Tax Implications for Businesses Receiving Insurance Proceeds

Introduction to Insurance Proceeds for Businesses

As a business owner, it is critical to understand what insurance is in place and what insurance may be applicable in the future for proper business planning. It is equally as critical to understand how the level of insurance coverage may impact your business in the event that a claim arises. Generally, an insurance policy is a contract in writing whereby one party (the insurer) agrees to indemnify and hold a person or business (the insured) harmless from loss or damage which the insured may become legally obligated to pay as a result of a specific event or events (the risk). In return, the insured typically pays a premium to the insurer. An insured may pay premiums for years without ever making a claim on a policy. Insurance policies can be complicated and are subject to various state and local laws as well as regulations . There are many different types of insurance and the following is a brief overview of some common forms of insurance that business owners may have: In addition to understanding often-complex insurance policies, it is important that the insured understands how their insurance is taxed in the event a claim is made. For instance, if the insurance proceeds received by the insured are taxable, the insured should be aware of the tax implications of receiving insurance proceeds in order to properly plan for the potential tax liability. As a general matter, insurance proceeds are usually taxable to the extent that they exceed the insured’s basis in the insured property. This is commonly known as the "taxable extent" of insurance proceeds.

Are Insurance Proceeds Taxable Income?

There are some general rules about how insurance payments for damages to business property or business vehicles, or business losses or business interruption, are treated under the Internal Revenue Code. If the insurance proceeds are for the repair of damaged business property, that is not taxable. However, if the proceeds are for the sale or other disposition of damaged property and result in gain, that gain is considered taxable as income from sale or exchange. If the insurance proceeds are for a casualty or theft loss of business property, the proceeds are taxable but just to the extent that the proceeds are greater than your basis in the damaged or stolen property. Insurance proceeds received that constitute a return of premium are not considered taxable income. A business cannot deduct from taxable income the cost of purchasing a life insurance policy on one of its officers or employees if the business is the beneficiary of the policy. The purchase price of a policy where the business is the beneficiary is considered taxable income to the business. If the insurance proceeds are for business interruption, those proceeds are taxable as income if the proceeds are received in lieu of the lost income itself. If the proceeds are contingent on the loss occurring, such as for liability insurance, the proceeds are not taxable. If the insurance involves an indemnity payment for the loss of goodwill or goodwill itself, that is not taxable.

Insurance Proceeds are Not Taxable

A number of different types of business insurance may provide non-taxable proceeds if you are reimbursed or compensated for losses as a result of physical injury the insurance company has agreed to indemnify you for. In addition, health insurance, such as the proceeds from certain policies that provide long-term care may fall into this category and be non-taxable. If your business is a sole proprietorship or a single member LLC, a reimbursement for assets may not be subject to income, such as a loss of account receivables or loss of business inventory, or trade samples for loss of customers. Generally, if these reimbursements are used to replace the loss property, no gain is realized. In addition, it is important to note that you may receive insurance proceeds for future lost profits as part of a business interruption claim for business property or inventory. However, if you use those proceeds to replace business assets, no income is required since you will not be taxed on property received in-kind as a direct trade for property that is given up.

Exceptions and Special Cases

Not all Policies are Simple, and There are a Few Special Cases to Consider
Let’s start with the obvious-the tax implications above relate to business insurance policy proceeds (equipment, property ++), and that such proceeds are not taxable because they replace like kind property; this rule can break down in a few situations. If the insurance policy has a salvageable or residual value once the loss is paid for, the business should recognize the amount of any salvageable or residual value received. For example, if the business received $10,000 for a piece of equipment which it sold for $2,000 rather than keeping it or using it, then only $8,000 would qualify as a like kind exchange under Section 1031-the residual $2,000 being taxable. Don’t forget that some insurance policies are multi-use. For example, an insurance policy may allow for a combination of medical expense and property coverage, for example. Under IRs Rev. Rul. 70-162 even though the premium for the combined policy usually has to be allocated on a pro-rata basis, for purposes of determining the extent to which the proceeds are taxable, the facts and circumstances must be considered and a method that is consistent with real world fact patterns must be applied. If the proceeds are clearly related to a particular type of loss, then such proceeds will not be recharacterized as proceeds of another type of loss.

Documenting Insurance Proceeds for a Business

Given the potential of an insurance recovery in a business losses, it is essential that you comply with all of the requisite tax record keeping requirements. If the business loss was significant and the recovery is substantial, there is a reasonable chance that your tax return may be audited by the IRS and you will want to have the documentation ready. If you do not have it, the IRS may not provide you the benefit of an audit in your favor. So if you are going to go through the process of pursuing an insurance recovery, you should also ensure that you are being diligent with your record keeping.
Generally, the policyholder must maintain a detailed record of the insurance proceeds as they relate to the business. Record keeping requirements include keeping receipts related to the financial loss , including: It is important to note that having good books, records, and documentation will also help if you are forced to show that the business was profitable at a specific point in time. A policyholder may have a claim that the business was unfortunately worth more after the damage occurred than the day that the damage happened, because a customer may have attempted to purchase the business, and in doing so caused the policyholder to reject an earlier offer to purchase the business at a lower price. If the purchase offer is documented in a written letter of intent, a copy of the letter of intent should also be maintained as a record. As is discussed in more detail below, if you do not keep these records, the IRS may deem the higher value fictitious and will require you to pay the tax based on the original valuation.

Consult with a Tax Professional

Consulting with tax professionals to properly determine the taxability of the insurance proceeds and compliance with federal and state tax laws is essential for the following reasons:

• Insurance proceeds are not taxable to the extent that they do not exceed the adjusted basis of property before a casualty or theft (except for gain from life insurance contracts payable by reason of death).
• Insurance proceeds that are used to restore or replace property damaged in a casualty or theft generally are not taxable. Rather, the basis of the property is reduced by the amount of insurance proceeds.
• When insurance proceeds simply reimburse a business for the cost of a deductible, the proceeds should be reported as miscellaneous income on a company’s return and may be subject to self-employment or other taxes.
• Businesses may be able to replace purchased insurance plans with refund plans or sell their insurance policies back to their insurance companies without incurring income tax liability.
• Too little or too much tax may result if certain accounting methods are not used or are not properly applied when a business receives insurance proceeds.
• Tax planning may help serve business objectives such as facilitating the purchase of additional insurance coverage, adjusting the basis of assets and reducing federal or state tax liabilities through proper tax transfer strategies.

Conclusion and Best Practices

As noted, the tax implications of business insurance proceeds are myriad and can depend on the nature of the payment being received. Best practices to keep in mind when considering insurance proceeds and their tax implications include:

• speak with an accountant early in the process to determine if there may be income tax implications to a claim and how to avoid them. The insurance broker may be able to recommend an accountant;
• present an accurate and complete claim to an insurer , as an incomplete or inaccurate claim may be rejected, and cause the insurer and the insured to litigate over the claim damage versus the amount accepted;
• if possible, obtain a legal opinion from counsel on the impact of insurance proceeds (if any), prior to accepting the insurance proceeds in case of tax implications; and
• test after the end of the first fiscal period for the tax year of the loss, to determine if the insurance proceeds affected the taxable year.