 Hello and welcome to this session in which we will discuss distributions from corporation What's the big picture? Well when the corporation was formed by the shareholders It was formed by shareholders contributing money and property to form the corporation and remember in the prior session We looked at section three five one when we said if this transaction is under section three five one It's not taxable in return the corporation issue stocks to the owners simply put these individuals Become owners in this corporation. So this is how the corporation is formed at some point Money will start to flow also the other way From the corporation to the shareholders in form of distribution Now, why would that happen? Well, think about what what was the original motivation for the shareholders? Why did the shareholders invest it in the company? Why do you invest? You invest to earn money to earn cash. How do you earn the cash? The company Operates for example every year they prepare an 1120, which is the tax return. They list their revenues They list their expenses and hopefully the company will earn a profit. They will have more revenues than expenses What's gonna happen? Part of that profit Will be a distribution to the shareholders now notice I am being specific and using the term distributions because not all distributions Will be dividend so notice distribution is not the same of dividend because the first thing we are going to discuss is The three types of distribution. We're gonna have three types of distribution Knowing what type of distribution we are dealing with will determine its the tax consequences of that distribution So, let's go ahead and get started by discussing the three types of distributions Before we proceed any further. I have a public announcement about my company farhat lectures comm 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 through false questions as well as exercises Go ahead start your free trial today. The three types of distribution are first is dividend To recovery of capital three capital gain So any distribution might be classified under any of these categories and there are different tax consequences So we're gonna learn what each category is and how do we determine whether a distribution is dividends? Recovery of capital, which is we're gonna abbreviate as ROC or capital gains. What is dividend? Well, the dividend could be cash dividend so they can pay you cash Dividend dividend they could give you a property dividend some sort of a property or they could give you additional stock in proportion To your current Position so if you own 10% and they distribute 100 different stocks You'll get 10 of them and we're gonna talk about each one of those separately in a separate session whether it's cash property or stock How do we tax dividend? Well, it's a long-term Capital gain which is at the alternative rate as long as the dividend is considered a qualified dividend and what we mean long-term capital It could be zero 15 or 20% I hope you know this otherwise go to the Alternative rate or qualified dividend rate or the dividend is could be ordinary dividend, which is non Qualified dividend and if it's non qualified dividend guess what it's taxed at the ordinary rate The ordinary rate is the highest level of dividend Did the distribution might be considered recovery of capital? What is recovery of capital? Recovery of capital means we are giving you your money back Do you remember here at some point we contributed at the beginning when we formed this corporation? We contributed cash and property what we're saying here if it's considered ROC This distribution is giving you back your money and if we are giving you back your money That's a recovery of capital recovery of capital is not taxable. It's a recovery of the basis. It's a tax-free transaction now If it's not dividend if it's not recovery of capital, we're gonna see what determine whether it's a dividend or recovery of capital shortly Then it's capital gain usually it's long-term capital gain It's also taxed at the long-term capital gain alternative rate Which is the same thing as qualified dividend and why when is it capital gain? We're gonna have to determine when for each one. Now, let me tell you from a motivational perspective What do investors prefer? Well investors would prefer the least the distribution to be classified as a dividend So as a shareholder, they don't want the distribution to be Classified as a dividend. Why because if it's ordinary dividend, it's gonna be ordinary income If it's qualified dividend, they will have you know a lower rate nevertheless, they have to pay taxes on it So this is the least is a desirable category by the shareholder IRS knows this IRS loves to classify every distribution as Dividend well, what's the most desirable one for shareholders? You guessed it recovery of capital if the distribution is considered recovery of capital It's tax-free not tax-free tax Free and other words you are not paying any taxes because they are giving you your money back and shareholders loves it IRS hates it and in between second most desirable for for shareholders is capital gain because capital gain we know it's if as long as it's long-term We assume it's long-term. It's taxed at the alternative rate, which is 0 15 or 20 percent Now we need to know what's gonna determine whether