Aaron and Michele, equal shareholders in Cavalier Corporation, receive $25,000 each in distributions on December 31 of the current year. During the current year, Cavalier sold an appreciated asset for $60,000 (basis of $15,000). Payment for the sale of the asset will be made as follows: 50% next year and 50% in the following year, with interest payable at a rate of 6 percent. Before considering the effect of the asset sale, Cavalier’s current year E & P is $40,000 and it has no accumulated E & P. How much of Aaron’s distribution will be taxed as a dividend?

a. $0
b. $20,000
c. $25,000
d. $42,500

Dividend is an amount of money that a company pays out its earnings and profits (E&P) and/or reserves on a regular basis, especially yearly, to its shareholders, especially ordinary shareholders and preference shareholders.

It should be noted that reserves are accumulated E&P. Therefore, a company that does not have accumulated E&P can only pay dividend out of its current E&P. Any amount paid in excess of the current profit after tax when there is no accumulated E&P cannot be considered as dividend.

From the question,

Cavalier's current year E&P = $40,000

Cavalier's accumulated E&P = 0

Aaron's Shareholding in Cavalier = 50%

Amount received by Aaron = $25,000

Cavalier's total amount that can be considered as dividend = Cavalier's current year E&P + Cavalier's accumulated E&P

Cavalier's total amount that can be considered as dividend = $40,000 + 0

= $40,000

Dividend received by Aaron is Cavalier's total amount that can be considered as dividend multiply by Aaron's Shareholding in Cavalier. That is:

Dividend received by Aaron = $40,000 × 50%

= $20,000

Amount received by Aaron but not dividend = Amount received by Aaron - Dividend received by Aaron

Amount received by Aaron but not dividend = $25,000 - $20,000

= $5,000

Therefore, Aaron’s distribution that will be taxed as a dividend is $20,000 which is the actual dividend received by Aaron.

All the best.