Insured business losses; if they are unclaimed they may still be deductible.
In decisions dealing with the nonbusiness casualties of individual taxpayers, the courts eventually sided with the taxpayer and allowed a deduction when a claim was not filed. However, in the Tax Reform Act of 1986 (TRA), Congress revised the law to require individual (nonbusiness) taxpayers to file an insurance claim in order to take a casualty loss deduction, (1) but did not address the issue of business claims. Consequently, the necessity of filing claims remains an unresolved issue for businesses.
The Argument for
a Sec. 165 Deduction
Sec. 165 has been the subject of much controversy in the last 25 years. All taxpayers can use Sec. 165(c)(3) to deduct casualty losses. However, a problem arises when a business taxpayer (not an individual) elects not to file an insurance claim with which some or all of a loss could have been recouped. It appears that the business taxpayer may not have to file a claim. And while there has been little legislative history attached to this provision, there has been much judicial action.
In Miller (2) and Hills (3) (both nonbusiness taxpayers), the appeals courts were very careful to reflect on the history of Sec. 165. Sec. 165 originated as part of the Revenue Act of 1894 and contained the language, "losses . . . not covered by insurance or otherwise and compensated for." Before final passage of the bill, the Senate Finance Committee changed the wording to "losses . . . not compensated for by insurance or otherwise. . . ." (14) After the 1894 Act was held unconstitutional, (5) the Revenue Act of 1913 reenacted the amended language. Since that time, the major controversy has centered around the phrase "not compensated for by insurance or otherwise." This does not seem to mean "not covered by insurance." The House Ways and Means Committee had included the phrase "and compensated for" in the original (1894) statute, which implied that the taxpayer should be compensated to have his casualty loss deduction reduced and not just be "covered by."
The IRS, on the other hand, has long argued that the loss results from the failure to file an insurance claim rather than from the casualty itself.
The regulations under Sec. 165 appear to lend credence to the position that "compensated for" does not mean "covered by." Regs. Sec. 1.165-1(a) states that "any loss actually sustained during the taxable year and not made good by insurance or some other form of compensation shall be allowed as a deduction. . . ." It would appear that if a claim is not filed, the loss is not made good or "compensated for."
Regs. Sec. 1.165-1(c)(4) also alludes to the receipt of compensation: "In determining the amount of loss actually sustained for purposes of section 165(a), proper adjustment shall be made for any salvage value and for any insurance or other compensation received." If the IRS's view is reasonable, one might suspect that the regulation would have stopped at "and for any insurance."
The subject of a "closed and completed transaction" has also been discussed in some cases. Regs. Sec. 1.165-1(b) states that "a loss must be evidenced by closed and completed transactions, fixed by identifiable events. . . ." A legitimate business decision not to file an insurance claim should fulfill the identifiable event requirement. In fact, Regs. Sec. 1.165-1(d)(2)(i) states, in part, "Whether or not such reimbursement will be received may be ascertained with reasonable certainty, for example, by a settlement of the claim, by an adjudication of the claim, or by an abandonment of the claim." An execution of a release, by the taxpayer, should be an "identifiable event" sufficient to document an abandonment of the claim. The regulation goes on to require a "facts and circumstances" examination to determine if a reasonable prospect of recovery exists with respect to a claim for reimbursement. The "abandonment of the claim" is one of the IRS's own examples to fix the prospect of recovery. (6)
A detailed review of the case law suggests that the IRS's position has been questioned regarding the allowance of a Sec. 165 deduction.
* The courts and Sec. 165 deductions
The leading case for insured casualty loss deductions is Kentucky Utilities (K-U), (7) a 1968 business case. K-U experienced a casualty loss when one of its generators was damaged. Warranty rights existed against the manufacturer (Westinghouse), but Westinghouse had stated that it was not at faul. K-U also had insurance (with a $10,000 deductible) with Llods of London. If Lloyds paid an insurance claim, it wanted subrogation rights against Westinghouse to sue under the warranty. For business reasons, K-U did not want anyone (itself or Lloyds) to sue Westinghouse, nor did it want Lloyds to pay the amount due under the policy. K-U was afraid that Lloyds would have to increase premiums or possibly cancel K-U's policy if the potential claim was paid in full.
