IRS Depa r t ment s Tax Relief Provisions for Disaster Losses Shirley Dennis-Escoffier Weather-related casualty losses have been on the increase with Hurricanes Harvey, Irma, and Maria recently leaving a trail of destruction. Businesses and their employees can take advantage of the tax rules to somewhat mitigate their losses. This column looks at the tax treatment of various options for providing disaster assistance to employees as well as the casualty loss rules for businesses and their employees and concludes with a summary of the Disaster Tax Relief Act passed by Congress on September 28, 2017. IDENTIFYING A QUALIFIED DISASTER AREA Special relief provisions apply when a casualty loss occurs in an area that is declared a disaster area by the president of the United States. Areas qualifying for disaster assistance (including those affected by Hurricanes Harvey, Irma, and Maria) are identified by the Internal Revenue Service (IRS) based on determinations made by the Federal Emergency Management Agency (FEMA); the FEMA website lists affected areas by county (https://www.fema.gov/ disasters). The IRS publishes news releases on its website regarding the specific relief provisions that are available for each disaster area (https://www.irs.gov/newsroom/tax-relief-indisaster-situations). FILING DEADLINES EXTENDED The IRS has issued several notices informing affected taxpayers of special relief including extended deadlines for filing tax returns. Affected taxpayers include any business entity whose principal place of business and any individual whose principal residence is located in a county designated as a disaster area. It also includes any individual who is a relief worker assisting in a covered disaster area and taxpayers whose tax records necessary to meet a filing or payment deadline are maintained in a covered disaster area. Affected businesses and individuals have until January 31, 2018, to file returns and pay any taxes that were originally due during the covered period. The covered period began August 23, 2017, for Hurricane Harvey; September 4, 2017, for Hurricane Irma; and September 15, 2017, for Hurricane Maria. This relief includes an additional filing extension for businesses with valid extensions that were due to expire on September 15, 2017, and an extension of the deadline for making quarterly estimated tax payments with a September 15, 2017, deadline and January 16, 2018, deadline, as well as relief for the October 31 deadline for quarterly payroll tax returns. For individuals, the relief applies for 2016 income tax returns that received an extension until October 16, 2017; however, the tax payments related to these 2016 returns were originally due on April 18, 2017, and so these payments are not eligible for relief. If an affected taxpayer receives a late filing or late payment penalty notice from the IRS that had original or extended filing, payment or deposit due Published online in Wiley Online Library (wileyonlinelibrary.com). DOI 10.1002/jcaf.22318 167
168 The Journal of Corporate Accounting & Finance / January 2018 dates falling within the postponement period, the taxpayer should call the telephone number on the notice to have the penalty abated. PROVIDING DISASTER ASSISTANCE TO EMPLOYEES Employers who want to provide assistance to their employees affected by these devastating storms have several ways in which they can do this in a tax-advantaged manner such as through qualified disaster relief payments, loans, and leave-sharing programs. Disaster Relief Payments Internal Revenue Code (IRC) Section 139 allows employers to provide tax-free disaster relief payments to individuals who reside in one of the counties that have been listed in a federally declared disaster zone. Qualified disaster relief payments are not treated as taxable compensation, so they are not subject to employment taxes and no federal income tax withholding is needed. A qualified disaster relief payment includes any amount paid to or for the benefit of an individual: 1. To reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster, or 2. To pay or reimburse reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or its contents to the extent that the need for such repair or replacement is caused by a qualified disaster. However, employers must consider whether the expense will likely be covered by insurance because if the employer pays for or reimburses any expenses covered by the employee s insurance, the payment will be considered taxable compensation subject to employment taxes and income tax withholding. Homeowner s insurance policies may cover some temporary living expenses but not others; for example, insurance might cover staying in a hotel until certain types of damages are repaired, but the policy may not cover meals. Most homeowner s insurance policies do not coverage flood damage, so individuals in flood zones need separate flood insurance. Many flood insurance policies do not cover all flood-related costs, so it is likely that even an employee with flood insurance will have costs not covered by that insurance. When employers make payments before the insurance coverage can be determined, it is important to keep track of these payments so that if it turns out some of the payments are taxable, they can be properly reported. Employer Loans to Employees A loan from an employer to an employee is not taxable