Uncertain limes, Uncertain Costs: Deducting Expenditures Subject to Pending Insurance Claims.

• Author: Kelley, Lee

The Experts: Lee Kelley, Kandyce Korotky, and Jeffrey Zink

With the global pandemic COVID-19 upending business operations worldwide, companies are incurring unexpected--and often large--costs. Some of these costs may ultimately be covered by insurance. Given the unprecedented circumstances, however, there are bound to be questions and disagreements about which of those costs are covered by companies' insurance policies. When a claim is resolved in the same taxable year that the cost was paid or incurred, it should be clear whether or not a company will be out of pocket for a particular expenditure. When a claim crosses tax years, however, the question arises whether the company will be out of pocket and whether the costs are deductible, despite the possibility of future reimbursement. In this article, we discuss the different types of costs that taxpayers may be incurring (losses versus expenses) and the various considerations that apply when determining whether to deduct a cost that might be reimbursed by insurance.

Question 1: What is the difference between a loss and an expense?

Companies are likely to incur various costs during crises. How those costs are categorized--as losses or expenses--determines whether and when those costs can be deducted. Section 162 provides that business expenses are generally deductible if they are both ordinary and necessary. The case law defines "ordinary" as customary and usual within the relevant industry, and does not rely on the frequency with which the expense is incurred. (1) "Necessary" means appropriate and helpful, rather than absolutely necessary or indispensable. (2) Section 165, on the other hand, provides a deduction for "any loss sustained during the taxable year and not compensated for by insurance or otherwise."

The standard for distinguishing expenses from losses for tax purposes has been described as "self-evident" and "found primarily in the nature and occasion of the expenditure." (3) The Tax Court has observed that, in practice, "this distinction is often difficult to apply." (4)

Amid murkiness, however, some concepts have emerged from the case law. For example, costs related to property that is not owned by the taxpayer immediately prior to the expenditure (such as property sold to a customer for which the company has provided a warranty) generally do not give rise to a loss but instead generally give rise to Section 162 expenses. (5) Expenditures to maintain business reputation or to retain customers' patronage and goodwill also typically give rise to ordinary and necessary business expenses, (6) but expenditures related to goodwill associated with business property may instead give rise to losses under Section 165. (7) In the event that an expenditure qualifies as both a deductible expense under Section 162 and a deductible loss under Section 165, the expenditure is generally deductible under Section 162. (8)

Question 2: Why does it matter whether an expenditure qualifies as a loss or a deduction?

The timing and amount of a deduction turn on whether a particular cost is a loss or an expense. (9) Determining when a Section 165 loss is deductible can be more difficult than determining when a Section 162 expense is, in that a Section 162 expense is deductible in the year of payment or accrual. The Section 165 regulations provide that a taxpayer's loss is not deductible until the year in which the loss is evidenced by a closed and completed transaction and fixed by identifiable events occurring in such taxable year. (10) Furthermore, a loss is deductible only up to a maximum amount equal to the taxpayer's adjusted basis in the affected property, (11) whereas an expense is generally deductible in the amount paid or accrued. As discussed in the next sections, standards differ for deducting losses and expenses reimbursable by insurance.

Question 3: What are the standards for deducting an expenditure potentially reimbursable by insurance as a Section 165 loss?

Section 165 specifically precludes a deduction for any loss that is "reimbursed by insurance" or otherwise. Courts have interpreted "reimbursed by insurance" broadly to preclude a deduction if the taxpayer has a "reasonable prospect of recovery," meaning that the taxpayer has a bona fide claim for reimbursement and there is a substantial possibility that the taxpayer...