The three parties worked out an agreement under which all three shared the loss. K-U's portion was $44,486. The Sixth Circuit upheld the district court's (and the IRS's) position that any expense above the $10,000 was not deductible as a Sec. 165 casualty loss or as a Sec. 162 ordinary and necessary expense. The Sixth Circuit relied on Sam P. Wallingford Grain Corp. (8) as its authority for disallowing the Sec. 165 deduction. This case seems clearly distinguishable from K-U's casualty loss issue, since Wallingford dealt with a successor corporation attempting to deduct voluntary payments on a predecessor corporation's debt. Later, the majority opinion in Miller pointed out that "Wallingford may have been pertinent for its holding that this voluntary payment was also not an ordinary or necessary expense under [Section] 23(c) of [the Revenue Act of 1928] [the predecessor of Sec. 162] but it does not appear relevant to the insurance issues in the instant case." (9)
In the next important case, Axelrod, (10) the majority opinion held that the taxpayer failed to prove (1) that the damage to his sailboat was the result of a casualty and (2) the amount of the damage. The majority did not reach the issue of not filing an insurance claim for the damage. The importance of this case lies in the concurring opinions of Judges Fay and Quealy. Judge Quealy proposed that the issue should not have been one of proof of a casualty and the resultant amount, but should have been one of first establishing that a loss actually took place. Judge Quealy stated: "Any economic disadvantage which petitioner may have sustained was not as a result of any casualty loss not being compensated for by insurance but rather was as a result of his choosing not to accept the funds available in compensation for any casualty loss." (11)
Judge Fay, in his concurring opinion, believed the "covered by" versus "compensated for" discussion was premature since it was not at issue in Axelrod (no cause or amount was ever established). He continued by saying that the loss still existed, regardless of whether the taxpayer sought reimbursement: "Such a loss is no less real or permanent than that suffered by an uninsured individual and accordingly should equally give rise to a mitigating tax deduction. The effect of a contrary view is to discriminate against persons carrying insurance a result which I do not think was intended." (12) He believed the taxpayer would be faced with situations in which he would be "forced" to not file a claim. To disallow a deduction because of this is "highly artificial and divorced from reality." The judge did go on to make clear that the reasons for not filing a claim should be valid and practical.
Bartlett (13) was the first case in which the "compensated for" versus "covered by" conflict was examined in a reported decision. In this case, a personal casualty resulted from an automobile accident involving the taxpayer's son. The district court relied extensively on K-U and on Judge Quealy's concurring opinion in Axelrod, concluding that the claim had to be filed or there was no casualty loss, as defined in Sec. 165. According to the court, the (economic) loss resulted from the voluntary failure to file a claim, which is not covered by Sec. 165.
Since this was the first time the "covered by" versus "compensated for" issue was addressed, the court certainly could have examined the legislative history of Sec. 165, entertained Judge Fay's concurring opinion in Axelrod, and tied in the Regs. Sec. 1.165-1(d)(2)(i) possibility of "abandonment of the claim." Instead Bartlett added to the following of K-U and Axelrod (i.e., Judge Quealy's opinion) and to the impetus needed to add Sec. 165(h)(4)(E) to the Code. This requirement for an individual to file an insurance claim before taking a Sec. 165(c)(3) deduction could be construed to discriminate against individuals in favor of businesses. But in Bartlett, Judge Blair noted that "[t]he Constitution does not bar the Internal Revenue Code from distinguishing between persons on the basis of the magnitude of their need for a deduction." (14)
These three cases laid the groundwork for Rev. Rul. 78-141, (15) in which the Service made no argument regarding the "compensated for" means "covered by" issue but launched its attack on the failure of the taxpayer (an attorney) to file an insurance claim. Citing Bartlett and Axelrod, the ruling pointed to the idea that the economic loss resulted not from the casualty, but from the voluntary failure of the respective taxpayers to file an insurance reimbursement claim.