compensation as long as there is a reasonable expectation of repayment. Employers can generally loan up to $10,000 to employees without charging interest; however, for loans to employees eligible for IRC Section 139 qualified disaster payments, it may be possible to provide higher amounts interest free. Leave Banks Employers may set up leave banks that allow employees to deposit their accrued vacation, sick, or personal leave for use by employees adversely affected by a disaster. An employee is considered adversely affected by a disaster if the disaster caused severe hardship to the employee or the employee s family that requires the employee to be absent from work. To be considered a bona fide employer-sponsored leave bank, a written leave-sharing plan must meet the following requirements specified in Notice 2006-59: The amount of leave that can be donated by a donor in any year does not exceed the maximum amount of leave that an employee normally accrues during the year. The plan does not allow a leave donor to deposit leave for transfer to a specific leave recipient. The employer must make a reasonable determination, based on need, as to how much leave each approved leave recipient can receive under the leave-sharing plan. A leave recipient can receive paid leave (at his or her normal rate of compensation) from the leave bank only if this leave is used for purposes related to the disaster. A leave recipient cannot convert leave received under the plan into cash in lieu of using the leave. However, a leave recipient can substitute leave DOI 10.1002/jcaf
The Journal of Corporate Accounting & Finance / January 2018 169 received under the plan for leave without pay used because of the disaster, and a leave recipient can use leave received under the plan to eliminate a negative leave balance that arose from leave that was advanced to the recipient because of the disaster. The plan adopts a reasonable limit, based on the disaster s severity, on the period of time after the disaster occurs during which a leave donor can deposit the leave in the leave bank, and a leave recipient must use the leave received from the leave bank. Leave deposited for one disaster can be used only for employees affected by that disaster. Any leave that is not used must be returned within a reasonable period of time to the leave donors so that the donor will be able to use the leave. The amount of leave returned to each donor must be in the same proportion as the amount of leave donated by that donor to the total amount of leave donated for that disaster. Leave-Based Donation Programs Employees can donate their leave to provide assistance to aid hurricane victims through an employer s donation program. Employers may set up a program in which employees can donate their accrued vacation, sick, or personal leave in exchange for equivalent cash donations made by the employer through January 1, 2019, to qualified tax-exempt organizations that provide relief to hurricane victims. The employees are exempt from tax on the forgone income, and employers may claim these payments as business expenses under IRC Section 162 without being subject to the charitable contributions limits that apply under IRC Section 170. Employees donating leave do not have compensation income on the donation, saving them both income and payroll taxes, but they cannot take a charitable contribution deduction. Employers benefit by deducting the payments as business expenses and reducing their employment tax liability. Employee-to-Employee Gifts Sometimes employees want to help out colleagues affected by a disaster but need assistance in coordinating their efforts. Businesses may agree to assist by collecting amounts from various employees to benefit of a group of adversely affected employees. When an employer assists in pooling employee-to-employee payments, these gifts need to be separate from any employer assistance; so businesses should set up a separate bank account for collecting these employee gifts. When providing funds to recipients on behalf of the donor employees, these payments should be labeled as employee-to-employee gifts. DETERMINING AMOUNT OF CASUALTY LOSS The rules governing casualty losses are contained in IRC Section 165 and the related regulations. A casualty is the loss or damage of property that results from an event that is sudden, unexpected, or unusual in nature that can be identified. Examples include hurricanes, floods, fires, and earthquakes. Regulations Section 1.165-7(b)(2) states that the loss must be calculated separately for each identifiable piece of property. For example, if a commercial building and its surrounding landscaping are damaged in a hurricane, the building and the landscaping are considered separate pieces of property. The taxpayer must separately compute the casualty loss deduction for each, based on the fair market values and tax bases of the two individual properties. Requiring separate casualty loss computations for each property prevents borrowing basis from undamaged property to support a larger casualty loss deduction for damaged property. This becomes relevant if the damaged property s adjusted basis is lower than the reduction in its fair market value, such as when the damaged property has been substantially depreciated. The amount of the loss is the lesser of the decline in value or the adjusted basis of the property. The decline in value is the difference between the fair market value of the property immediately before and immediately after the casualty as determined by a competent appraisal. A casualty loss is allowable only to the extent the reduction in fair market value reflects the physical damage caused by the disaster. Other factors, such as buyer resistance or an anticipated decline in future profits, cannot be considered in this determination. DOI 10.1002/jcaf
