Insured business losses; if they are unclaimed they may still be deductible.

• Author: Price, Charles E.

Businesses face many situations in which a casualty loss may be properly insured, but for specific reasons, an insurance claim is not filed. Many reasons may exist for this failure to file an insurance claim: When a business has had difficulty obtaining insurance, it may fear the cancellation of the policy if a claim is filed. If the business must have insurance to maintain a business license, the decision not to file a claim is more critical. Or the business may have reason to believe that the policy premiums will increase dramatically when a claim is filed. Sometimes this additional premium cost is greater than the after-tax cost of deducting the out-of-pocket costs of the casualty. If the business elects to pay (out-of-pocket) the settlement, or suffer the loss, it may still have either a Sec. 162 or a Sec. 165 deduction.

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...