In the meantime, the IRS continued to win Sixth Circuit cases, primarily because of the Golsen (16) rule (under which the Tax Court must follow a circuit court's decision in cases appealable to that circuit court). The IRS even won the first round in Miller, (17) again because the Miller case was in the Tax Court and happened to lie in the Sixth Circuit (i.e., the Golsen rule had to be applied). In Miller, the court for the first time viewed the "forced nature" of not filing an insurance claim. The Tax Court's decision was vacated eight months later and the later decision was upheld on appeal to the Sixth Circuit.
Hills, a Tax Court case in the Eleventh Circuit, offered a fresh opinion on the voluntary failure of the taxpayer to file an insurance claim. In its decision for the taxpayer, the court was not compelled to follow the Golsen rule. The taxpayer was faced with a no-win situation, namely, file a claim and lose the insurance or not file a claim and lose the casualty loss deduction. The IRS suggested a two-part analysis of the situation: (1) determine if there has been a loss and (2) only then consider whether the loss has been compensated. The Service dropped the "covered by" versus "compensated for" issue and therefore implied that the taxpayer was not compensated for by insurance. It continued to make the argument that the loss was economic and was caused by the voluntary election of the taxpayer not to file an insurance claim. In adopting the IRS's two-part analysis, the Eleventh Circuit held for the taxpayer. The court first made it clear that Congress knew the diference between "covered by" versus "compensated for" when Sec. 165 was enacted, and it was the court's duty to enforce the statute as it was enacted. Continuing, the court noted that the statute clearly separates "losses" and "not compensated for by insurance," implying that Congress intended for losses to be determined and then examined separately. Finally, if the taxpayer should have a duty to pursue compensation, the statute would have read "covered" instead of "compensated." (18)
Two items are worth noting from the Tax Court's decision in Hills. First, the court took another approach to clearing the "definitional air" regarding "covered by" versus "compensated for." The Tax Court relied on a dictionary definition to determine that "'compensated' does not comport with the [IRS's] interpretation. To compensate denotes 'to pay' or 'to make up for'." (19) The court went on to explain:
The reason for denying a loss deduction when a taxpayer's loss has been compensated (made up for or paid) is relatively easy to comprehend. The taxpayer has not sustained a true economic loss when the detrimental effects of the loss (vis-a-vis the taxpayer's net worth) are counterbalanced by the receipt of money or replacement property. However, to expand the meaning of compensated from actual to potential recoupment defies the word's acceptation. (2) (Emphasis supplied by the court.)
Secondly, the court stated: "When a taxpayer fails to pursue a right of insurance recovery, his economic loss is nonetheless sustained and a deduction should be allowed. To hold otherwise would unjustifiably advantage taxpayers who voluntarily decline insurance coverage." (21)
At this point the Tax Court, the Sixth Circuit and the Eleventh Circuit were in agreement that "compensated for" did not mean "covered by" and that the taxpayer did not have to file an insurance claim to make his casualty loss deductible. Also, the Hills and Miller courts made it clear that the issue of a taxpayer being forced or compelled not to file an insurance claim was not necessary for their holdings. However, in Hills, the Tax Court seemed to be more concerned with the taxpayer's fear of the policy being canceled or the premium increasing substantially.
Decisions after Hills and Miller primarily followed these cases. In O'Neill, (22) the Tax Court explained why it was no longer following K-U and why it vacated its first decision in Miller. In Khinda, the Tax Court affirmed its position in Miller by noting, "To compensate denotes 'to pay' or 'to make up for'. However, to expand the meaning of 'compensated' from actual to potential recoupment impermissibly enlarges the statute's restriction." (23) (Emphasis supplied by the court.)