170 The Journal of Corporate Accounting & Finance / January 2018 As an alternative to appraisal, Regulations Section 1.165-7(a)(2)(ii) permits the cost of repairs to the damaged property to be used as evidence of the loss if the repairs are actually made and the taxpayer can establish that: The repairs were necessary to restore the property to its condition immediately before the casualty. The amount spent for the repairs is not excessive. The repairs do not make any additional improvement beyond repairing the damage. The value of the property after the repairs does not as a result of the repairs exceed the value of the property immediately before the casualty. Regulations Section 1.165-7(b)(1)(ii) provides a special rule for business property that is completely destroyed in a casualty. The decrease in fair market value is not considered, and instead the measure of the loss is the property s adjusted basis when it is completely destroyed. Whether the basis or the decline in value is used to determine the amount of the casualty loss, this amount must be reduced by insurance proceeds or any similar compensation that the taxpayer receives due to the casualty (including amounts that the taxpayer can reasonably expect to receive). A basis adjustment is then required because the casualty loss deduction permits the taxpayer to essentially accelerate a future depreciation benefit. Thus, the basis of damaged property must be reduced by the deductible casualty loss. Accelerated Casualty Loss Claims Although casualty losses are usually claimed on the tax return for the year the loss occurs, an election under IRC Section 165(i) is available for losses that occur in a presidentially declared disaster area allowing the loss to instead be claimed on the preceding year s tax return. When claiming losses for the 2017 hurricanes, the 2017 tax return normally would be filed in 2018, so this election allows an acceleration of the deduction for these losses by claiming them on the 2016 tax return. If the due date (plus extensions) for the 2016 return has not passed, the election is made on the 2016 return with a statement on Form 4684 including (a) the name and date of the disaster and (b) the address (including the city, town, county, parish, state, and zip code) where the damaged property was located at the time of the disaster. If the due date (plus extensions) has passed, the taxpayer must either file an amended return or a refund claim. The taxpayer can provide the required information by writing on the top of Form 4684: Section 165(i) Election, the name of the disaster, and the state in which the damaged property was located at the time of the disaster. Additional information can be provided in the explanation of changes section on Form 1120X or Form 1040X. This elective provision allows an acceleration of relief available for what in many cases will be substantial casualty loss deductions. The specific details of this election are discussed in detail in Revenue Procedure 2016-53. Character of Loss Depreciable property used in a business and held for more than one year is considered Section 1231 property. IRC Section 1231(a) permits a taxpayer to net its Section 1231 gains and losses for the year and to claim a net Section 1231 loss as an ordinary deduction and a net Section 1231 gain as a long-term capital gain (subject to certain recapture provisions). IRC Section 1231 provides special netting rules for involuntary conversions such as casualty losses so if the taxpayer recognizes a net casualty loss (disregarding noncasualty Section 1231 transactions), the loss is recovered as an ordinary deduction. If the taxpayer recognizes a net gain for the involuntary conversion (for example, if the taxpayer receives net insurance proceeds in excess of the property s remaining basis and is unable to defer the gain through IRC Section 1033), those net gains are included with the taxpayer s noncasualty Section 1231 gains and losses for the year and subject to the normal netting rules. In applying this provision, the taxpayer must take into consideration not only recognized casualty losses, but also any recognized casualty gains. For example, if the taxpayer sells the damaged property for its salvage value, the taxpayer recognizes gain to the extent that the sale proceeds exceed the property s remaining tax basis. However, casualty gains that can be deferred under IRC Section 1033 would not offset the year s casualty losses for purposes of Section 1231. Inventory Taxpayers have two options in accounting for casualty DOI 10.1002/jcaf