a Distribution is dividend recovery of capital or capital gain in order to learn this we have to learn about certain terms Starting with a term that we called current earnings and profit That's gonna lead us into something called EMP earnings and profit. So we're gonna look at something called Current earnings and profit which can lead us to something called earnings and profit. What is earnings and profit? Earnings and profit is the company's accumulated capital. What is that? So this is a new term earnings and profit What is earnings and profit? Think of it as retained earnings from financial accounting What is retained earnings from financial accounting? Think of it. It's not the same think of it and you're gonna see why in Financial accounting what we do is we generate revenues then we deduct the expenses and hopefully we have net income What's gonna happen to that to that net income net income goes into? Retained earnings and in other words, we're gonna keeping this income unless we paid in dividend And if we paid in dividend, we're gonna deduct the dividend then we're gonna have some retained earning left Then the following year what we do is we generate revenues Minus expenses we get net income again and that net income will be added to beginning retained earning and if we don't pay Dividend again the processor beats itself. So this is what retained earning the earnings that we are keeping retained earnings Now in taxation, we have this term called earnings and profit earnings and profit again Think of it as retained earning, but it's not the same. What is it then? It's the company's ability to pay dividend without impairing its capital. What does that mean? It means What is the company ability? What is the ability notice the ability? Do they have the ability do they have the capacity to pay dividend to pay you dividend without touching the money that you sent them? The money that you contributed to them. Well, where does the money come from if you did not contribute it to the company? Where is it coming from? Well, it's coming from their earnings Well, okay, then that's easy then what you're telling me earnings and profit is the same thing as taxable income. No No, why because you're gonna see many reconciliation But let me give you an example quick example to kind of scratch the surface here Think of money bond interest income when we prepare our 1120 when we prepare our 1120 We're gonna report all our revenues minus the deductions and we're gonna get to a profit of 100,000 including in this revenue was 300,000 of revenue but the company also had for the sake of illustration 10,000 of Munibod and Munibod interest income Well, hold on a second. They only reported 300,000 of revenue But they also received a check from a state government for interest rate interest income that they received Well, this 10,000 is not included in this 300,000 because it's not taxable. It doesn't go on form 1120 Well, nevertheless, we receive the money So that's why what we say earnings and profit is the economic ability to pay dividend Therefore what we have to do we have to go with okay if taxable income is 100,000 Now we're gonna do we're gonna add to it the $10,000 of municipal bond that we did not Account for now. This is I gave you the simple adjustment But there's gonna be many many adjustments some of them are pluses some of them are minuses to come up to Earnings and profit. So this is the point. It's not only taxable income. It's more than taxable income It's the capacity to pay dividend and there are two categories of to earnings and profit current earnings and profit C EP and AEP accumulated earnings and profit. So we have to understand what is CEP? What's current earnings and profit and what's AEP? Well, if you understand what CEP is You're gonna easily understand what AEP. So let's discuss CEP and Accumulated earnings and profit. Well, what is CEP? CEP is I told you we start with taxable income That's the starting point Then what we do we have to have some reconciling item and we're gonna spend few minutes discussing the reconciling item Sometimes we're gonna add the taxable income. Sometimes we are going to deduct from taxable income. So current earnings and profit Reflect the effect of current earnings operation on dividend-paying capacity So CEP tells you how much from this year you increase your dividend capacity Or you reduce your dividend capacity. Usually if you if you made a profit you increase it usually Here's what's gonna happen to CEP CEP at the end of the year is closed to AEP So what does that mean? It means whatever? CEP we have at the end of the year. We have to close it down to zero and goes into AEP therefore the beginning of CEP every year is zero. Why is it zero? Because whatever is left at the end of the year. It's closed into AEP What's AEP? Accumulated. What's what's accumulated? It's undistributed earnings from prior years and this could go back as far as I believe early the 1900 I'm gonna see the specific here on the next slide. So undistributed earnings from prior year It means how much the company is keeping in profit from year to year Not only in profit and dividend-paying capacity because remember AEP is the accumulated of CEP So dividend capacity from prior years. This is where it's parked in AEP now. Let's Discuss now a little bit more in specific Current