourth scenario is it's negative CEP negative AEP You don't have any positive taxable income plus or minus adjustments and from prior years you don't have any Accumulated earnings and profit well the distribution that you make will be no will have no dividend Now again, we're gonna go over the order of distribution. This is important The distribution is dividend to the extent of CEP and AEP and it has to be in this order Once that's used up any Distribution made in access of CEP and AEP is considered return of capital to the extent of basis Once that's used up anything left is considered capital gain And we're gonna work many many different scenarios illustrating this concept Starting with the first one the first one basically we said we have positive CEP positive AEP We still have to know a little bit more about this if positive balance in both current and accumulated Distribution are deemed first from the CEP. So if you have positive CEP and positive AEP first you say I'm I'm taking money. I'm distributing money from the current year then once that's used up I'm distributing money from AEP which is both different, but first you use up CEP the current that's why it's called the current if the distribution exceeds current EMP You must allocate current and accumulated to each distribution. Let's assume you made a distribution And we're gonna see an example and that distribution in total a greater than CEP and AEP It's greater than both of them. So they are not enough So we have to see how to allocate this how to allocate this if CEP is positive allocate Current CEP on a prorata proportionally using a dollar amount if CEP is positive If CEP is negative what you have to do is you have to assume that we not we earned we We generated this negative with this loss Equally throughout the year. Therefore, we allocate negative CEP evenly. We allocate positive CEP Proportionally prorata. Don't worry. We're gonna work examples. We always allocate AEP chronologically Why are we saying this because you're gonna see in certain examples? We're gonna be making payments not by the end of the year We're gonna make him payments throughout the year for example mid-year or the first quarter Then how do we have to allocate the payment if we have positive and or negative CEP and AEP will work examples Start with a simple example We have shareholder a owns 100% of the company the company distributed $35,000 at the end of the year. We're assuming 1231 is the end of the year right now CEP is 30,000 AEP is 20,000 again. What do we say? How much of that payment is dividend? How much of it is a return of capital? How much of it is capital gain? Well of the 35,000 the first thing we're gonna say 30,000 is definitely dividend and that's gonna make CEP go down to zero. Well, we still have 5,000 the 5,000 is AEP comes from AEP and that's also dividend and we're gonna have remaining AEP of 15 so the whole payment is dividend Let's take a look at another example. We have 30,000 in CEP 5,000 AEP and we assume we're gonna have 11,000 in basis Here's what we did. We made a distribution two distributions one april 30th for 18,000 another distribution on november 30th of 22,000 so notice Both CEP and AEP are positive But we have to notice that we made a distribution total of 40,000 we made a distribution total of 40,000 But both CEP and AEP together they are 35,000 in other words We made the distribution but and but but it is in access of CEP and AEP Well since since CEP is positive what we're gonna do since CEP is positive It is positive. We're gonna allocate the payment from CEP on a pro rata to each distribution What is pro rata? What's pro rata? Well The pro rata is the first distribution is 18,000. It's 18 out of 45,000 out of 40,000 What's 40,000 the 18 plus 22 is 40,000. This is the total. So what we say is of the 30,000 of the first of the 30,000 of The 30,000 of CEP we're gonna assume 45 percent of it was up to april 30th Why? Because we assume that we earned 45 percent of CEP Based on the distribution based on the pro rata distribution 18 out of 40 which is 45 percent was distributed from CEP And the remainder the other payment Which is the distribution of 22,022 out of the 40 which will be that's going to be the ratio is 55 percent So simply put 13,500 Is taken out of CEP for the first distribution so the first distribution was 18,000 This is how much we distributed 18,000 on april at the end of april So how do we know how much of that from CEP? Well, we We use the pro rata 18 out of 40 18 out of the total is 45 percent. We assume 45 percent comes out of CEP well If the 18,000 13,500 of it came out of CEP Where's the remainder remainder coming from if we have AEP? It's gonna come out of AEP And we do have 4,500 remaining and that's gonna come out of AEP now the balance in CEP now is 16,500 the balance in AEP is 500 and both of those are considered what? Both of them are considered Dividend both of them are considered dividend now Let's see. What else do we have here? So actually we distributed not 18. We distributed. Sorry 30,000 Now we this no we distributed 18,000 the first on on april 15th. So what we did is we Made the distribution basically we