The Journal of Corporate Accounting & Finance / January 2018 171 losses to inventory held for sale to customers. First, the loss can be recovered through the normal operation of the taxpayer s inventory accounting method. By properly reporting the opening and closing inventories for the year, the taxpayer would recover the lost inventory through its cost of goods sold. Under this approach, the loss cannot also be claimed as a casualty loss under IRC Section 165. Any insurance or other reimbursement would be included in gross income. Under the second option, the loss is computed separately. Under this approach, the taxpayer eliminates the affected inventory items from cost of goods sold by making a downward adjustment to opening inventory or purchases. The deduction must be reduced by insurance proceeds or other reimbursements, but that amount would not be included in gross income (except to the extent it exceeds tax basis). POST-CASUALTY REPAIRS The casualty loss provision does not address the treatment of expenditures to repair the damaged property. The fact that the cost of repairs is acceptable as evidence of the loss of value in the property does not convert the casualty loss deduction into a deduction for the cost of repairs. The IRS views the decision to restore the asset to its pre-casualty operating condition as a separate event from the casualty. The cost of repairing the property cannot be deducted as repairs, but must instead be capitalized under IRC Section 263 as restoration of property to its pre-casualty operating condition. The following is based on examples provided in Regulations Section 1.263(a)-3(k)(7). Example: XYZ Corporation owns a building that it uses in its business. A storm damages the building at a time when it has an adjusted basis of $500,000. XYZ claims a casualty loss deduction of $50,000 and reduces its basis in the building to $450,000. XYZ hires a contractor to repair the damage to the building and pays the contractor $50,000 for the work. XYZ Corporation must capitalize the $50,000 paid to the contractor because it adjusted its basis as a result of the casualty loss. If, instead, XYZ Corporation received $50,000 of insurance proceeds to compensate for its casualty loss, it could not claim a casualty loss deduction, but still must reduce its basis in the property by the amount of the insurance proceeds. Additionally, XYZ must still capitalize the $50,000 paid to the contractor because it made a basis adjustment relating to the casualty. Although the same capitalization requirement applies whether the taxpayer adjusts the basis of property damaged in a casualty for claiming a loss or the receipt of insurance proceeds, a taxpayer without insurance and with no tax basis in the property damaged would not be required to capitalize. The regulations effectively take the approach of allowing a taxpayer to choose between two separate deductions: a loss deduction under IRC Section 165 and a repair expense under IRC Section 162. Although the regulations do not directly require an election between the two deductions, they instead achieve the same result through an election to use a general asset account. General Asset Account A general asset account (GAA) is a depreciable account containing one or more similar units of property. Units of property generally may be included in the same GAA if they are acquired in the same year and are depreciated in the same manner. A loss on the disposition of property from a GAA is usually not recognized until the last unit of property in that account is retired. This election applies not only to a disposition of an entire unit of property but also to a disposition of components of a unit of property that are either required to be treated as separate units of a building or that the taxpayer consistently elects to treat as separate units of property for disposition purposes for property other than buildings. A GAA election allows a taxpayer to continue depreciating property or components of property in the same manner in which it previously had been depreciated, even after disposition of the property or components. By using GAAs, a taxpayer may choose to continue depreciating the remaining basis in the component that has been disposed of (without an adjustment to its depreciable DOI 10.1002/jcaf
172 The Journal of Corporate Accounting & Finance / January 2018 basis) or instead claim a loss deduction for the remaining basis of the asset. This choice is available only if the asset is placed in a GAA. Thus, the regulations permit a taxpayer electing to use a GAA under Regulations Section 1.168(i)-1 to effectively forgo recognizing the casualty loss (without reducing basis) and instead claim a deduction under IRC Section 162 for the cost of the replacement property, provided that the replacement cost is not otherwise required to be capitalized under a different provision of the regulations. This election can be particularly important when the remaining basis of the damaged property is insignificant compared to the cost of repairing it. INVOLUNTARY CONVERSIONS In some situations, casualty gains may result from insurance payments that are in excess of the taxpayer s basis in the damaged property. Taxable casualty gains are reported as income in the year the insurance reimbursement is received. Fortunately, some or all of the tax on casualty gains may be deferred under the involuntary conversion rules. When a taxpayer uses all of the insurance proceeds that are received from a casualty to purchase replacement property within the required time period (at least two years), IRC Section 1033 defers the gain and instead reduces the basis of the replacement property by the untaxed gain. If, however, the