earnings and profit CEP. How do we compute CEP? And this is the heart of this session how to compute current earnings and profit Well, always we're gonna start in theory the balance at the beginning of the year is zero Why it's zero because we're gonna close this account at the end of the year So we're gonna start with taxable income whatever taxable income is coming from 1120 We're gonna look at the 1120 you're gonna be giving taxable income then we are gonna be making certain adjustments to taxable income We're gonna call these reconciling item. So we're gonna go from beginning CEP, which is basically zero Corporate taxable income plus or minus certain item end up with Current CEP now if we pay any dividend, let me just real quick if we pay any dividend from CEP We're gonna deduct that dividend and whatever's left from this number. Whatever's left. Whatever's left from this number goes to AEP Accumulated earnings and profit. There are two type of reconciling items that we have to be familiar with and we're gonna look at them in Examples some items are Execluded from taxable income that does affect current earnings and profit There are certain items that you don't see and the tax return. You don't see on the 1120 They're not on the 1120, but they affect your ability to pay dividend Those items could be pluses. Those items could be minuses. What could be some examples? I already told you tax exempt income like municipal bond You don't see it. You don't add it as revenue on The 1120 but it is indeed revenue you receive the money, but it's not taxable Life insurance proceeds if it's for the benefit of the one of the executives If the company received this it's a plus you have to add Federal income tax refund from prior years. This is called like a time in adjustment. So from the prior year You overpaid your taxes now. They're giving you the money back Well, if they give you the money remember you did not deduct the federal income taxes Now you don't have to include it in federal income because it's a refund. You receive the money you add it What do you deduct? Well access charitable contribution? Remember when you make a charitable contribution Let's assume you made a million dollar worth of a charitable contribution of that one million dollar You might be able to deduct eight hundred thousand only because that's ten percent of your taxable income You are limited. Well, but you wrote a check for a million. Well, it means you have to deduct an additional 200,000 although it's not on your 1120, but I did make that payment Now you're gonna see that this access charitable contribution when you deducted later this 200,000 It's gonna be a positive adjustment because you deducted it from a prior year now You're taking a deduction without paying. We'll look at an example Federal income taxes is the classic one. This is the classic example. What do I mean by classic example? Remember when you file your form 1120 you're gonna have to pay your income taxes. Let's assume your income taxes are 150,000 so you wrote a check for 150,000 to the federal government and you send it with your return But if you look at your 1120 at your form 1120 tax form, you never deducted this money You cannot deduct your federal income taxes on your federal income tax return. Da, this is your bill for that, right? But did you pay it? Sure? I paid it. Therefore, what do I have to do? I have to deduct it when I'm computing my current earnings and profit Interest that you paid on tax exempt interest. Well, remember tax exempt income is exempt It says exempt well interest on tax exempt interest also not deductible Well, it's not deductible, but you did pay it. Therefore you have to deduct it same concept applies to fines Penalties and lobbying cost all these payments that you made for fines Penalties and lobbying cost they are indeed real money. You wrote a check for them But you could not deduct them on your 1120 therefore what they all do they reduce your dividend paying capacity There are also other items included in taxable income that does not affect CEP I'll give you an example the dividend received deduction when you prepare your form 1120 and you did if you received dividend The government gives you a deduction a deduction called the dividend received deduction that deduction reduced your taxable income Why because it's a deduction but that deduction you did not pay a penny for it. It's given by the government therefore what you do is you The add that your dividend receive deduction because it reduced your taxable income without reducing your dividend paying Capacity now the best way to illustrate all these concepts is to work a series of examples I'm gonna start with with a simple example To show you how to compute current earnings and profit because current earnings and profit goes into determining your earnings and profit Which is very important in determining once you determine earnings and profit. It's gonna help you determine whether that distribution is Dividend recovery of capital or capital gains So I just want under I want you to understand why we are going through all this trouble to to understand one concept It's important. Let's start with the first example Phoenix paid $80,000 in federal income taxes and also earned $4,000 in tax exempt interest from the state of Florida bonds So that's what they did