INTRODUCTION II. SIGNIFICANCE OF ISSUES IN LIGHT OF NEW TAX LAW III. THEORETICAL JUSTIFICATIONS FOR THE DEDUCTION A. Haig-Simons Definition of Income B. Casualty and Theft Deductions C. Utility D. Significance of Purpose IV. LOSSES OF BUSINESS AND INVESTMENT PROPERTY A. Deductibility B. Section 1231 Characterization V. THE MEANING OF "OTHER CASUALTY" AND "THEFT" A. Inadequacy of Current Standards B. A Change of Meaning VI. CONCLUSION I. INTRODUCTION
Section 165(a) of the Internal Revenue Code (the "Code") states that "There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise." (1) This broad rule is severely limited, especially for individual taxpayers, by restrictions contained in that Code section. For example, an individual taxpayer may deduct a loss only if it was sustained in connection with (1) the trade or business of the taxpayer, (2) (2) a transaction entered into for profit that is not connected to a trade or business, (3) or (3) a casualty or a theft of the taxpayer's personal-use property (i.e., property not connected to a trade or business or a transaction entered into for a profit). (4)
For individuals, the Code divides property into three separate categories--business, investment, and personal. As noted above, taxpayers typically can deduct losses involving either business or investment property regardless of the cause of the loss. (5) However, losses suffered by an individual's personally used property generally are not deductible. The exception to that latter rule applies when "such losses arise from fire, storm, shipwreck, or other casualty, or from theft." (6)
The principal issue that arises in applying section 165(c)(3) is determining the meaning of the term "other casualty." The other items listed in section 165(c)(3) are specific, and so there is no issue in determining when an event that causes a property loss qualifies for one of those explicitly listed examples. "Other casualty" is a broader and less specific term and requires clarification to determine what events fit within it. The term "other casualty" was not included in the original version of the statute; the term was added to the statute in 1916. (7)
The Internal Revenue Service (8) and the courts, applying the maxim of ejusdem generis, used the three expressly identified casualties in section 165(c)(3) for guidance in establishing the meaning of the broader term "other casualty." Taking what they deemed to be the common elements in the three explicitly identified casualties, they determined that an event will qualify as an "other casualty" only if it is "sudden," "unusual," and "unexpected." (9) The presence of those three elements has been adopted by both the Service and the courts as the requirements for constituting a casualty. (10) In addition, the event must be the proximate cause of the loss. (11) In this Article, the author disputes the appropriateness of making the presence of those three elements a condition for qualifying for the casualty deduction in light of the apparent congressional purpose for allowing that deduction. Moreover, two of those three elements are not always present in the three named casualties and so cannot be said to be common to them.
One common element that is shared by the three listed casualties is that they cause physical damage to property. A number of courts have held that the casualty loss deduction applies only to a loss incurred because of physical damage to the taxpayer's property. (12) The author agrees that that limitation is proper.
This Article will review the casualty and theft loss deduction including a review of the significance of that deduction in light of the 2017 Tax Cut and Jobs Act (the "2017 Act"). (13) It will set forth the most likely theoretical justifications for allowing a deduction. It will also explore the historical treatment of the provision and how the three factors noted above have been applied. In light of the congressional purpose for allowing the deduction, the current definition does not properly distinguish between events that should qualify for the deduction and those that should not. The currently existing standard is too restrictive. I will show that because the current standard excludes from deductibility events that should be covered, there are inconsistencies in the judicial decisions applying the Code provision. It appears that courts have struggled with trying to reconcile the results invited by the currently applied standard with the results that seem proper.
While most of the focus concerning the casualty and theft loss deduction is on personal losses, the definition of "other casualty" can be important to business and investment losses as well. Of course, businesses do not have personal losses and so generally all losses of a business are deductible. Nevertheless, the determination that a business or investment loss did or did not occur as a result of a casualty can affect the timing and characterization of the deduction of that loss. (14)
Regardless of whether the courts' definition of "other casualty" is appropriate for a loss of personally used property, it is my contention that whatever definition is adopted for that purpose should not be used to determine the timing and realization of a business or investment loss because the role of the casualty characterization in applying the realization requirement is very different from the role it plays in section 165(c)(3). On the other hand, it is proper to use the section 165(c)(3) definition of casualty in determining the character of a business or investment loss. There has been little, if any, commentary on those issues and a major contribution of this piece is to shed light on them.