cost of the replacement property is less than the insurance proceeds, then gain is recognized to the extent the insurance proceeds are not reinvested. EMPLOYEES LOSSES When an employee sustains a casualty loss, the first step is to determine whether the property is business or personal-use property because additional limits apply to personal-use property. The rules for an employee s business losses are similar to those previously discussed. IRC Section 165(c) governs the deduction for losses incurred in any transaction entered into for profit or for employee property that is used in performing services as an employee. The difference is that employees will report these losses as miscellaneous itemized deduction subject to the 2% of adjusted gross income floor. When an employee sustains a casualty loss to property that was used partly for business and partly for personal use, the mixed-use property must be separated into two assets. The amount of the loss is then calculated for each part with the personal-use portion subject to several additional limitations. Regulation Section 1.165-7(b) states that the amount of a personal casualty loss is the lesser of the adjusted basis of the property or the decrease in fair market value due to the casualty. Unlike business losses, there is no exception for personal-use property that is completely destroyed. IRC Section 165(h) further requires that a personal casualty loss be reduced by $100 for each event and the aggregate of all personal casualty losses for the year be reduced by 10% of adjusted gross income (AGI). In applying the $100 floor, every casualty occurring during the taxpayer s year is treated as an event, so a dozen assets damaged in the same storm would be subject to one $100 floor. When a taxpayer makes the election to deduct a disaster loss on the tax return for the preceding year, that previous year s AGI is used in computing the 10% floor. Deductible personal casualty losses are fully allowed in determining a taxpayer s net operating loss (NOL) for the year so the limitation on nonbusiness deductions in calculating an individual s NOL does not apply to a personal casualty loss deduction. According to IRC Section 172(d)(4)(C), a personal casualty loss (as well as a business loss) may create an NOL that can be carried back to earlier years to obtain a tax refund. For personal losses, another significant benefit of a presidentially declared disaster area involves the manner in which insurance proceeds for unscheduled personal property are treated for tax purposes. Under IRC Section 1033(h) (1)(A)(i), no gain or loss is recognized on the receipt of insurance proceeds for personal property that was part of the contents of the residence, provided the contents were not separately scheduled under the taxpayer s insurance policy. Any other insurance received for the residence and its scheduled contents will be treated as a common pool of funds for purposes of deferral or recognition of gain under the involuntary conversion rules. DISASTER TAX RELIEF ACT On September 28, 2017, the House and Senate passed the Disaster Tax Relief and Airport and Airway Extension Act of 2017, which combines DOI 10.1002/jcaf
The Journal of Corporate Accounting & Finance / January 2018 173 an extension of the Federal Aviation Administration (FAA) authorization and taxes that provide FAA funding with temporary tax relief for victims of Hurricanes Harvey, Irma, and Maria. Many of these tax relief provisions are similar to those provided to victims of Hurricane Katrina in 2005. This act includes provisions that: Encourage charitable contributions by temporary suspension of limitations on the deduction for charitable contributions associated with qualified hurricane relief made before December 31, 2017. Allow penalty-free access to retirement funds through an exception to the 10% early withdrawal penalty for qualified hurricane relief distributions, permitting the recontributions of retirement plan withdrawals for home purchases canceled as a result of a hurricane, and providing flexibility for loans from retirement plans for qualified hurricane relief by increasing the maximum amount that can be borrowed from $50,000 to $100,000 and delaying repayment dates. Allow disaster-affected employers an employee retention tax credit for 40% of wages (limited to $6,000 of wages per employee) paid to employees from a core disaster area. Allow larger deductions for personal casualty losses by eliminating the 10% of AGI floor for uncompensated disaster losses when an individual itemizes, but increase the $100 floor to $500. Allow individuals who do not itemize to increase their standard deduction for their net disaster loss. CONCLUSION When a casualty loss occurs, a number of taxplanning opportunities become available. Relief can be provided to employees that maximize the tax benefits to both employers and employees. Deductions may be available or rules employed to defer or avoid tax on payments received. The additional tax provisions passed by Congress at the end of September are welcomed relief for victims of the disastrous 2017 hurricanes. Shirley Dennis-Escoffier, PhD, CPA, is an associate professor of accounting at the University of Miami, Coral Gables, Florida. She is a past president of the American Taxation Association and has published numerous articles in tax journals. DOI 10.1002/jcaf