allocated the distribution Now the return of capital still 11,000 we did not touch that Then we made a distribution on on November 30th. How much was the distribution? The distribution was 22,000 of this distribution was 22,000 Again, how much of that it's gonna come out of CEP? How much of that it's gonna come out of AEP? We know the second distribution we assume 55 percent comes out of CEP on november 30th. We made a distribution of 22,000 how are we gonna allocate this distribution first thing it's gonna come out of CEP How much it's gonna come out of CEP? Again, we're gonna make a we're gonna make this pro rata distribution 22,000 this is the total distribution out of out of what out of 40,000 22 out of 42 is 55 percent. That's it. This is the ratio. So out of this amount 16,500 comes out of CEP, which is once it does that it's gonna bring CEP down to zero So that's gonna bring CEP After the distribution down to zero. So notice we have 22,016,500 came out of CEP Then we have the next thing to see if we have AEP that we have 500 of AEP that's gonna come up come out of AEP That's gonna make AEP also go down to zero And both of these are dividend they're considered dividend Now we still have to account for 5,000 Okay, what happened to that 5,000? What do we consider this 5,000? That's remaining from the distribution Well, if we have basis, it's gonna reduce the basis that we have basis. Yes, we have 11,000 of basis Therefore the 5,000 comes out of the basis Now how much do we have basis after this distribution 11 minus 5 equal to 6,000 so at the end of the day we have In total in total zero CEP At the end of the year CEP is gone AEP is gone The amount of this total distribution is 35,000 considered dividend, which is 18 and 17 And we have return of capital of 6,000. Those are the total balances I'm sorry, uh, 6,000 Um, total balance is a total balance of 6,000 in basis and return of capital We still have a basis of five. Okay, and the dividend is 35 Let's take a look at this example We have negative CEP notice here. We have negative CEP Positive AEP and we have 10,000 return of capital We made a distribution on April 30th for 32,000 now. What did we say? When we have a negative CEP when we have a negative CEP and we have 12,000 We're gonna assume that we incur this loss Not pro rata based on the distribution. We're gonna assume this loss is spread evenly throughout the year Well, the number is 12,000 if we're gonna spread it evenly throughout the year over 12 month We're gonna assume that each month we operated we are going to account for a thousand Therefore when we made the first distribution on on april On april on april 30th. What do we say if we made the distribution on april 30th? We say we have negative 4,000 negative 4,000 on april 30th because From january till april 30th. It's 4,000. Okay, so Of the 12,000 we assume 4,000 is as of april 30th Which mean negative 4,000 now the question is when I when I when I when I when I do this in my In my life class I ask the students how much dividend is there and some says well the dividend is 13,000 Some say the dividend is 25,000 some say none because basically on this 32,000 So let's assume how do we compute the dividend under those circumstances? Well Let's see. So we're what we're gonna do first. We are going to bring down net 4,000 We're gonna assume c e p is negative 4,000 as of april april 30th And we have 25,000. Well, if we have negative and positive What do what do we do if we have a negative c e p and positive a e p we can net them therefore as of april april 30th at the end of april we have 21,000 21,000 why because we can net them We can net them now we start to make the distribution How much did we distributed on April 30th. We distributed 32,000. Well, if we distributed 32,000 We have a e p of 21 and what's a e p considered dividend. Let's start with that So we're going to use the a e p what happened to our a e p after the distribution a e p went down to zero And that's 21,000 Of dividend now we distributed 32 We used up you we used up 21 Well, it means we still have to account for the remainder of the payment. How are we going to treat this? But remember also c e p balance is 8,000 because was negative 12 we used up for We still have negative negative eight And now the remainder the remainder the remainder is how much the remainder is 11,000. We still have 11,000 out of the 32 Well, the first thing we're going to do we're going to reduce we have return of capital of 10,000 We're going to use up 10,000 Return of capital still going to remain 1,000 from the distribution because the distribution is 32 21 is a e p dividend 10 is roc, which is not taxable the return of capital and the remainder is capital gain of a thousand so all in all C e p at the end of the year will be zero. Why because c e p will be zero because we're going to transfer this c e p to a e p So this 8,000 of c e p doesn't stay as a 11 to 11 20 x 8 because it has to be closed now when we start the beginning of 1108 We're starting with negative with negative a e p. So we started with 25,000 a e p We made the payment we used that up And we said that's dividend we distributed then at the end of the year