Later that same year (1984), the Tax Court drew an analogy to medical expense deductions under Sec. 213(a) that are "not compensated for by insurance or otherwise." In Weaver, (24) the taxpayer had medical coverage for out-of-pocket expenses, but he failed to file a claim. The Tax Court concluded that the reasoning used in Hills and Miller for Sec. 165 losses "is equally applicable to medical expenses under section 213 and consequently the out-of-pocket medical expenses paid by petitioners are deductible even though they failed to seek reimbursement of such expenses from their insurance." (25)
The IRS failed to persuade the court to make an analogy between Sec. 162 and Sec. 165. The Service cited Heidt, (26) in which the taxpayer's deduction for unreimbursed business expenses was disallowed because he failed to file for reimbursement from his employer. (27) The Tax Court replied, "This we cannot do because the pivotal language of 'compensated for by insurance or otherwise' does not appear in section 162." (28)
* The Tax Reform Act of 1986
Congress effectively overruled Hills and Miller and placed a requirement on individuals who are covered by insurance to file a claim for reimbursement in order to claim a casualty loss deduction. The TRA House Report stated:
Where the taxpayer has the right to receive insurance proceeds that would compensate for the loss, the loss suffered by the taxpayer is not damage to property caused by the casualty. Rather, the loss results from the taxpayer's personal decision to forego making a claim against the insurance company. The committee believes that losses resulting from a personal decision of the taxpayer should not be deductible as a casualty loss. (29)
The Conference Report made it clear that the policy's deductible is still potentially deductible as a casualty loss even though not insurance claim is filed. (30) The House Report's explanation of the bill made it clear that Congress intended the provision to apply only to individuals.
The Possibility for
a Sec. 162 Deduction
In Kentucky Utilities, the Sixth Circuit also held that the expense above the $10,000 deductible was neither "necessary" nor "ordinary" under Sec. 162, citing Welch (31) as its authority.
In Rev. Rul. 78-141, the IRS, relying on K-U, disallowed the deduction under Sec. 162. The Service also noted that in Heidt (32) the taxpayer was denied a Sec. 162 deduction for failing to claim reimbursement from his employer for a business expense.
In Waxler Towing, (33) however, the district court disallowed a casualty loss deduction--since the taxpayer failed to file an insurance claim for damage to one of its barges--but did allow a Sec. 162 "ordinary and necessary business expense deduction" for casualty related expenses. When the court discovered that one year's increased premium was double the actual cost of repair for the casualty, that the claim, it filed, would most likely result in cancellation of the policy (according to the insurance agent) and that the insurance was "absolutely required" in the taxpayer's business, it felt compelled to allow the deduction and help keep the business going.
This deduction is limited to the business taxpayer that can prove "sufficiently compelling business reasons" for failing to file and collect its insurance. Otherwise, the expense is more extraordinary and therefore not deductible. In Hills, the IRS suggested that the nondeductible economic loss of the taxpayer, for failure to file a claim, was in fact a nondeductible form of insurance premium. This type of logic may hold for individuals arguing a Sec. 162 deduction, but for a business, the insurance premium is allowable and should be deductible.
In contrast, in Campbell, (34) the Tax Court held that the out-of-pocket payment to the proper person, to make good an erroneous payment to the wrong person, was not an "ordinary and necessary" business expense. Campbell was an actuarial consultant. He had a $1 million errors and omissions policy with a $5,000 deductible. The erroneous payment amounted to $13,035. Campbell argued for a Sec. 162 deduction; the IRS allowed only a $5,000 deduction (the deductible). The court cited Heidt, which generally held that an employee may not deduct unreimbursed business expenses for which he could have been reimbursed. Later, the court cited its decision in Whitney, in which it noted that a taxpayer "must seek his redress and may not secure a loss deduction until he establishes that no recovery may be had." (35) Finally, the court cited an earlier argument made in Lee Mercantile Co. (36) that the government should not have to share in a loss because the taxpayer failed to enforce a valid claim against a responsible concern.
In summary, the argument for a Sec. 162 ordinary and necessary business expense should not be taken lightly. The courts have taken a critical view of unclaimed, but insured, losses. The district court found that "sufficiently compelling business reasons" were present in Waxler Towing for failing to file a claim and collecting insurance, and thus allowed the Sec. 162 deduction. The Tax Court, on the other hand, was not convinced in Campbell (and in other cases involving similar issues) that a Sec. 162 deduction should be allowed. In fact, the Tax Court has generally believed that the government should not be in a position of sharing the burden of loss (via a tax deduction) with a business taxpayer that has failed to file a claim against a responsible party.
