Navigating the Business Insurance Claim Maze
Business insurance has a clear purpose…to protect a business from financial loss should a significant "unexpected" event occur. The most obvious situations are fires, storms, theft, flooding, etc., that would cause a business to incur more expense to repair or replace property, procure temporary use of alternative property and/or even temporarily close. However, there are other less obvious situations where an unexpected event, such as getting involved in a tax controversy with the IRS and having significant professional services legal fees, may also require a business to use its insurance coverage. Importantly , some of these claims may not be covered under traditional property or casualty insurance. That’s where Directors and Officers Liability Insurance may provide coverage and mitigate loss.
When such a business insurance claim arises, will the amount received to settle (or partially settle) such a claim end up increasing a business’ taxable income for tax purposes? That is the question we will address in this blog post.
We will start by evaluating what a business insurance claim is, how one may arise, and how should one evaluate a business insurance claim.
It Helps to Understand Taxable Income
According to the IRS definition of taxable income, it is money you receive for providing goods, services, and investments. The Internal Revenue Service (IRS) generally requires taxpayers to report business income as taxable. This tax therefore applies to all businesses, regardless of their entity structure (sole proprietorship, corporation, partnership, etc.).
Some types of income are exempt from taxation or not subject to taxation. Generally, you need to report all business income you receive in cash, property, or services unless there is an exception that allows you to exclude it. For example, amounts that you receive as a gift or an inheritance, certain scholarships, and workers’ compensation received should not be included on your tax return or into your business gross receipts.
Examples of business income include:
• Interest and dividends received from investments
• Rent received from leasing a building, equipment, or vehicles
• Sales you receive from retail or wholesale transactions
• Fees paid to you for your services
• Commissions paid to you for selling goods and services
• Your share of the partnership income and profits
• Unemployment compensation
When you receive insurance proceeds, they are generally taxable income if you are reimbursed for business loss. For example, if a fire destroyed your inventory, the amount received from your insurance for the value of the inventory is taxable. Legal settlements may or may not be taxable but seem to fall under the general definition of taxable income.
Insurance Claims Taxable?
Insurers pay a multitude of claims every year to commercial policyholders. Obviously, if the goal of an insurance policy and the coverage it provides is to consider losses suffered by the policyholder a zero-sum game – what was lost is paid in full with no additional costs – then the funds paid by the insurer should not be taxable to the policyholder or considered income. That said, this area of the law is not that simple and the income tax treatment of claim payments made to a business can be controlled by the structure of the policy and the circumstances of the loss.
As a general matter, income tax principles dictate that the payment of an excess loss or damage claim is not taxable to the recipient. Generally speaking, gains are taxed but losses are not. Accordingly, for example, it has been often stated that the recovery of a "total loss," as contemplated in a property insurance policy, is not considered taxable income. As a result, the recipient of such a claim payment is not taxed on the extra amount it receives as compensation for the loss. The tax code provides for an income tax treatment that contemplates the offset of the payment received in a total loss situation as the basis for the damaged property. The income tax treatment of an insured’s receipt of a claim payment can, however, be affected by the type of insurance purchased, the amount of the loss, the type of loss, and the structure of the insurance policy. In a property and casualty context, for example, if business interruption coverage is purchased and the policyholder is paid for the loss income it suffers due to a covered loss, under certain circumstances that payment may be treated as taxable income. This is because the intent of the policy is to make the insured whole, rather than compensate the insured for losing its property. Similar considerations apply in a liability coverage context if the property is damaged as a result of the insured’s negligence resulting in a claim payment, which compensates the insured for losing and/or repairing its property.
It Depends on the Circumstances
A business insurance claim may or may not be taxable income depending on how the money was used. Following is a discussion of the tax implications for three types of claims: claims on damaged or lost property, business interruption claims, and liability claims.
Damaged or Lost Property
If your business carries a property policy, you will have to report the insurance payouts as taxable income when you file your federal income tax return. However, you may be able to offset the tax liability by deducting the fair market value of the damaged or lost property on your 1040 Schedule A as an individual casualty loss. If the damage doesn’t exceed 10% of your adjusted gross income, you can choose to file an insurance claim or not. If the amount is greater than 10%, you must file a claim. If the total loss exceeds the claim amount, the difference becomes a casualty loss that lowers your tax bill.
Business Interruption
Insurance payouts from a business interruption claim are also considered taxable income by the IRS. But you can offset the tax liability by deducting what you spend to rebuild, including payroll costs and payment for damages not covered by your business interruption policy. Where this type of claim is concerned, it pays to plan carefully. For example, a large portion of your payment may have to be allocated to payroll costs, which means those funds would not be available to cover costs associated with repairs and reconstruction.