From the prior year from 20 x 7 we generated 8,000 negative c e p, which is transferred to a e p Also your bases are zero So next year when you make when you make a distribution, let's assume the following year the company did not have a positive c e p That's assumed. That's the case. They operated the business taxable income is negative plus or minus adjustment is negative negative c e p Any distribution they make it will be only capital gains because the bases are zero We're going to assume that no bases were created as well. So everything will be capital gain Let's take a look at this example. We have negative c e p and positive a e p we made a distribution on april 30th of 18,000 we made a distribution on november 30th Of 22,000 total of 40,000 c e p is negative c e p is negative When c e p is negative, what do we have to know if c e p is negative? We allocate We allocate the loss Over equally over the year now since it's 12,000. That's easy. We're gonna allocate the loss over 12 So that's easy And when do we net them because we have negative c e p positive a e p? We are allowed to net them under this scenario. We net them At the time of the distribution, okay Therefore the first four month is we have a loss of 4,000 again 12,000 divided by 12 By this by the november distribution We have seven months seven thousand of losses And by the end of the month by the end of the year for the month of december We're gonna have a negative loss. So these losses equal to 12,000. This is the c e p that we said Was incurred evenly throughout the year. Let's go ahead and start to allocate this This distribution well the first thing we do we're gonna we're gonna say we're standing as of april 30th as of april 30th We have a negative 4,000 c e p and positive a e p of 24 if we have negative c e p positive a e p What can we do? We can net them. So I'm gonna net them. So I'm gonna transfer this 4,000 To a e p and makes a e p now 21,000 on this date. We made a distribution of 18,000 great The a e p will be able to to absorb all the distribution. So out of the out of the 18,000 all of it is dividend All of it is dividend all of it is dividend And we have 3,000 remaining in a e p now we're gonna fast forward till 11 30 by 11 30. We assume we incurred 7,000 of losses now we have 7,000 of losses on c e p and 3,000 of a e p negative c e p positive a e p What do we do? We net them. So we're gonna positive c e p to transfer to a e p when it's transferred to a e p. It's going to give us a e p of negative 4,000 now now c e p is zero as of 11 30 A e p is negative 4,000 now we made a distribution of 22,000 well of the distribution how much of it is dividend nada. We don't have any dividend because we don't have any A e p a e p is negative So 10,000 of it is roc because we have return of capital of roc now the basis is zero And guess what what do we have to do with the remaining 12,000 the remaining 12,000 is Capital gain now then by December we have an additional By December we have an additional c e p of negative 1,000 Maybe you cannot see it but at the end negatives negative 1,000 and what's that going to do? That's going to be close to a e p and a e p at the end of the year will be negative 5,000 because negative c e p is transferred at the end of the year to a e p a e p is already negative It's going to be negative a e p of 5,000 Let's look at another scenario where c e p is positive c e p is positive And a e p has a deficit negative now Again under those circumstances. We don't net them out. We don't net them out. We net them out under scenario 3 We don't net them out Distribution is deemed taxable to the extent of positive earnings and profit. Let's take a look at a few examples We have this example Corporation distributed 75,000 and we have stock basis of 10,000 we have stock basis of 10,000 well If we have a positive c e p we assume that The of the 75,000 30,000 is c e p which is dividend which is dividend And how about the remainder? Well the remainder what's going to happen is we're going to eat up of the 75,000 It's going to eat up the basis the basis now are zero which is this is this distribution is tax free and anything left Is capital gains, which is 35,000 so simply put of the 75,000 30,000 is dividend 10,000 is our oc return on capital not taxable And this is 10 k and the remainder is 35 k. This is how we distributed this This this 75,000 let's look at scenario 3 and scenario 4 If accumulated EMP is positive and current is negative at the date of the distribution You can net them out you can net them out Okay, and we did this earlier if balance is zero or deficit Distribution is return of capital if the overall you know if we don't have a e p or n c e p when we net them It's zero if it's positive. It's it's dividend to the extent of the balance in In a e p. Let's look at an example At the start of the year slate ink a calendar year taxpayer has accumulated EMP of 10,000 accumulated Of 10,000 so c e p is The corporation experience a deficit in c e p c e p is negative 15,000 And a e p Is positive 10 Okay positive 10 a e p is positive 10 on july 1st notice in the middle of the year slate distributed 6,000 of cash to rebecca rebecca has