to compute current earnings and profit We're gonna start with their taxable income whatever their taxable income is and what we're gonna do from this amount Let's assume it's a million just kind of I should have gave you a taxable income It's a million then I would say well They paid 80,000 in federal income taxes, but that 80,000 was not deducted from the million I'm going to deduct the 80,000 now, which will make their Current earnings and profit 920,000 this is their dividend paying capacity. So they did pay it. It's real money, but it's not deductible Then we're gonna add to that $4,000 from the interest received from the state of California, Florida So their current earnings and profit for that year 924,000 and this is goes into their earnings and profits of they pay anything from this amount for that year any Distribution the distribution we're gonna see later. It's considered dividend again. Think of the form 1120 Those two numbers are not on the form Well, but we did make the payment and we did receive the money. This they're not on the form Let's take a look at another example Raven Enterprises transfer a property with a basis of 20 to its only shareholder for 15,000 so they have something for 20,000 they give it to the shareholder and the only shareholder. Is this a related party transaction? Yes Now, what does that mean? It means the company cannot take the loss as per section 267 Cannot take the 5000 loss when determined taxable income. Why because the transaction is between related parties Did the company lose 10,000? Yes, they lost 5,000 worth of asset. Okay Giving the overall economic impact of the transaction 5,000 is decreased in net asset. This loss minimizes current earnings and profit For the sale years basically you lost 5,000, but you cannot record this 5,000 So I lost 5,000. I could not deduct. I'm gonna reduce my current earnings and profit because it reduced my current Capacity to pay dividend my current earnings capacity to pay dividend Sometime what we have is called timing adjustment a charitable contribution is a classic example So let me give you this example and see how it works during 20 x3 for hat makes charitable contribution 18,000 which of which cannot be deducted when figuring out taxable income for the year Why because remember there is there's a 10% limitation of taxable income as a result The 18,000 carried forward to 20 x4. So I made the contribution I could not deduct it in 20 x3. It was fully deducted in 20 x4. Now, remember I have 20 x3 I have 20 x4 in 20 x3. I could not deduct this contribution So I'm gonna arrive to my taxable Income whatever my taxable income was and what I'm gonna do to compute my CEP I am going to deduct the 18,000 and that's gonna give me my CEP for 20 x3 What happened is in 20 x4? I was able to deduct this 18,000. I deducted this 18,000 to arrive to my taxable income It's 18,000 that was deductible. I arrived to my taxable income. Well in 2018 It was deducted, but I did not really wrote the check in 20 20 x04. So what do I do? I will add the 18,000 to my taxable income to come up with 20 x4 current earnings and profit. So this is called the timing adjustment Why? Because the excess contribution Did affect my 20 x3 Earnings and profit And also affected negatively the fact that negatively 20 x3, but it affected it positively in 20 x4 when it was permitted to be deducted without me writing the check in that year So no, remember I wrote the check in 20 x3. I took the deduction in 20 x4 It doesn't matter. We have to understand this timing adjustment That the same concept would apply to net operating loss and capital losses carry over you're gonna take them in different years Make sure which year you deduct them to add them back sometime what's gonna happen with CEP is you have to make certain Accounting method adjustment Because when you compute CEP you might have to use different rules think of CEP as using different Accounting rules and we have to look at few accounting different accounting rules That's not all of them at some point. I will have a list of all the adjustments, but let me show you a few accounting rules The installment method is not allowed for EMP calculation So if you sell something and you said I'm gonna be using the installment method That's not allowed. What's gonna happen for that year? You're gonna assume that you received all the amount So it's not allowed an adjustment is required for the third gain from annual property sales under the installment method Simply put the installment method means you made a sale today this year So you made the sale, but you are going to receive receiving the money the next three years year two Year three and year four you made the sale in year one Well, guess what? Although you're gonna be receiving the money in year two year three and year four. We're gonna for CEP All the principal payment considered in the year of sale. So we'll look at an example, but this is what I want you to know It's not allowed. You say I'm using the installment method. It does not matter also for Earnings and profit when you compute earnings and profit you cannot use maker. So if you have any depreciation You have to Recompute your depreciation using the alternative depreciation rate ADR will work an example Also section 179 deduction is spread over five years So if you took a section 179 