 Hello and welcome to the session in which you would look at the CPA exam simulation that illustrate the concept of determining whether a distribution, whether a cash distribution is considered dividend or return of capital. Remember, dividend is taxable to the shareholder while return of capital is tax free. Now, how do we determine whether a distribution is taxable, which is dividend or return of capital tax free? It all depends on how much accumulated earnings and profit and current earnings and profit we have. So we're going to look at five different scenarios and determine whether the contribution, whether the distribution is taxable, return of capital, or it could be something else. If return of capital is not enough, then it's called capital gains. So this is a quasi CPA simulation. You are giving the AEP, you are giving the CEP, you are giving the cash distribution and you have to determine whether it's dividend or not. Let's go ahead and get started. Before we proceed any further, I have a public announcement about my company, farhatlectures.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. Starting with the first scenario for scenario A. Accumulated earnings and profit is negative. What does that mean? It means from prior years, the company did not have any accumulated earnings and profit. It's negative. It means they distributed more than what they kept, but the current this year, they have $50,000 of current earnings and profit. So this year, they made a profit taxable income plus and minus the adjustment, their current EMP is positive. The company distributed $110,000 in cash. How are we gonna treat this cash disbursement? First thing you need to know, when AEP is negative and CEP is positive, you don't net. So you don't net them. So what we do is this. We say, okay, of the 110, we're gonna first treat the first 50 coming from CEP. So the first 50 is dividend. So since it's coming from CEP, it's dividend. And what's left is 60,000. So we made a distribution of 60,000. Our CEP went down to zero because we used that up. So the first 50 is dividend. What about the remaining? The remaining is capital return of capital. Notice 50 plus 60 equal to 110. Let's take a look at scenario B. In scenario B, we have a positive AEP and a negative CEP. When we have a positive AEP and negative CEP, well, think about it. What is CEP? CEP eventually goes to AEP. Well, we don't have CEP. We don't have current earnings. That's already negative. Well, if it's already negative, we close it to AEP. What does that mean? That means the first thing you do when you have a positive AEP and negative CEP, you net them. And if you net them, if we said plus 130 minus 100, what we're left with is 30,000. And that's the only amount of dividend we are going to have. Therefore, if we distribute it 210,000, 30,000 of it will be dividend. And the remainder, it's not dividend. What is it? It's return of capital. Therefore, 30,000 is dividend, which is taxable to the shareholder. 180 return of capital. Let's take a look at the third scenario, C. Positive AEP, positive CEP. And we distributed 170,000. Well, guess what? We have plenty of CEP and AEP. But first, what we do, just kind of make sure we are in order. First, we take 170 minus 80 CEP. And what's left is 90. And we have 90. We're gonna take out the remaining 90 from AEP. So it's simply put, we have 10,000 and AEP remaining after the end of the year. Therefore, the full amount is dividend. None of it is return of capital because we had plenty of AEP and CEP. As a matter of fact, we still have AEP of 10,000. Let's take a look at scenario D. Scenario D, we have a positive AEP, negative, positive AEP, negative CEP. What do we do when we have those? When we have those, we can net them. We can net them because CEP end up an AEP and we have no CEP, we have negative. Therefore, we net them. If we net them, what's gonna end up happening? We're gonna end up with 50 AEP. So we made a distribution of 170. Well, 50 is dividend and remainder is return of capital. Now, let's change the scenario a little bit here. Let's change the scenario a little bit. And let's assume D was distributed. The distribution was made on July 1st. What is July 1st? July 1st is mid-year, which is July 1st is the beginning of July, which is exactly the mid-year. Whether it's, we said end of June or July 1st, they're both considered mid-year. When this is considered mid-year and we have a negative CEP, negative CEP, what did we learn about if we have negative CEP? We assume that we not earned, we experienced that loss evenly throughout the year. Well, if we experienced 70,000 of losses and the current here, we assume as of July 1st, we have 35,000 of losses. So we're gonna take the 35,000 of losses because we are making the distribution on July 1st and we're gonna net it out with the AEP. AEP, we don't evenly distribute, we don't relatively distribute, it's in chronological order. Therefore, what we do is we net them and what we do is we have, as of July 1st, we say we have 85,000 of AEP, which is, it could be considered dividend, okay? And basically, AEP is gone because we net it against the 35,000 of CEP. Therefore, when we made the distribution of 140,000, 85,000 of it will be dividend and the remainder of it, which is 55,000, will be return of capital. And by the end of the year, we're gonna have a CEP of an additional 35,000, which will go into AEP, will go into an AEP and AEP will be negative 35 because CEP will have to be closed out. Let's take a look at another example that's much, much simpler. I should have started with this example, but I think it's benefit to work both examples. That's assuming we made the cash distribution of 30,000 under three different scenarios. So those are three separate scenarios. Accumulated AEP is 100, current CEP is 50, so we have plenty. So what do we do with this 30,000? The whole 30,000 will be dividend because this is, we have plenty. But remember, just kind of make sure we understand this. Of this 50, first we take it out of CEP, okay? So what we have is 20 of CEP at the end of the year and this 20 CEP gets added to the 100 of AEP. So at the end of the year, we have 100 AEP because what's left of that 50 is 20 and it's close to AEP. Let's look at scenario two. Scenario two, we have 100 negative and 50 positive, but we have to be careful. The positive is CEP. If the positive is CEP, we don't net them. Well, what's gonna happen? The same concept basically first, we'll take the 50,000 of CEP and we used 30,000 out of it as dividend. We have left 20 positive CEP. That 20 positive CEP, it's gonna make ending AEP negative 80 because it's gonna reduce it, okay? But of the 30,000, the whole amount is dividend. Let's take a look at the third scenario. We have positive AEP, negative CEP. When we have positive AEP, negative CEP, we can net them. Again, why do we net them? You can memorize it, but remember, CEP eventually goes into AEP. Well, there's no CEP, CEP is negative. Well, if it's negative, close it to AEP and reduce AEP. Now we have, what do we have? We have 5,000 AEP, therefore the only amount of dividend we have is 5,000. And what happened to the remaining 25,000 for scenario three? If we have basis, it's return of capital. If not, it's capital gains. I hope those two exercises illustrated the concept of accumulated earnings and profit when it comes to cash distribution and current earnings and profit when it comes to corporate cash distribution. We have to determine how much of the cash distribution from a corporation is considered dividend. And remember, dividend is taxable. It's dividend to the extent of CEP and AEP. Once we used up CEP and AEP, then we have return of capital, ROC, which is not taxable. Once we don't have any basis remaining, what we do is then we look at the transaction as capital gains. What should you do now? Go to Farhat Lectures, look at the additional MCQs, additional simulations, exercises, lectures, through false questions that can help you understand these concepts better. Good luck, study hard and of course, stay safe.