a basis of 7,500 and we have a basis For rebecca of 7,500. Okay What do we do? We're gonna go to july 1st and net them out Okay, what do we net them out? Do we net the 15,000 plus 10? No, we're gonna assume c e p is incurred evenly So as of july 1st, which is the middle of the year we have negative We have negative 7,500 of c e p. So negative c e p Plus a e p we net them out as of july 1st when we net them out We net half of c e p because we assume that as of july 1st. We have losses of only 7,500 overall We still have a positive a e p. Well, if we made a distribution to rebecca of 6,000 of the 6,000 We're gonna say 2,500 is dividend And the remainder is return of capital Now rebecca's balance after that will be 4,000 because what we did is we reduced her basis by 4,000 therefore her remaining basis is 3,500 Okay, now a what happened to a e p a e p is A e p is down to zero now. Why because remember what we did is we said As of july 1st, we have negative 7,500 that Reduced this to 2,500 then of this 2,500 we use 2,500 to become dividend now a e p is zero by july 1st Assume now the current deficit in rebecca's account is 30,000 if we assume rebecca's deficit Is 30,000 not 15 When we get to july 1st, we're gonna take 15,000 Out of c e p and close it to a e p a e p is only 10 that's gonna make a e p negative 5,000 well if a e p negative 5,000 and we distribute at 6,000 None of that 6,000 is is dividend because a e p is negative None of it is dividend and out of the 6,000 she only has a basis Of 7,500 so we're gonna reduce the basis from 7,500 reduce the basis by 5,000 On rebecca basis is reduced to zero from 5,000 We're gonna assume that her be her basis is zero two we're changing the scenario here We're changing assume her basis are 5,000 if her basis are 5,000 and we distribute at 6,000 Well the 5,000 would reduce her basis to zero and the 1,000 remaining will go into capital gain Now assume the deficit in a e p is Is 10,000 now we're assuming here we have a deficit in c e p and a deficit in a e p Well the same scenario there's no dividend and Her basis will go down to zero and everything else will be capital gain Let's take a look at more examples. Let's assume we have the shareholder C e p is 30 a e p is Negative 20 do we net no we don't we only net when it's the opposite Corporation distributed 20,000 good 20,000 it's come it's gonna come out of c e p We have plenty of c e p and we're gonna have 10,000 left in c e p and that 20,000 is dividend because it's coming out of c e p and we still have a e p of 10,000 20,000 now by the end of the year what's gonna happen this a e p Is transferred the c e p is transferred to a e p Plus and our e e p for the following year is negative 10,000 because and c e p will be zero at the beginning of the year We talked about this in the prior session in this example. We have c e p of 30,000 a e p of 20,000 and we have roc basis of 10,000 We made a distribution of 75,000 of the 75,000 30,000 will be absorbed as c e p as dividend 20,000 will be absorbed as a e p also a dividend And this is the balance for both of these will be zero because we use them up now of the 75,000 that we distributed 50,000 is considered dividend what remain is 25 out of the 25 10,000 will be absorbed to return of capital to the basis and the basis is zero And anything remain which is 15,000 is considered capital gain. Let's look at another example We distribute at 75,000. We have positive c e p negative a e p return of capital is 10,000 Of the 75,000 we don't net don't net now. We don't net 30,000 is absorbed under c e p And make c e p equal down to zero and all of it is dividend all the 30,000 is dividend Well of the 75,000 30,000 is absorbed into c e p And 10,000 it's going to be absorbed into the basis. We have a basis of 10 And anything left is return of capital 35,000. Let's take a look at another example We have negative c e p positive a e p return of capital is 10,000. We made a distribution of 75 What do we do now? We net we net because we have negative C e p positive a e p we net them when we net them we have a e p what remain a e p as 5000 Now 75,000 of that amount we're going to say 5000 coming from a e p as dividend. That's fine That's going to make a e p go down to zero and What else do we have to do? We don't have any dividend anymore. We look at Basis we have 10,000 of basis 10,000 will be absorbed as basis tax free to the shareholder And anything else that remains after the 10,000 Is Capital gains, which is 60,000. So of the 75,000 just to kind of go back and summarize 5k is dividend 10k is ROC return of capital and the remainder is Capital gains What should you do now? You got to go to far hat lectures and work additional mcqs through folds That's going to help you understand the difference between current and accumulated earnings and profit in determining How much of the cash distribution from a corporation is dividend? How much of it which is dividend taxable? How much of it is return of capital which is tax free and how much of it is Capital gains. This is an important topic whether you are a CPA exam candidate an enrolled agent or an accounting student Good luck. Study hard and of course, stay safe