deduction for tax purposes, they're gonna say no way You cannot take the full deduction for EMP. What you have to do is you have to only take Prorated over five years It means every year you have you can only take 20% of the deduction for the purpose of C EMP which we will look at examples Also, you cannot take first-year depreciation. So if you took a first-year depreciation, you have to make an adjustment for that It's not allowed for CEP. The best way to illustrate all of this is to look at examples Let's assume starting with the installment method and 20x3 Sparrow company a calendar year taxpayers sells a track of unimproved land for 180,000 the basis in the property is 40,000 For the terms of the sale Sparrow would receive 100,000 and x4 80,000 and x5 along with the interest of 5% and Sparrow does not up out of the installment method. They want to use the installment method now remember I don't care what they use for tax purposes. They want to use the installment method. That's fine But when I'm computing my CEP, I have to assume what I have to assume the whole sale took place in 20x3 Since Sparrow taxable income for 20x3 won't reflect any gain from the sale the corporation must make 140,000 positive adjustment Hold on a second. The sale was 180. Why is it 140? Well, that's the deferred gain Remember we sold it for 180 the basis was 40,000. So we have a gain of 140 what's gonna happen? We're gonna take this gain and say this is a positive adjustment to CEP hold on a second But it's not in my taxable income. I don't care as far as dividend-paying capacity. You made the sale Now what else do we have to do now? We have to compute the gross profit margin on this transaction So we made a profit of 140 on a sale of 180 the profit margin is 77 point seven eight Rounding rounding. This is rounding. It's seven seven seven. It's rounding. So here's what's gonna happen in 20x3 in the year of sale nothing was taxable remember because you're using the installment method under the Installment method you wait until the payment is made and you compute your taxes if you don't know the installment method You gotta you gotta know this but for EMP purposes I Have to add It's added therefore I have a positive adjustment for the year of the sale although I did not receive a penny yet But installment method those are the rules. It's called an accounting adjustment for 20x4 you received $100,000 the first $100,000 how much of that $100,000 is taxable? Well, remember you receive a cash of 100,000 the profit on this is seventy seven point seven eight It means on your taxes. You are going to report seventy seven thousand seven hundred and seventy eight Dollars in profit. That's taxable. That's a great. It's gonna go on your W2. It's gonna increase your taxable income in That year in 20x4 you have a negative adjustment because you already added all the profit from this Transaction in 20x3. Therefore you have a negative adjustment of EMP for 20x4 20x5 you received $80,000 you received $80,000 in 20x5. Well, if I received $80,000 for tax purposes I'm gonna multiply it by the gross profit percentage for this sale Which is seventy seven point seven eight rounding and that's gonna give me a profit of sixty two thousand two hundred and twenty-two dollars Boom that goes on my W2. I have to pay taxes on that on my EMP I have to deduct this sixty two thousand two twenty-two because this whole amount was Added to EMP in the year of sale. So notice If you add those two they should equal to one hundred and forty thousand just FYI Let's take a look at a depreciation adjustment because that's important. Remember. What do we have to use? We have to use ADR. Let's assume on January 2nd silver spent fifty thousand dollar to acquire an equipment With an ADR midpoint of ten years and makers class life of seven So for makers, it's gonna be seven years for ADR It's gonna be ten years. We're gonna spread over more years. It's more conservative. You're taking less deduction The equipment was depreciated under makers and the asset was sold on July 2nd x3 So x so we kept it x1 full x1 x2 All the way till mid x3 and we sold it for forty five thousand now Let's compute the depreciation for both. So now I'm assuming here, you know how to use makers Obviously you should okay. So now for twenty x1 will take fifty thousand times year one makers for seven year fourteen point two nine The depreciation for makers is seven thousand one hundred and fifty. So on your form eleven twenty you took a deduction of seven thousand one hundred and fifty great For the For ADR, it's fifty thousand divided by ten Then it's considered mid-year. So it's ADR mid-point life times one half you took a deduction for ADR not ADS ADR of 2500 here's what you did you took an access deduction You took you took too much deduction You took too much deduction for makers because you took seven thousand one hundred and fifty What we're saying is since you took too much deduction for makers We're gonna add back 4645 the difference in the depreciation method for year x2 take fifty thousand times Year two seven year maker rate 24 point four nine for makers you took 12245 for the ADR method it's fifty thousand divided by ten we have a full year we took Five thousand once again you took for makers you took too much deduction twelve thousand two hundred and forty five We're gonna