Covered But Unclaimed
Some Policy Issues and Views
If a business taxpayer chooses to self-insure, there exists a legitimate business deduction when a payment has to be made for a claim or assertion of civil wrong. This payment may be the result of a judgment or an out-of-court settlement. In any case the payment is deductible. Mos businesses do not have the capital to self-insure and, therefore, elect to share the risks with an insurance company for a premium that is also eligible for a Sec. 162 deduction. When a business is faced with a situation in which the policy will be canceled or the premium will increase substantially, the IRS has argued (in Hills) that the loss the taxpayer suffers is, in effect, an additional premium borne by the taxpayer. In Hills, the taxpayer was an individual and the additional premium was not deductible. However, in a business case, the IRS's argument works for the taxpayer since such premiums are deductible. Therefore, the failure to file a claim and the resulting uncompensated loss should be deductible for businesses. It would seem that the Code should not discriminate between a business that self-insures and one that cannot afford such a luxury. When a business self-insures and incurs a $100,000 casualty loss, it has a deduction of $100,000. If the firm has a $10,000 deductible insurance policy, the firm pays and deducts $10,000. If the firm, for business reasons, files no claim and has to pay the remaining $90,000, it should be allowed to deduct the additional payment. The major difference between the two scenarios is that the insured taxpayer is also deducting the premiums for the policy. Since the premiums are income to the insurance company, the Government experiences no real net tax loss. For this, the Government receives tax revenues from the firm's continued income taxes and from its employees' income taxes, a result that would not arise if the firm could not exist without continued insurance. The same relative position results if the insurance company pays and deducts the $90,000 payment made on behalf of the policy holder. The Government still suffers the same total net tax loss (i.e., if the firm deducts the costs of its own casualty payment as opposed to the insurance company making a tax-free payment to the firm and then taking the deduction).
As a matter of sound business policy, the business taxpayer is not usually going to pay the $100,000 and not file an insurance claim. At an average tax rate of 30% the firm still nets a cost of $70,000. If the firm files the claim and the premium increase is a marriage, the firm loses only the $10,000 deductible. As a practical matter, the firm should elect to pay its own claims only when it has a strong argument for drastic premium increases or policy cancellations that may force the firm out of business. So, the problem should be self-regulating.
Tax Court decisions after Hills and Miller have made it clear that filing a claim was not paramount to claiming a Sec. 165 casualty loss. Congress, in contrast, made it clear that the individual (nonbusiness) taxpayer would be required to file a claim to take a deduction. It may not be possible to reconcile why Congress chose not to require businesses to file an insurance claim to deduct a casualty loss. But in accordance with the Tax Court's trend and Congress's failure to include businesses in the claim filing requirement, it appears that filed claims are not necessary unless Congress expands Sec. 165(h)(E)(4).
(1) Sec. 165(h)(4)(E), added by TRA Section 1004(a).
(2) Dixon F. Miller, 733 F2d 399 (6th Cir. 1984) (53 AFTR2d 84-1252, 84-1 USTC P9451), aff'g TC Memo 1981-431, vac'g TC Memo 1980-550. The taxpayer's (an individual) friend ran Miller's boat aground. Miller failed to file an insurance claim for fear that the insurance company would cancel not only his boat policy, but his personal automobile and apartment policies.
(3) Henry L. Hills, 691 F2d 997 (11th Cir. 1982) (50 AFTR2d 82-6070, 82-2 USTC P9669), aff'g 76 TC 484 (1981). The taxpayer's (an individual) vacation home had been burglarized several times. Since the house was located in a rural area and, thus, any fire loss would likely be total, Hills felt forced to keep his insurance for the fire protection. He believed if he filed a claim for the theft, the insurance company would cancel the entire policy.
(4) See Sidman, Seidman's Legislative History of Federal Income Tax Laws 1938-1861 (New York, Prentice-Hall, Inc., 1938), at 1018.
(5) In Pollock v. Farmers' Loan & Trust Co., 157 US 429 (1895) (3 AFTR 2557), rehearing 158 US 601 (1895) (3 AFTR 2602).
(6) See Regs. Sec. 1.165-1(d)(2)(i).
(7) Kentucky Utilities Co., 394 F2d 631 (6th Cir. 1968) (21 AFTR2d 1263, 68-1 USTC P9361), aff'g in part and rev'g in part 250 F Supp 265 (W.D. Ky. 1965) (16 AFTR2d 5980, 65-2 USTC P9741) (upheld on all parts relevant to this article).
