Wednesday, December 29, 2010



This is a case study of how tax return preparation by a “professional” who does not investigate details and research the law for proper application can end up costing the taxpayers a lot of money, plus aggravation and unnecessary stress.

In the early part of the decade just ending taxpayers suffered a loss in a fire that swept through a canyon as part of a large Southern California fire that was declared a federal disaster area. Taxpayers rented the home they lived in and as such, had no insurable interest in the real property. Their only possessions were personal property that they maintained in their rented home that burned to the ground in the fire along with approximately three dozen other homes.

Soon after the fire, taxpayers collected an insignificant amount of insurance proceeds for their personal possessions. Yes, they were substantially under-insured.

It was subsequently determined that a third party might have liability for the loss of these 35 homes. A lawsuit was filed. The income tax treatment of the settlement of that case is the subject of this article.
The issues to be covered in this saga are the following:
1. Was the tax return that was filed for the year of the loss to claim a disaster casualty loss for the adjusted cost basis of the assets in excess of the insurance proceeds correct?
2. Because of the amount of the loss, the excess loss was carried back to prior years. Was this handled correctly?
3. When the lawsuit was settlement was the tax reporting for the proceeds received in the year of the settlement reported correctly?

We start with the casualty loss claimed in the year of the fire. The taxpayers filed a tax return for the year of the fire claiming a casualty loss. Because the actual insurance coverage was so inadequate, the loss claimed on the return for the year of the loss was more that the rest of the taxpayers’ other net taxable income for that year. The accountant prepared a claim for refund of previously paid taxes for two of the three years prior to the year of the fire. That was not necessarily incorrect. However, if the taxpayers had advised the accountant that the lawsuit was being filed or that they intended to file a lawsuit, then one of the requirements for claiming the loss on the tax return for the year of the fire would not have been met. The Internal Revenue Code states that the loss may be claimed on a tax return for the year in which “the loss is sustained.” Sounds simple, but what does it mean to be “sustained?” For a loss t be “sustained,” it must be “incurred” and “settled.” For this loss the year of the fire determines when it was “incurred.” But the fact that a lawsuit was being pursued means that it was not settled. Maybe when the original return was filed it was not known that an unrelated third party might have some culpability for the loss that would lead to filing a lawsuit to recover damages. When I got involved, five years after the fire occurred, it was not a point that I could address, so I did not ask.

What I did know was that the taxpayers had received a Federal Tax benefit of about $11,000 due to the loss being claimed in the manner it was claimed on the return for the year of the fire and carryback claims for the unused balance of the loss.

Certainly, the cash that the losses generated in reduced or refunded taxes assisted the taxpayers in that period.

The law is clear, a casualty loss can be claimed on a tax return once three steps have been finalized. First, obviously, the loss itself must have occurred and it otherwise qualifies as a casualty loss. Second, it must be settled. Once these two facts have been determined, the loss is then determined to have been sustained.

Well the fire did occur and it was declared to be part of a federal disaster. Therefore, the first step had occurred, there was a fire that qualifies as casualty loss. But, has it been settled at the time the original tax return was filed? If at the time the return was filed the lawsuit had been in some stage of development, then the answer is no, it was not settled because there was still some prospect of additional proceeds being received that might affect the ultimate outcome.

I was not the accountant who prepared the original return. When I was asked to review the situation, I did not ask that question because, under the circumstances there was no way to come to a clear resolution. To claim that the original returns had been filed incorrectly when I had to deal with a subsequent issue would have made the process very difficult. I had to deal with the situation that I believed I could be successful in winning for the taxpayers. It is unlikely that the accountant who prepared the return for the year of the fire inquired about the possibility of additional proceeds being on the table. The accountant might have asked: “How much insurance coverage did you have and how much did you collect?” Both amounts being the same, it would be easy to stop there. Although the coverage was so small compared to the loss, more inquiry might have been called for. It would have been advisable to ask, “Are there any other parties who may have culpability or liability for the loss?” Or, “Are you in the process of suing any party due to an allegation of underinsurance?”

If any questions such as these had drawn out an answer that there might be additional possible proceeds, then the loss was not settled at that time. Therefore the loss computed based on the proceeds received to that date should not have been claimed on the tax return for the year of the fire. Claiming this loss over three years did get the taxpayers some money back, but at what ultimate cost. Accountants love to make clients happy by giving them a return claiming refunds. But, sometimes that is not always the best thing to do, regardless of the fact that it may actually be wrong.