Liability
Just like physical damage claims, business liability claims are generally considered to be taxable income by the IRS. However, both may be eligible for tax-free treatment via the casualty loss deduction. If your business receives a liability payment from a claim, such as negligent, intentional tort, or defamation, and you use all of the funds to pay off judgments or settlements arising from those lawsuits, you may be able to avoid paying taxes on the money you receive since you won’t have any additional gain.
Are Business Insurance Premiums Deductible?
In stark contrast to the tax treatment of business insurance claims, amounts paid for business insurance are generally tax-deductible. This is because the purchase of a business insurance policy is an ordinary and normal expense of doing business. With some exceptions, these premiums are fully deductible as business expenses and will decrease the amount of taxable income to the business.
The tax treatment of business insurance premiums differs somewhat from the treatment of personal insurance premiums. The Internal Revenue Code Section 262 prohibits the deduction of personal, living or family expenses. Instead, personal insurance premiums are usually added to adjusted basis of property or deducted as an itemized deduction on Schedule A.
Unfortunately, this is not the case with business insurance premiums. One exception from the general prohibition on deducting business insurance premiums is the recurring premium associated with life insurance. Any amount categorized as a recurring premium for life insurance is not deductible but may be considered as an undisputed claim in the future if it presents or has presented a claim to the insurance company.
For individual taxpayers, such as self-employed individuals and partners in partnerships , there are additional restrictions on the deduction of premiums paid for business insurance. Premiums paid for business insurance are deductible by self-employed individuals under I.R.C. § 162 as "ordinary and necessary" business expenses on a Schedule C where such insurance is purchased to protect a trade or business. For partners in partnerships, premiums paid for partnership liability insurance (buy-sell insurance) are treated as guaranteed payments under I.R.C. § 707(c). A qualified employee benefit plan may also purchase life insurance for the benefit of an employee or purchase a business overhead life insurance policy insuring the owner-principal of the business where the insurance is owned by the employee or business.
One possible deduction that may affect the taxable income of a business in a prospective situation is the business interruption insurance claim. In the event of a loss of use of a business, an amount received pursuant to a business interruption insurance claim may offset business income resulting from the loss suffered. While not considered taxable income for purposes of obtaining a business interruption insurance policy, a claim paid pursuant to the terms and conditions of the policy and compensating for the actual loss of business income may be fully taxable as ordinary business income.
Your Reporting and Other Compliance
Once the correct answer is known, what you do with this information becomes important. If the claim funds are NOT considered taxable income to your business, then there is nothing more you need to do. If it is known that they are, then you should make sure you are properly reporting and paying taxes on the payments you have received and will be receiving.
First, track the funds you receive in a separate bank account to be used only to deposit any payments for business-related claims you have received and pay any expenses related to the claim from that account. This creates a separate paper trail that you or your accountant can easily reference.
Second, let your accountant or CPA know both at the beginning of the claim process and as you receive payments for the claim, so that these amounts can properly be reported and accounted for in accordance with Internal Revenue Code ("IRC") §1231. This tax code section refers to the gain or loss from sales or exchanges of property held for more than one year and it specifically refers to gains or losses from the disposition of certain types of assets that would ordinarily be classified as long-term capital gain under IRC §§ 1221(a)(2) or 1231(b). Notably, there is no time requirement for insurance proceeds—they can be received anywhere from 0 to more than 12 months after the loss. Intuitively, one might think that if the claim payment is more than 1 year after the underlying loss occurred, it would be considered long-term capital gain. However, that is not the case, the focus is instead on how the proceeds are categorized—if they are properly categorized as a §1231 property, then any gain upon disposition (a sale or exchange) of that property will be treated as long-term capital gain and any losses will be treated as ordinary losses.
Third, if you are paid your claim funds on an ongoing basis, it may be beneficial to conduct a regular check-in with your accountant or CPA to let them know how much you have received, what it has been used for and how much remains. This way if any funds received were classified as long-term capital gain under IRC §§ 1221(a)(2) or 1231(b) you are more likely to be in a position at tax time to be capped at the 15% tax rate.
Conclusion and Tips
As you can see from this blog post, it is clear that there are a number of tax implications from business insurance claims and losses. Depending on the type of insurance claim, if a business suffers a loss, it is possible that some or all of that amount may be taxable income. However, it is also possible that some or all of that amount may not be taxable and could actually work to benefit the business when it comes time to file taxes with the IRS.
While this may all seem pretty confusing, the thing to remember is that when looking closely at your specific situation, there are a number of issues that need to be resolved on a case-by-case basis. These issues will depend on: what type of policy you have , what type of loss you have sustained and how you have been compensated for that loss.
On the business side of things, it is probably safe to say that your primary concern is getting back up and running as quickly as possible. However, what is important to remember is that the compensation from an insurance claim can potentially offset a business loss in two ways: (1) getting reimbursed by the insurance company for property not owned (i.e., temporary relocation); and (2) reducing the tax consequences of claim income. While not every insurance claim will be subject to income tax, the majority of them will. With this being said, if you are not a tax expert – hire one.