SIGNIFICANCE OF ISSUES IN LIGHT OF NEW TAX LAW
As briefly set out in the introduction, this Article sets forth two major contentions. One is that the standard currently used by the courts and the Service to determine what constitutes a personal casualty (resulting in a gain or loss) is too narrow and should be expanded. The second contention is that the standard for determining what constitutes a casualty for a loss due to damage to property used in a trade or business or in a profit activity should be different from and of a broader scope than the standard that is applied to personal casualties. As to the first issue concerning personal casualties, while the recent adoption of the 2017 Act, (15) reduces the importance of that question, it continues to be a significant issue. As to the second contention that a different and broader standard should be used for determining what is a casualty for a loss incurred by property used in a trade or business or profit activity, the 2017 Act has no effect whatsoever on the importance of that issue.
Section 11044 of the 2017 Act adds section 165(h)(5) to the Code. Section 165(h)(5)(A) provides that no deduction will be allowed for a personal casualty loss except to the extent that it is attributable to a "Federally declared disaster" area. (16) Section 165(h)(5)(B)(i) creates an exception to that denial of a deduction and allows the deduction of a personal casualty loss to the extent of the taxpayer's personal casualty gains for that period. Thus, it is still important to determine what constitutes a personal casualty gain and personal casualty loss. In addition, section 165(h)(2)(B) provides that if a taxpayer's personal casualty gains exceed his personal casualty losses for a taxable year, they are treated as long-term capital gains and losses respectively. That provision was left intact by the 2017 Act and also makes it important to determine what constitutes a personal casualty gain or loss. The characterization as a casualty can qualify a loss for a deduction and can qualify a gain for capital gain treatment. Consequently, except for a loss incurred in a Federally declared disaster area, the standard for determining what constitutes a personal casualty arises whenever a taxpayer has a personal casualty gain. An example of a personal casualty gain is a receipt of an insurance payment for an item damaged in a personal casualty in which the amount of the payment is greater than the taxpayer's basis in the damaged item.
As noted previously, the 2017 Act deals only with the deduction of personal casualty losses which otherwise would be deductible under section 165(c)(3). The 2017 Act has no application to casualty losses of business property or property used in a profit activity, which are allowable under section 165(c)(1) and (2).
Section 11045 of the 2017 Act adds section 67(g) to the Code, which provision denies a deduction for all Miscellaneous Itemized Deductions. Miscellaneous Itemized Deductions are itemized deductions not listed in section 67(b). None of the casualty loss deductions are Miscellaneous Itemized Deductions, and therefore none of them is affected by section 67(g). The casualty losses incurred in a trade or business are nonitemized deductions and so are not affected by section 67(g). Personal casualty losses and losses incurred in a profit activity are expressly excluded from Miscellaneous Itemized Deductions by section 67(b)(3).
THEORETICAL JUSTIFICATIONS FOR THE DEDUCTION
Haig-Simons Definition of Income
An initial question to consider is what are the theoretical justifications of and purpose for allowing a casualty and theft loss deduction. While the identification of the purpose of a provision is not dispositive of the issue of how it should be construed (and it is not a purpose of this Article either to defend or repudiate the appropriateness of the deduction), the construction of a statutory provision is greatly aided by viewing it in light of the most likely purpose for its adoption.
To understand the theoretical justification of the casualty and theft loss deduction, we need to step back and consider the theoretical structure of the federal tax system as a...
THE MISCONSTRUCTION OF THE DEDUCTIONS FOR BUSINESS AND PERSONAL CASUALTY LOSSES.
|Author:||Kahn, Jeffrey H.|
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COPYRIGHT GALE, Cengage Learning. All rights reserved.