Taxpayers could benefit from the disaster loss provision that allows deductions on their prior-year tax returns, but uncertainties on how the rules apply to a pandemic could leave them hanging.
President Trump’s declaration of the coronavirus crisis as a federal disaster that warrants government assistance under the Stafford Act triggered an additional tax planning tool — beyond the provisions in the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) — that permits acceleration of specified disaster losses.
During recent webcasts on increasing liquidity and optimizing loss carrybacks, tax professionals highlighted planning opportunities associated with the disaster loss provision. Some, however, cautioned about the uncertainties in applying existing rules to a disaster like the coronavirus.
The tax rate arbitrage inherent in the CARES Act net operating loss carryback provision — the ability to generate a refund in a 35 percent tax rate year from a loss incurred in a 21 percent rate year — has spurred taxpayers’ interest in mechanisms for increasing NOL carrybacks, Brian Peabody of EY said during a District of Columbia Bar Taxation Community webinar.
The section 165(i) election that allows eligible coronavirus-related losses to be deducted on a prior-year return “is clearly a hot topic these days,” Peabody said, adding that the extent of the benefits depends on the taxpayer’s specific situation. For example, Peabody said for companies in business sectors that generated more income in 2014 than 2015, the ability to shift 2020 losses into 2019 could be valuable because of the temporary five-year loss carryback rule under the CARES Act.
Ellen McElroy of Eversheds Sutherland (US) LLP said during her firm’s webcast that she has discussed “with a number of clients . . . taking advantage of the availability of disaster losses under 165(i).”
But applying those rules to identify and quantify eligible losses — which have generally been used for hurricanes and other natural disasters — to something like the COVID-19 emergency is treading new ground, McElroy said.
“There certainly will be circumstances where it may be appropriate to claim a 165(i) loss, but I would say it is something that needs to be done with great care,” McElroy said. But she said it wouldn’t surprise her if the IRS issues guidance because it’s an unprecedented situation.
Loss Deduction Rules
Section 165(a) allows a deduction for any loss sustained during the tax year and not compensated for by insurance or otherwise. Allowable loss deductions are generally claimed in the year of the loss.
However, losses attributable to a federally declared disaster may be deducted on the taxpayer’s prior-year return under section 165(i) — allowing taxpayers that suffered a loss and in need of cash the opportunity to monetize those losses more quickly and reinvest in the business by reducing prior-year taxes.
Taxpayers must make an election to deduct a disaster loss for the preceding year either on an original or amended income tax return for that year within six months of the initial due date for filing the return for the year in which the disaster occurred.
The general rules for deducting losses (reg. section 1.165-1(b)) require that the loss be evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the tax year.
Courts have determined that a closed and completed transaction generally occurs upon a sale or other disposition of the property or may be satisfied if the taxpayer abandons the asset or the asset becomes worthless.
For nondepreciable property (reg. section 1.165-2), losses incurred in a business or in a transaction entered into for profit and arising from the sudden termination of its usefulness are deductible under section 165(a) for the tax year in which the loss is sustained if the business or transaction is discontinued or property is permanently discarded.
Reg. section 1.165-11, promulgated in the 1960s, originally provided that the section 165(i) election for disaster loss rules applied to losses arising from fire, storm, shipwreck, or other casualty. Treasury later clarified in amended regulations that the election “is properly available whenever a taxpayer incurs a deductible disaster loss whether or not that loss is technically a ‘casualty’ loss.”
A disaster loss is defined as one that occurs in a federally declared disaster area, is attributable to that disaster, and is otherwise allowable as a deduction under section 165(a) and reg. sections 1.165-1 through 1.165-10.
However, losses attributable to a disaster under those rules historically “have been those incurred by more capital-intensive industries for damages incurred from natural disasters” — which involved more tangible losses than what businesses are experiencing as a result of the coronavirus pandemic, McElroy said.
Thus, it’s unclear “how the previous authorities apply in the present context,” she said.
Similarly, Carol Conjura of KPMG LLP pointed out during her firm’s webcast that the loss has to be sustained within the declared disaster area — which would generally be the physical location of the property — but the rules for intangible property are less clear, creating some uncertainty.
Situations related to the coronavirus pandemic that might give rise to losses, and therefore eligible for the disaster loss election, include the permanent closure of a business; abandonment of leasehold improvements; retirement of fixed assets; and abandonment of a business transaction.
Other examples practitioners pointed to include disposal of inventory or other property that is unsalable, securities sold at a loss, or losses from the sale or exchange of business property, all of which must be specifically attributable to the pandemic.
Determining eligible section 165(i) losses is in part “based on facts and circumstances that point to COVID as the overriding reason for the loss,” Conjura said. But the losses businesses are experiencing aren’t “easy to pinpoint” like casualty losses, Conjura said.
“Documenting the supportive facts for why the loss is attributable to COVID is going to be critical, and the type of documentation [needed] will depend on the type of the loss,” Conjura said. “For example, if the loss arises from terminating a transaction or closing a facility, . . . documenting the taxpayer’s intent would seem to be most relevant,” along with documenting that the closure is permanent, she said.
