Question

If a company experiences a complete loss of an office building as a result of a fire and receives a $2 million recovery payment from the insurance company:

Explain the tax consequences if the company decides not to rebuild.

Identify the tax consequences if the company distributes the $2 million to its two (2) shareholders, assuming that no stock was exchanged in return.

Under what conditions will the distribution meet the requirements to be treated as a partial liquidation and not a dividend?

Please differentiate between retained earnings and earnings and profit. Provide at least two items used in the computation of earnings and profit that are not included in retained earnings computation and explain reasons why they are not used.

Please make sure you read the entire questions and post something that has not be stated previously.

Answer 1

1. If the company decides not to rebuild then the casualty loss due to fire will be treated as an involuntary conversion as per the tax provisions, regulations and laws. In such a case the $2 million proceeds from the insurance company will attract a normal tax. This will be the case if the proceeds of $2 million exceed the building’s tax basis.

Tax basis of the office building = Original cost – Depreciation write offs + cost of improvements.

If a profit is generated on the recovery payment then of $2 million then the amount of gain will have to be calculated and then taxable income will have to be calculated. On the other hand in cases of loss from the involuntary conversion the company will be allowed to deduct the loss when the income is reported.

2. If the company distributes the $2 million to its two (2) shareholders, assuming that no stock was exchanged in return then there will be tax consequences for the company. The first possible consequence will be the distribution will be taxed as dividends. This will be to the extent the payment is paid from the company’s current or accumulated earnings & profit (E&P). In the situation in which the distribution exceeds amount of E&P the amount will be treated as return of the shareholders’ capital investment into the company.

Another possible scenario is that the distribution will be -deductible by the business, and therefore, will generally not be taxable on the shareholders’, to the extent of their tax basis in stock owned in the company. If the distribution exceeds the company’s earnings and profit (E&P) and the shareholders’ tax basis, it will be taxed on the individual shareholders as a capital gain.

3. The distribution will meet the requirements to be treated as a partial liquidation and not a dividend when certain requirements are met. The first of them is when the distribution is not the fundamental equivalent of a dividend. The second of them is that the distribution is done as a result of termination of a qualified business.