Election to Accelerate Disaster Loss Deductions May Create Cash Flow Opportunities
By Ken Maeng, J.D.
6.1.20 | Client Alert – COVID-19 Update
On March 13, 2020, President Trump declared COVID-19 to be a national emergency1. The federal emergency declaration provides an opportunity for business and certain other taxpayers to receive early tax relief while weathering the impact of the pandemic storm. Specifically, under section 165(i) of the Internal Revenue Code, taxpayers may elect to claim certain disaster loss deductions on their tax returns in the tax year preceding the year in which the losses were actually sustained. This means that if a taxpayer makes the section 165(i) election, qualifying COVID-19 related disaster losses that were sustained in 2020 will be treated as though they were sustained in 2019, and such losses would be deductible on the taxpayer’s 2019 return.
Historically, these rules have been applied to natural disasters such as a hurricane storm, tornado, or fire. Therefore, the application of these rules to incorporeal disaster losses caused by the COVID-19 pandemic is one of first impression, and there is some level of uncertainty whether they are eligible for this special treatment because COVID-19 losses do not result in actual physical damage that is usually associated with a casualty loss. Moreover, in certain instances it may be difficult to attribute a loss to the COVID-19 pandemic underlying the emergency declaration. When considering whether to claim a section 165(i) loss, taxpayers must be mindful of the application of other subsections and limitations within section 165 generally. Clarification of the application of these rules to the COVID-19 pandemic is expected from the IRS.
Eligibility and Limitations
A taxpayer who sustained a loss in 2020 in connection with a trade or business or a transaction entered into for profit that is directly attributed to the COVID-19 pandemic may be eligible to make a section 165(i) election. Disaster losses may be claimed by businesses or other taxpayers in connection with investments or income-producing property including those sustained by C corporations, S corporations, partnerships, or sole proprietorships.
In general, to claim a disaster loss under section 165(i), the loss must be deductible under section 165(a) and (1) arise from a “closed and completed transaction”; (2) be “fixed by identifiable events”; (3) in most cases, be sustained in the tax year the disaster occurred; and (4) be incurred in a federally declared disaster area (i.e., in the context of the COVID-19 pandemic, the federally declared disaster area is within the U.S.). Economic losses for certain incomplete transactions, such as lost revenue, declines in fair market value and loss of goodwill cannot be deducted, even if they are related to COVID-19. Moreover, the amount of loss that may be claimed is limited to a taxpayer’s basis in the affected property, and is reduced by any amount reimbursed from insurance.
Pending administrative guidance, specific losses that may qualify as a disaster loss deduction may include but are not limited to:
- Impaired inventory, supplies, and other properties that have been abandoned, expired, destroyed, or sold at a loss;
- Abandonment of leasehold improvements (that are not rent payments);
- Abandonment of pending business deals for which costs have been capitalized;
- Closure costs associated with the disposition of inventory and/or fixed assets;
- Securities that have been sold or exchanged resulting in a loss (subject to careful analysis of the surrounding facts and circumstances); and
- Worthless securities (subject to certain limitations and fact-based criteria).
With respect to losses incurred in connection with property held for investment, like the sale of securities, section 165(i) provides the possibility of claiming a capital loss deduction in 2019, to offset 2019 capital gains, for sales or other dispositions occurring in 2020. To do so, the taxpayer is able to demonstrate that the loss is directly attributable to the COVID-19 disaster. We expect additional guidance from the IRS on this particular issue, but such an allowance would potentially allow individuals to essentially carryback a capital loss that would otherwise not be permissible.
Section 165(i) can be an economic lifeline for many taxpayers who suffered economic loss due to the COVID-19 pandemic, as it may result in quick access to cash through accelerated deductions and refunds of overpaid estimated taxes. These deductions may also create or increase 2019 net operating losses (NOL), which are subject to favorable treatment pursuant to the CARES Act’s new carryback rules2.
Real estate and other businesses may benefit by accelerating losses from the abandonment of leasehold improvements, the sale of real property, or the abandonment of pending deals for which costs have been capitalized. Section 165(i) may also be particularly beneficial for restaurant and retail businesses because they may treat COVID-19-related inventory impairments as disaster losses eligible to be recovered on their 2019 federal tax return, rather than accounting for those losses through their inventory accounting in 2020. Importantly, if a taxpayer’s disaster loss involves inventory impairments, it must decrease its opening inventory for the year of the loss to avoid a double benefit.
To make the election to include COVID-19 related disaster losses sustained in 2020 on the 2019 tax return, the taxpayers must file Form 4684, Casualties and Thefts, with their 2019 tax return3.
Taxpayers who have already filed their 2019 tax return may file an amended return with Form 4684. An amended return with Form 4684 is due no later than six months after the regular due date for filing the original return (without extensions) for the disaster year (2020).
The following chart provides the applicable deadlines for calendar year taxpayers electing under section 165(i) to take a disaster loss sustained in 2020 on a 2019 tax return:
Tax Return with Form 4684 for Individuals and C Corporations Due By:
|Tax Return with Form 4684 for Individuals and C Corps Due By:||Tax Return with Form 4684 for Partnerships and S Corps Due By:|
|Original 2019 Tax Return||July 15, 2020||March 16, 2020|
|Extended 2019 Tax Return||October 15, 2020||September 15, 2020|
|Amended Tax Return||October 15, 2021||September 15, 2021 for non-BBA partnerships and S corps and September 30, 2020 for BBA partnerships 4|
While the section 165(i) election is revocable, if a taxpayer makes the election, all section 165(i) losses attributable to COVID-19 must be claimed in the year immediately preceding the year (2019) in which the losses were actually incurred (2020). Taxpayers are expected to maintain supporting documentation evidencing a clear connection of the loss with the COVID-19 disaster, as scrutiny by the IRS should be expected. In addition, taxpayers may be subject to other IRS requirements, such as the filing of disclosure statements under the rules applicable to certain reportable loss transactions. Questions relating to state conformity with federal treatment should also be considered.
We encourage interested taxpayers to contact Naya Pearlman at 212.324.3388 | email@example.com or their tax advisor at Berdon LLP to further explore tax opportunities associated with making a section 165(i) disaster loss election. For more information on other matters related to the COVID-19 pandemic, please contact your Berdon advisor.
1 Under Rev. Rul. 2003-29, a disaster includes an event declared as a major disaster or an emergency under the Robert T. Stafford Disaster Relief and Emergency Assistance Act.
2 Under the Tax Cuts and Jobs Act (TCJA), the taxpayers could only offset 80 percent of taxable income with net operating losses and TCJA NOLs can only be carried forward. The CARES Act removed the 80% cap for utilization of NOLs generated in 2018, 2019 and 2020 and gave individuals and businesses an ability to carry back these losses for up to five years going as far back as 2013.
3 Rev. Proc. 2016-53 specifies the procedure for making or revoking the election.
4 Rev. Proc. 2020-23.