Beyond determining what is a qualifying pandemic-related loss under section 165(i), taxpayers also face challenges valuing the loss and supporting that assessment, McElroy said.
The amount deductible for casualty losses under reg. section 1.165-7 is generally the lesser of the decline in the fair market value or the adjusted basis of the property determined under section 1011, adjusted for salvage value and insurance or other compensation received.
The regs also provide that the “fair market value of the property immediately before and immediately after the casualty shall generally be ascertained by competent appraisal [that] must recognize the effects of any general market decline affecting undamaged as well as damaged property which may occur simultaneously with the casualty.”
What About Stock Losses?
Declines in stock value from mere market price fluctuations don’t give rise to a deduction under section 165(a). Losses for declines in stock value may be deductible, though, if the loss is recognized under reg. section 1.1002-1 upon the sale or exchange of the stock.
Also, for securities that become wholly worthless during a tax year, the resulting loss may be deducted as an ordinary loss for noncapital assets, or as though it were a loss from a sale or exchange on the last day of the tax year for capital assets.
Documentation that “shows the movement in stock prices in relation to the timing of the disaster” would obviously apply for taxpayers seeking to claim those losses, Conjura said.
Conjura described a situation in which a taxpayer owned stock that was valued at $100 in December 2019, declined to $90 in January, but then precipitously dropped to $10 in March. If the stock was sold — resulting in a total loss of $90 — “it looks pretty clear that maybe COVID caused $80 of the $90 loss because I can see that it happened at the time when the disaster became clear,” Conjura said.
That documentation alone, though, may be insufficient to justify that the loss was attributable to the pandemic, Conjura added. That means that taxpayers should consider other factors, such as the underlying business of the company, and provide supplemental support if, for example, the investments were in the hospitality or retail sectors, she said.
How to demonstrate that a stock loss was sustained in a disaster area also remains uncertain, according to Conjura.
For casualty losses, it’s easy to determine if they occurred in the United States, but “there’s no guidance for determining where a loss [occurs] with respect to intangibles like securities,” Conjura said.
“So we find ourselves having to come up with arguments and develop the position right now,” Conjura said. She said one possible answer would be the security holder’s residence, which would be straightforward.
However, an alternative view could be that the applicable location is that of the issuer, which “would be a much more difficult exercise because a worldwide issuer of stock — like a big hospitality company . . . [is located] all over the place.”
If a multinational corporation determines and substantiates that a stock loss is related to the COVID-19 pandemic, which affected its worldwide business operations, that will likely require an allocation of the losses, Conjura suggested.
“That’s an issue . . . that is really crying out for more guidance from the government at this time,” Conjura said.
Barbara Young, vice president of global tax accounting and compliance at Marriott International, who joined McElroy on the Eversheds Sutherland webcast, said that section 165(i) “is one item that I’m hearing from a lot of firms about in terms of opportunity.”
But Young said she is uncertain that “the guidance that preexisted COVID is sufficient to really determine what is the scope of the potential items that could be included in a 165(i) loss claim.”
“I’m a little leery right now about engaging any party to help identify . . . what could be included” as a qualified disaster loss, Young said, noting additional concerns she has about the potential audit risk.
If IRS guidance clarifies the application of section 165(i), “it may be worthwhile engaging an outside party to assist with putting together a package to support a loss” if the cash tax benefit may far exceed the expenditure, Young said.
McElroy emphasized that applying the disaster loss rules to a pandemic is new ground because it’s unlike previous disasters. “To make such a claim, you’re going to have to look closely at the established case law and administrative guidance so that you can articulate the argument to support that you’re entitled to the loss in this context,” McElroy advised.
Determining and justifying pandemic-related losses will require a lot of work, according to McElroy.
“There’s going to be significant examination scrutiny to the losses,” McElroy said. “That’s part of the reason that I think that we’re going to see additional guidance, just because [the] IRS has to be thinking about this as well.”
McElroy also pointed out that taxpayers could be subject to other IRS requirements if their section 165 losses are $10 million or more.
Reg. section 1.6011-4, aimed at curbing abusive tax avoidance transactions, requires taxpayers claiming large section 165 losses, and any material advisers to the transaction, to file disclosure statements with the IRS.
The threshold amount for reporting those losses per tax year is generally $10 million for corporations, including partnerships with only corporate partners. Lower thresholds apply for other partnerships, trusts, and individuals.
Rev. Proc. 2013-11, 2013-2 IRB 269, identifies specific section 165 losses that aren’t taken into account in determining whether a transaction is a reportable loss transaction. It appears that the IRS would have to specifically determine whether any coronavirus-related losses that would be considered a reportable transaction would otherwise be excluded from the computation of the threshold for reportable losses.
McElroy noted, however, that the section 165(i) election to accelerate the losses and claim a refund in the prior year wouldn’t require pre-refund review by the Joint Committee on Taxation.
Under section 6405(a), the JCT is required to review IRS reports on corporate taxpayer refund claims in excess of $5 million before a refund is made. No payment is made until 30 days after the date the IRS submits the report for JCT review. Under section 6405(c), regarding refunds attributable to section 165(i) disaster losses, amounts are paid before JCT review but are subject to later review that could require taxpayers to repay part of a refund with interest.