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More Ideas Percolating for Potential Disaster Loss Claims

Posted on June 2, 2020

New considerations are emerging concerning pandemic losses incurred this year that might be eligible for a deduction on a taxpayer’s 2019 return under the loss provision for federally declared disasters.

Taxpayers shouldn’t overlook the possible benefits of section 165(i), which allows eligible coronavirus-related losses to be treated as if they were incurred in the preceding year, according to Scott T. Mackay of EY.

The provision “hides in the weeds most of the time, but . . . when you have the right fact pattern, it can achieve a great benefit,” Mackay said during his firm’s May 29 webinar.

This long-standing rule “plays nicely with all the new stimulus legislation” and with what Treasury is trying to do, which is figure out how to get money into people’s hands, how to help enterprises, and how to protect the economy through the tax code, Mackay said.

Daniel J. Kusaila of Crowe LLP similarly said taxpayers should have section 165(i) on their radar because it might help them to take the losses in 2019 rather than in 2020. Speaking during the May 29 virtual Federal Bar Association Insurance Tax Seminar, Kusaila said the provision is “broad enough where I believe you have to look at it.”

That means taxpayers should review their financial results and consider whether activities and events that have affected their businesses have characteristics that fall within the disaster loss provision’s requirements, Kusaila said.

Beyond ‘Early Movers’

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 need cash the opportunity to monetize those losses more quickly and reinvest in their business by reducing prior-year taxes.

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.

Many “early movers” focused on abandonment of property, such as companies “shuttering a manufacturing facility because the capacity demands are down and they just don’t feel like they are ever going to reopen it,” Mackay said.

The question then is how to evidence a closed and completed transaction to qualify for the section 165(i) accelerated loss, Mackay said. He noted that section 168 provides specific rules for abandoning property or transferring it to a scrap account and “how to trigger those losses in a year prior to an ultimate sale.”

One area that’s drawing interest concerns the treatment of costs to protect an asset, Mackay said.

Some law indicates that it’s better to treat those expenditures as a direct loss rather than as an ordinary and necessary deduction or as a capitalizable expense, according to Mackay. He said some taxpayers are exploring whether the amount they are paying their employees not to work is “really a protection of existing workforce in place, such that [they] can treat that as a loss and recover that through this provision.”

Inventory Matters

Retailers of seasonal goods have inquired about inventory that they will never sell. Easter products were a particular focus because businesses had a lot of Easter eggs that weren't sold, Mackay said.

“If folks are willing to destroy the inventory, then we’re looking at the ability to get into the [section 165(i)] loss treatment and move [those losses] back a year,” Mackay said.

The treatment of the sale of inventory outside the normal course of business has drawn the interest of some taxpayers, Mackay said, noting that under inventory rules, basis is generally recovered under section 471 as cost of goods sold, and therefore isn’t a section 165 loss.

But Mackay said his firm is exploring the ability of taxpayers to exclude an “abnormal sale” of inventory from the typical cost recovery rules and instead claim a loss.

Making the Election

Some taxpayers are considering whether it’s worth moving 2020 losses to 2019 to get an extra year to carry back losses — to 2014 — under the Coronavirus Aid, Relief, and Economic Security (CARES) Act’s (P.L. 116-136) five-year rule, Mackay said.

Others are making the section 165(i) election “for the speed of refund because the [2019] return is processed electronically,” and taxpayers can offset their income and request a refund through that process, Mackay said.

However, section 165(i) isn’t a provision that “you have to wring your hands” over, because the election is revocable, Mackay noted.

Taxpayers make the election by including their 2020 losses on their 2019 returns, but if they determine, for example, that their modeling wasn’t quite right and that they would be better off with the loss in 2020, they can amend the 2019 return and shift the loss back to the 2020 return, Mackay explained.

Under reg. section 1.165-11, taxpayers must elect to deduct a disaster loss in the preceding year either on an original or an amended income tax return within six months of the initial due date for filing the return for the year in which the disaster occurred.

To revoke the election, taxpayers must file an amended return to remove the loss for the preceding year on or before the date the taxpayer files the disaster year return or amended return, and they may make the revocation within 90 days of when the election must be made.

Uncertainty Persists

Practitioners have raised myriad questions about how the provision that has most often been applied to property casualty losses would apply to the pandemic, suggesting that it’s an area in need of IRS guidance.

The rules are more difficult to navigate for the COVID-19 crisis compared with traditional disaster losses, such as those from a hurricane, in part because of the potential challenges in attributing some 2020 losses to the pandemic, Mackay said.

Eric Solomon of Steptoe & Johnson LLP, who joined Kusaila on the Federal Bar Association webinar, echoed that concern. “For example, if you have a business that is struggling, and then it [files for bankruptcy] at this time, how can you prove that it’s attributable to” the federally declared disaster? he asked.

Another uncertainty is that the disaster losses are treated as if they arose in the prior tax year, Solomon said.

“Does that mean the event occurred in the prior taxable year and your computation of the loss and any limitations of the loss are as if the entire event occurred in the prior taxable year?” Solomon asked.

“There are a lot of interesting issues under 165(i) that have not been previously explored,” Solomon added.

“Guidance may be coming from Treasury on the application of section 165(i) to a non-natural disaster,” according to Alston & Bird LLP’s June 1 Federal Tax Advisory. “Meanwhile, taxpayers should consider its use and availability” to deduct losses in 2019 that otherwise would be reported for 2020, the firm said.

The advisory noted that the coronavirus has caused the loss of many businesses, and that “stock has become worthless because of the pandemic and the declared disaster.”

IRS Chief Counsel Michael J. Desmond pointed out May 20 that some advisers believe that depreciation in the value of equity qualifies as an ordinary disaster loss, while others disagree. The IRS is looking at that question, but it’s unclear how it might be addressed, Desmond said.

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