have a positive adjustment of seven thousand two hundred and forty five for twenty x3 We took fifty thousand times seventeen point four nine and it's gonna be eight thousand seven hundred and forty five Then we are going to take five thousand divided by ten times one half Which gonna be two thousand five hundred because it's a mid-year. We sold it mid-year so all all in all the depreciation is For makers total of twenty eight thousand one thirty five the depreciation for ADR is Ten thousand the difference between them overall we had a positive adjustment of eighteen thousand one hundred and thirty five Now bear in mind for twenty x3. We multiply this by one half. I don't have the one half here But we multiply it by one half now When we sold it remember when we sold this asset we sold it for forty five thousand So what does that mean? It means we have to compute the proceeds amount realized minus the adjusted basis under each method well The amount realized whether it's for income tax or for EMP purposes It's 45,000. This is how much we received for this asset Then we are going to do what deduct the adjustment the another adjustment the adjusted basis Well, what is the adjusted basis for income tax? Well, the asset has a cost of one fifty thousand. We already took twenty eight thousand one thirty five Therefore the adjusted basis is twenty one thousand eight sixty five. So we made the profit of Twenty three thousand one thirty five Why because the basis is twenty one thousand the difference between the amount realized and the basis is the profit now for ADR We the the cost was fifty thousand we only took ten thousand of the appreciation the basis the adjusted basis Is forty thousand forty five minus forty thousand we have a profit of five thousand There's a difference in the profit between the income tax and AEP Well, if we compute the difference in the profit guess how much it's going to be it's going to be eighteen thousand one thirty five And that's going to be a negative adjustment. So notice as we were depreciating the asset We had a positive adjustment of eighteen thousand one thirty five, but that positive adjustment was recaptured when we sold the asset Why because for income tax purposes, we have a higher profit for income tax purposes We have a higher profit. Why do you have a higher profit? Because the basis is higher that we have a higher basis So therefore we have less profit for for EMP. We have a higher we have We have lower profit because the basis was not eroded. We only eroded five thousand of the basis well, we have a negative adjustment because It we recaptured the depreciation when we when we make the sale Let's take a look at section 179 remember section 179. What do we have to do when we have section 179? We have to spread the expense over five years for CEP on January 2nd a zoo for a five-year depreciate the appreciable asset into service the purpose the purchase price was 50,000 and the company claimed section 179 for the entire amount. Well, it's five years starting with x2 and year x2 They for tax purposes, they took the deduction. They happily took the deduction one hundred thousand How much can they take for EMP? Well, you have to be spread over five years, which is 20 percent We have to deduct from EMP only 10,000 it means so let me show you this On 11 20 we had revenues And we had expenses part of this expenses was this 50,000 now Then we got the taxable Income now we're gonna have to go from taxable income to CEP Well of this 50,000 we're only supposed to deduct 10. So what do we have to do? We have to add $40,000 to taxable income. So if we add $40,000 to taxable income add 40,000 so minus 50 Plus 40 the net deduction for EMP is only 10,000 This is how we came up with the 10,000 for year one, but the adjustment is for 40,000 Now x3 how much can we how much can we deduct for tax purposes for this asset? None because the full amount was deducted in x2 So on x3 what we do now we deduct the 10,000 because remember the 50,000 the 50,000 asset Will have to be spread over five years. So we did year one year two 10,000 year three 10,000 and the adjustment is 10,000 Okay, so keep that in mind that for year one you'll take the difference and we'll work another example But I hope you can see this that in year one. We only have to take an the EMP adjustment is for 40 To make it net the difference is 10 to only have a 10 Why did we why did we have a positive adjustment? Because we took too much deduction We have to add back. We have to add back the 40,000 So for EMP the deduction should be only 10,000 the effect on the adjustment Then in the following year every year you will deduct 10, 10, 10. So notice the adjustments plus 40 notice here plus 40 Let me just show you here plus 40 Minus 440 basically the adjustment is zero and what you did is you for tax purposes You took it all in one year for EMP you took the deduction over five years and the adjustment Basically cancel each other out Now the only reason you're gonna learn how to compute CEP is to work additional examples And this is what I would do. I would look at additional simulation and exercises That's gonna help you understand this topic. I also have plenty of mcqs through false on far hat lectures This is where you should go now and work mcqs. Good luck study hard. This is an important topic and stay safe