With all the economic hardship emerging from COVID-19 and the shuttering of the American economy as a result, taxpayers are looking for any relief and stimulus they can find. While much of the current focus has rightly been focused on legislation such as the Coronavirus Aid, Relief, and Economic Security (CARES) Act, there are lesser known preexisting provisions within the Internal Revenue Code (the “IRC” or “Code”) which impacted taxpayers could potentially avail themselves of. One such provision which is IRC Section 165(i).
Disaster Loss Deductions
IRC Section 165(a) provides that any loss sustained during the taxable year which is not otherwise compensated by insurance or other reimbursement is deductible. When taxpayers prepare to file their 2020 tax year, may will certainly invoke this provision. However, 2020 tax year returns will not be filed until early 2021 at the earliest. While taxpayers certainly would stand to benefit from claiming the loss, the delay in recognizing any benefit from such claim may come too late.
Recognizing that, for seriously impacted taxpayers, the timing of a standard loss under Section 165(a) might be unmanageable, Congress added Section 165(i) which provides special rules for losses related to disasters. Under Section 165(i), any loss occurring within a disaster area and attributable to a federally declared disaster may be carried back to the preceding tax year at the taxpayer’s election. Specifically, pursuant to Treas. Reg. § 1.165-11T(e), a taxpayer suffering a disaster related loss may file an amended tax return for the preceding tax year and claim the loss for such prior tax year. As set forth in Treas. Reg. § 1.165-11T(f), a taxpayer has until six months after the due date for filing the tax return for the year in which the disaster occurred to elect to carry the loss back to the preceding year, rather than taking the loss in the year it occurred. By permitting a taxpayer to amend a prior year return and claim the disaster loss in such tax year, the taxpayer can generate an immediate refund and gain access to the relief much more quickly. Moreover, due to the modification of the net operating loss (“NOL”) rules under IRC Section 172 as provided by the CARES Act, the 2019 loss, in cases where it creates an NOL, may also be carried back as many as five tax years when uses in conjunction with such NOL rules.
Federally Declared Disasters
To elect the application of Section 165(i), a taxpayer must establish two elements. In the case of the COVID-19 pandemic, the first condition, the occurrence of a disaster, is clearly met. As provided in Section 165(i)(5) and Treas. Reg. § 1.165-11T(b), a disaster is “any disaster subsequently determined by the President of the United States to warrant assistance by the Federal Government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act”, and a disaster area is, “the area so determined to warrant such assistance”. On March 13, 2020, President Trump declared a national emergency under the Stafford Act (the “Declaration”), which has been accepted as adequate for triggering the federal disaster declaration provisions of the Code. The area subject to such declaration is the entirety of the United States. Therefore, for any loss occurring anywhere within the United States during the effective dates of the Declaration is, in theory, eligible for carryback under Section 165(i). However, the second element of the two-prong test is far more complex.
Losses Attributable to a Disaster
Section 165(i) requires that the disaster loss be attributable to the disaster. A disaster loss is any loss occurring within a disaster area attributable to the disaster which is otherwise allowable as a deduction for the disaster year under Section 165(a) and the regulations thereunder. Under the Treasury regulations governing Section 165, a loss must be evidenced by closed and completed transactions and fixed by determinable events. For a typical disaster, this is relatively simple standard to meet. If a tornado destroys a taxpayer’s warehouse, the completed transaction is the complete loss of the warehouse, and the fixed and determinable event is the tornado causing its destruction. Additionally, for purposes of Section 165(i), the loss is clearly attributable to the disaster, as the building, but for the tornado, would still be standing. However, for the COVID-19 pandemic, the question as to whether the transaction is closed, as well as to what extent it is attributable to the disaster, is far less clear.
For the most part, it is unlikely COVID-19 will cause casualty losses which are easy to attribute to the disaster. Additionally, in many cases, it will not be clear that the transaction resulting in the losses is closed and completed. As such, the question is whether losses related to the failing of a business or the decline in value of an asset could be claimed under Section 165. For instance, there have been arguments that stock losses resulting from the collapse of the stock market in March might be claimed as disaster losses under Section 165(i). While a simple decline in value is definitively not an allowable loss under Treas. Reg. § 1.165-4, there is in theory an argument that if stock were sold for a loss, it could be claimed the loss was related to the COVID-19 pandemic, a Presidential declared disaster.
That being said, absent guidance blessing this strategy, this would seem to be a tenuous position to take. While the COVID-19 pandemic certainly has had a significant impact on the stock market, attributing the entire decline in value to COVID-19 and not any other normal market forces would be nearly impossible. Similarly, it may be appealing to claim disaster losses from the failure of a business or the collapse of a transaction after significant costs had been expended pursuing it. As evidenced by Treas. Reg. § 1.165-2(a), the regulations under Section 165 allow losses with respect to nondepreciable property which arise from a failed or discontinued business transaction. Nonetheless, it is still uncertain how exactly it could be shown that the loss was clearly related to COVID-19, and not just it being a bad business decision. Based on a statement made by IRS Chief Counsel Michael Desmond at the Financial Research Associates Private Investment Fund Tax Master Class on May 20th, the IRS is looking at the issue.
Possible Heightened Scrutiny
While a case-by-case analysis of all situations is certainly warranted, taxpayers should cautiously approach a refund under Section 165(i). Historically, the IRS has viewed losses, particularly substantial losses, with a degree of skepticism. Under Treas. Reg. § 1.6011-4, large Section 165 losses ($50,000 for individuals, and increasing for pass-through entities and corporations) are considered reportable transactions and must be disclosed to the IRS. While certain Section 165 losses are excluded from reportable transactions under Rev. Proc. 2013-11, there is no current guidance accepting COVID-19 pandemic-related losses from being reported. Ultimately, without guidance from Treasury as to how Section 165 losses emerging from COVID-19 pandemic will be viewed, taxpayers should exercise caution. Although some situations may be clear-cut enough to warrant taking the retroactive loss under Section 165(i) absent guidance, a significant cost-benefit analysis should be undertaken, considering the upside of taking the loss immediately versus waiting for (hopefully) forthcoming guidance. That being said, taxpayers should keep Section 165(i) in mind as we move forward. As stimulus funds allocated by Congress run dry, creative application of existing Code provisions may be the best way to stem the tide until Congress can act again.
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