(8) Sam P. Wallingford Grain Corp., 74 F2d 453 (10th Cir. 1934) (14 AFTR 861, 1934 CCH P9571).
(9) Miller, note 2, 6th Cir., at 84-1 USTC 84,119.
(10) David Axelrod, 56 TC 248 (1971).
(11) Id., at 261.
(12) Id., at 259.
(13) Albert L. Bartlett II, 397 F Supp 216 (DC Md. 1975) (36 AFTR2d 75-5574, 75-2 USTC P9648).
(14) Id., at 75-2 USTC 87,971.
(15) Rev. Rul. 78-141, 1978-1 CB 58. The taxpayer (an attorney) gave erroneous advice to a client. He reimbursed the client for expenses incurred as a result of the advice. Although covered by malpractice insurance, he failed to file an insurance claim for fear of cancellation of the policy or a substantial increase in the premiums.
(16) Jack E. Golsen, 54 TC 742, 757 (1970), aff'd, 445 F2d 985 (10th Cir. 1971) (27 AFTR2d 71-1583, 71-2 USTC P9497), cert. denied.
(17) Miller, note 2.
(18) Hills, note 3, 11th Cir., at 82-2 USTC 85,420-85,421.
(19) Id., TC, at 486-487, citing Webster's Third New International Dictionary (1971).
(20) Id., at 487.
(21) Id., at 488.
(22) William J. O'Neill, Jr., TC Memo 1983-583. The taxpayer (an individual) failed to file an insurance claim for winter ice storm damage.
(23) Jagtar Singh Khinda, TC Memo 1984-432, at 1740. The taxpayer's (an individual) car was stolen and items in the trunk were never recovered. Khinda failed to file an insurance claim.
(24) James R. Weaver, TC Memo 1984-634.
(25) Id., at 2585.
(26) Marvin A. Heidt, 274 F2d 25 (7th Cir. 1959) (4 AFTR2d 5997, 60-1 USTC P9135), aff'g TC Memo 1959-31.
(27) See also IRS Letter Ruling (TAM) 8102010 (9/29/80). The IRS disallowed a medical expense deduction because the taxpayer failed to file an insurance claim for the expense. The Service cited Rev. Rul. 78-141, note 15. See also Thomas V. Orvis, 788 F2d 1406 (9th Cir. 1986) (57 AFTR2d 86-1356, 86-1 USTC P9386), aff'g TC Memo 1984-533, and the cases cited for disallowance of employee business expenses because the taxpayers could have sought reimbursement from their employers, but did not.
(28) Weaver, note 24, at 2585.
(29) H. Rep. No. 99-426, 99th Cong., 1st Sess. 658 (1986).
(30) H. Rep. No. 99-841, 99th Cong., 2d Sess. II-343 (1986).
(31) Thomas H. Welch v. Helvering, 290 US 111, 114-115 (1933) (12 AFTR 1456, 3 USTC P1164).
(32) Heidt, note 26.
(33) Waxler Towing Co., Inc., 510 F Supp 297 (W.D. Tenn. 1980) (48 AFTR2d 81-5808), and related proceedings at 510 F Supp 297 (W.D. Tenn. 1980) (48 AFTR2d 81-5274, 81-2 USTC P9541).
(34) Donald F. Campbell, TC Memo 1987-480.
(35) Charles D. Whitney, 13 TC 897 (1949), at 901, quoted in Campbell, id., at 2580.
(36) Lee Mercantile Co., 79 F2d 391, 393 (10th Cir. 1935) (16 AFTR 657, 35-2 USTC P9554), aff'g 1934 P-H BTA Memo P34,031, aff'g an order of this court, quoted in Campbell, note 34, at 2580.
|Printer friendly Cite/link Email Feedback|
|Author:||Price, Charles E.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1992|
|Previous Article:||Saving the S election; an analysis of recent letter rulings suggests that the IRS has been reasonable in granting waivers of S termination.|
|Next Article:||CPA-client privilege vs. the confidentiality ethics requirement.|