In: Accounting
Explain when and how the built in loss exception works in regards to liquidating distributions. Be thorough in your explanation and provide an example to illustrate your analysis.
Answer:- Liquidating distribution, also known as a liquidating
the dividend, is the amount of capital given to the owner when a
company is liquidated/dissolved. When a company no longer can
continue its business and its assets are liquidated, the firm
either issues non-cash liquidating distributions, cash liquidating
distributions, or both.
The distribution is made acording to capital invested,If any amount
is left after paying preferred holders or bondholders, stockholders
are paid a portion of the money.
Proceeds from a cash liquidation distribution can be either a
non-taxable return of principal or a taxable distribution,
depending upon whether or not the amount is more than the
investors' cost basis in the stock. The proceeds can be paid in a
lump sum or through a series of small installments.
Payments in excess of the total investment are capital gains. If
the amount the investor receives is less than their original cost
basis invested in the stock, the investor may report a capital
loss. This loss can only be reported once the firm issues a final
cash liquidation distribution.
The duration of the holding period determines whether the capital
gains are classified as short-term or long-term gains.
For example-ABC Corporation is going through liquidation. Harry and
Tom are shareholders. Harry' s cost basis of his shares in ABC
Corp. is $100. When he receives a cash liquidation payment of $125,
$100 of that is a return of capital and is not taxable, while $25
is the gain and is taxable.Tom has an original cost basis of $150.
When he receives his payment of $125, it does not cover his
original cost basis in the stock. So,Tom has a loss of $25.
So from the above example it is clear how the built-in loss
exception works in liquidating the distribution.