Structuring insurance contracts to qualify under Sec. 1033.

• Author: Bakale, Anthony
• Position: Tax treatment of insurance proceeds

Taxpayers frequently enter into insurance contracts to protect their businesses from a variety of problems. Typically, insurance policies are purchased to protect against fire, flood or other natural disasters, as well as strikes or other manmade disasters that can halt a business. In addition to policies to insure the value of a particular business asset, other policies, known as "use and occupancy insurance" and" business interruption insurance" may be designed to compensate a business for lost profits during a-disaster period. The tax treatment of the insurance proceeds received from one of these types of policies varies, depending on what the payments are compensation for.

The tax treatment of insurance proceeds received for damage to a taxpayer's business depends on whether the proceeds compensate for lost profits or for the damage to (or loss of the use of) an asset used in the taxpayer's trade or business. Amounts received as recovery of lost profits are included in the taxpayer's income and subject to income tax in their entirety. These amounts do not qualify for the Sec. 1033 deferral provisions. "Lost profits" include compensation for services that the business has rendered and reimbursement of lost anticipated profits.

Generally, under Sec. 1033, insurance proceeds received as a result of damage to a taxpayer's property can be reinvested in qualified replacement property without recognizing income. Sec. 1033 states "if property (as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation) is converted into property similar or related in service or use to the property so converted, no gain shall be recognized." The taxpayer has two years after the close of the first tax year in which any part of the gain on the conversion is realized to elect to invest the insurance proceeds received in property similar or related in service or use; the two-year period for reinvestment increases to three years for real property. Sec. 1033 relates only to gains; losses related to the destruction of property are recognized in the year of the destruction. Regs. Sec. 1.1033(a)-2(c)(8) states that the proceeds of a use and occupancy insurance contract (that by its terms insures against an actual loss of net profits of the business) are not proceeds from an involuntary conversion, but are income in the same manner that the profits for which they are substituted would have been. Therefore, payments received under an...