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On March 13, President Trump invoked the Stafford Act and declared a national emergency due to the COVID-19 pandemic. As a result, under Code Sec. 165(i), certain taxpayers may be able to deduct disaster losses that are attributable to COVID-19 on their 2019 return, even though the pandemic is occurring in 2020.

 

This rule is significant for at least a few reasons. First, to the extent that 2019 may have been a more profitable tax year than 2020, such losses may be easier to utilize against 2019 income than 2020 income. Furthermore, certain provisions in the CARES Act, such as the temporary repeal of business loss limitations and modifications to the net operating loss rules, may increase the likelihood of being able to utilize these losses.

 

In summary, this opportunity can reduce current income and cash tax payments and potentially allows for a refund if a 2019 return is amended. However, a careful facts and circumstances analysis is required to determine eligibility.

 

Background

Under Code Sec. 165(i), a taxpayer who has sustained a loss attributable to a federally declared disaster (i.e., a COVID-19) in a taxable year (i.e., 2020) may elect to deduct that disaster loss in the preceding year (i.e., 2019). To deduct a disaster loss related to COVID-19 in 2019, a taxpayer must establish that the loss is otherwise deductible under Code Sec. 165 and the regulations thereunder.

 

Generally, Code Sec. 165 permits taxpayers to deduct any loss sustained during a tax year that is not compensated for by insurance or otherwise. Although all losses incurred by a business are deemed to be a business loss, an individual taxpayer’s deduction is limited to: (1) losses incurred in a trade or business or any transaction entered into for profit; and (2) losses that arise from a casualty (i.e., a fire, storm, or shipwreck).

 

Because of these limitations on individuals, it may be more likely that corporations can benefit from this rule. For example, while an individual investor might be able to deduct tanked airline stock as a disaster loss, businesses in certain industries, such as restaurants, hospitality, retail, and entertainment, have a lower hurdle.

 

Examples

A determination of whether a loss will qualify under Code Sec. 165(i) necessitates a thorough examination of the facts and circumstances, as well as any specific deductibility rules that may apply based on the type of expense. Moreover, although the pandemic meets the definition of a federally declared disaster, the IRS has not specifically ruled on the applicability of Code Sec. 165(i) to COVID-19.

 

Examples of losses that might qualify for the accelerated deduction opportunity include, but are not limited to, the following:

 

  • Inventory impairments (i.e., a restaurant that must shut down temporarily and reopen as a take-out only operation may have food that spoiled during the time of the shutdown);
  • Worthless stock or partnership interest (but not bad debts) due to events such as bankruptcy (or substantial insolvency), termination of business operations, liquidation, or receivership;
  • Costs associated with permanent closures of store and facility locations;
  • Complete abandonment of fixed assets (i.e., leasehold improvements or equipment);
  • Abandonment of pending business deals (i.e., expenses incurred to plan a prospective merger or acquisition);
  • The termination of payments to cancel contracts, leases, or licenses; and
  • Prepaid events, travel, conference space, or hotel rooms when the taxpayer is not provided a refund or credit.

Examples of losses that will probably not qualify for disaster loss treatment include, but are not limited to, lost revenues, decrease in value due to economic hardships or other market forces, and goodwill losses. Moreover, items normally considered operating costs should not give rise to Code Sec. 165 losses.

 

Procedural Requirements

Pursuant to Rev. Proc. 2016-53, an election under Code Sec. 165(i) is made either on an original or amended income tax return for the preceding year (i.e., 2019). The due date for making the election is six months after the due date for filing the income tax return for the disaster year (i.e., 2020).

 

The due date for the election is determined without regard to any extension of time to file. Thus, an election should be made by September 15, 2021 for partnerships and S corporations or by October 15, 2021 for C corporations and individuals. Although these deadlines are more than a year away, it is advisable to claim these losses now on a yet-to-be filed 2019 return, or to amend a previously filed 2019 return to obtain immediate cash savings.

 

Note, if the claimed loss is over a certain threshold amount, then such losses should be reported on Form 8886 as reportable transactions.

 

For more questions or information on this Tax Alert, please reach out to one or more of the following individuals:
Name:            Meghan Andersson, JD, LLM
Office:            Irvine, CA
Phone:           (949) 623-0542
Email:             mandersson@singerlewak.com
Name:            Jason Borkes, CPA, CM&AA
Office:            Irvine, CA
Phone:           (949) 623-0516
Email:             jborkes@singerlewak.com
Name:            Mark Cook, MBA, CPA, CGMA
Office:            Irvine, CA
Phone:           (949) 623-0478
Email:             mcook@singerlewak.com
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