This article was updated on June 26, 2020.
The invocation of the Stafford Act on March 13, 2020 opens the door for an additional tax planning opportunity for individuals and businesses alike. Specifically, this declaration by President Trump that the COVID-19 pandemic is federally declared disaster and that the entire U.S. is a federally declared disaster area opens the door for Internal Revenue Code (IRC) Section 165(i).
Under Section 165(i), a taxpayer can elect to claim a loss “attributable to a federally declared disaster” in the immediately preceding year. Whether the IRS will agree that Section 165(i) is available for the pandemic is currently unknown, as it was not envisioned at the time that the geographic area would be the entire country and the disaster would be a global pandemic. In absence of clearer guidance, we can interpret what types of losses may be attributable to the pandemic based on extrapolation of prior interpretations of Section 165 and the disaster loss rules. The following provides a quick look at what you need to know.
What Benefits Does Section 165(i) Offer?
To use Section 165(i), taxpayer losses must not only be attributable to the federally declared disaster but also be otherwise allowable under Section 165(a). These losses must be sustained in the taxable year and “evidenced by closed and completed transactions, fixed by identifiable events,” and they must not be compensated by insurance.
Taking a 2020 loss in 2019 means that businesses may be able to access cash benefits—and soon—from Section 165(i), because the original due dates for filing extension 2019 tax returns was moved to July 15, with the possibility to extend to Sept. 15 or Oct. 15, 2020, depending on the entity or individual status. The availability of benefits depends on who the taxpayer is. Different rules apply to businesses and individuals claiming losses under Section 165(i). For business filers, all business losses are presumed to be trade or business losses. Individuals, on the other hand, are limited under Section 165(c) to losses incurred in a trade or business, in a transaction entered into for profit, or losses arising from casualties. As a result, there are more opportunities for businesses to claim a section 165(i) loss than there are for individuals.
Individuals – Differing Results of IRS Pandemic Treatment
For individuals, the benefits of the opportunity will depend on whether the IRS treats the pandemic as a casualty. If the pandemic is determined to be a casualty, this results in the best opportunity for taxpayers, because the deduction can offset ordinary income as well as capital gains, depending on the size of the loss. If the pandemic were not determined to be casualty, an individual would need 2019 capital gains and could then use 2020 stock losses attributable to the pandemic to offset their 2019 capital gains obligations.
Considering Stock and other Capital Assets as Impacted
Regardless of whether the IRS treats the pandemic as a casualty, stocks or assets sold at a loss in 2020 may qualify for Section 165(i) treatment. The closer the stock is to the types of businesses hit hardest by the pandemic (hospitality, retail, airlines, ETFs, REITs, etc.), the better the argument that the loss will qualify. The rash of bankruptcies and store closings bolster the argument that drops in stock prices may be affected by the pandemic. However, there is no bright line test to determine which stocks may qualify. Timing of the sale of stock may not be relevant, either, as long as the loss itself is attributable to the COVID-19 disruption.
When the Pandemic Qualifies as Casualty
The definition of what constitutes a casualty is less than clear. Because Section 165(i) was passed with more traditional natural disasters in mind—earthquakes, fires, etc.—the definition has historically involved property damage from a discrete event in a limited geographic region; however, the statute is not written with that specific limitation. Tax court cases have tried to bring some additional clarity for other types of disruptive events that result in disaster losses. IRS guidance, including Publication 547 and Rev. Proc. 2016-53, explicitly state that losses from a federal declared disaster is a form of casualty loss.
Taxpayers should also note that personal casualty losses claimed under Section 165(c)(3) are generally subject to restrictions under Section 165(h), specifically losses that exceed $100 and net casualty losses to exceed 10% of adjusted gross income (AGI). Assuming you have a net deductible personal casualty loss attributable to a federally declared disaster, it may be claimed on Schedule A as an itemized deduction. It will not be subject to the 2% of AGI limitation on miscellaneous itemized deductions, nor is it subject to the suspension of those deductions from 2018-2025 imposed by the tax reform law commonly known as the Tax Cuts and Jobs Act.
When the Pandemic is Not Classified as a Casualty
It is certainly possible to have a casualty loss with respect to transactions entered into for profit or with respect to trade or business property. However, the IRS may take the position that the pandemic is not necessarily a casualty, due to its more gradual effect on the economy, stocks and other impacts. If the taxpayer can claim a loss on fixed stock losses that are attributable to the pandemic, then they could still benefit from a Section 165(i) election, provided they have 2019 capital gains.
Businesses – Loss Qualification
Businesses have a lower hurdle to Section 165(i) benefits, because all transactions are presumably trade or business transactions. If a business loss qualifies, it is probably going to give rise to an ordinary deduction that can be used to directly reduce 2019 taxable income. Losses will have to be qualified and not compensated by insurance. Items normally considered operating costs, like compensation, are unlikely to give rise to Section 165 losses. A business may have paid rent after the store was ordered closed and could not generate income during the rental period. This would likely be taken into account in determining operating income, rather than a Section 165 loss. The procedures for making the section 165(i) election are explained in IRS Rev. Proc. 2016-53, although they are less clear for businesses.
Additional Filing Requirements
Certain levels of losses claimed under Section 165 trigger the reportable transaction rules, and absent an exemption, will require a taxpayer to file Form 8886 to report the transaction. Losses are not netted against capital gains or otherwise. So any Section 165(c)(2) loss, for example, being claimed by an individual in 2019 in excess of $2 million might require that the individual attach Form 8886 to his or her Form 1040, and file it in accordance with the governing directions. IRS Rev. Proc. 2013-11 excepts both casualty loses and losses where a taxpayer's basis is determined by what he or she paid for the asset from the reportable transaction rules, however. Accordingly, there is authority for not having to file Form 8836 for losses resulting from elections made under Section 165(i).
As with any potential tax savings opportunity, taxpayers should consider how timing factors into the ultimate benefit. For example, taking a loss in 2020 might increase a corporation’s net operating loss that it could carry back to a year when the maximum rate was 35%. Careful analysis is always important before making any major tax decision.
For more information on optimizing Section 165(i) tax losses, contact a member of our team.
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