Four years after the year of the fire, that lawsuit was settled and the taxpayers received a substantial payment, let us just say it was about 10 times the original amount of the insurance proceeds.

The taxpayers went to the accountant who prepared the original return and informed the professional that the lawsuit was settled and a very large check was received. “How should this be handled?” Yes, they did the right thing, the taxpayers asked the professional how to deal with this check. The professional was notified of the receipt soon after the end of the year it was received by the taxpayers. There was plenty of time to prepare a return for filing by April 15th. But the professional held the return until the last minute and handed the taxpayers the return on October 13th, two days before it was due to be filed on extension. You might think that that time was being spent researching the proper way to report the proceeds. In the meantime, the professional had computed what was the liability and had the taxpayers pay that amount with an extension application in April. On the return supplied to the taxpayers at the last possible moment, only a small balance due was left to be paid. The taxpayers felt bullied, after filing the return, the taxpayers sought this reporter out and we met and discussed the return. I determined that while the actual reporting needed to be determined, the reporting on the return as filed was absolutely incorrect in my opinion. It resulted in the maximum amount of tax liability that could have been reported as a result of the receipt of this large lawsuit settlement. So much for the professional wanting to produce a return with as small a payment of taxes as possible!

After several meetings and gathering substantial data from the taxpayers, I determined that a substantial amount of the lawsuit settlement payment was totally tax exempt from any tax liability. Yes, the loss that was reported on the original return and the returns for the two years prior to the year of the loss would have to be reversed and reported as income in the year of receiving the settlement. Other adjustments would also have to be made. By the way, the Federal Tax liability for reversing the prior deductions meant that in the year of the receipt of the settlement, just that portion of the Federal Tax liability would be about 2.5 times the original tax savings. That is correct, because of the “bunching” of income and other aspects of the return for the year the settlement was received, the repayment of those tax benefits that were claimed in the earlier years would require a tax liability of over 2.5 times the actual refunds and reduced tax liabilities realized in the past. Oh, you say, “why not simply go back anc ‘correct’ those years?” Well that is not what the tax law requires. The law, simply states that it is assumed that what you filed on the original return was what you believed to be true and correct. Any subsequent receipt is a new event that should be dealt with in the year of receipt. If it can be shown that the original return was incorrect, then there is the possibility for correcting the original return. In this case, the trail of information was just not there to pursue that avenue. Additionally, trying to add that argument to what was already a complex correction would have added substantial time and expense to the taxpayers cost of recovery without an absolute guarantee of success.

The treatment of the new proceeds as a current event that is not part of the original loss deduction is not inconsistent with the law regarding the requirement that the loss be settled to make the initial claim. In fact it is quite consistent. By filing the return and claiming the loss the taxpayer is representing that the case is closed and the loss is final. The subsequent collection does not change that. But if the original return for the year of the fire had been filed with only a disclosure of the fact that there had been a fire, then the additional proceeds would simply be an installment on the original claim and it, along with the original amount, would be analyzed and the tax consequences of the total proceeds determined and reported on the return in which the final settlement had been received.

In this case the story does not end with the filing of the return to correct the prior accountant’s incorrect return prepared for the year the large settlement was received. After all, while I believed strongly that the tax return needed to be corrected I do not have the final say. The corrections were made and the taxpayers filed the returns. The IRS decided to audit the claim for refund, as they often do. It took a while for the audit to arrive in the office of the IRS where I would advocate for my clients’ position. After one meeting with the examiner and a few telephone calls, the IRS decided that the claim should be paid. The claim for refund concluded with over 40% of the Federal Income tax liability for the year of the settlement being refunded back to the taxpayers.

The importance of having a full understanding of the key facts and the applicable law along with counseling the taxpayers on the full impact of their present decision along with the possible future impact of changes in circumstances is part of the responsibility of a knowledgeable professional when assisting taxpayers in these cases.

Disaster losses are different. The tax law actually contains a number of beneficial sections that are intended to assist taxpayers in a time of crisis and great stress. Understanding and applying those sections correctly can reap great benefits for taxpayers. Incorrectly apply them, or ignoring them altogether can cost taxpayers thousands of dollars and add stress and aggravation to an already overwhelming situation.

Thursday, May 27, 2010



By: John Trapani, CPA

We live in Wildland Fire and Earthquake Country; California is often referred to as the Shake and Bake State. Two years ago, the Governor declared that we have a year-round fire season. For over two years, Cal Tech and USGS seismic scientists have been warning that the southern leg of the San Andreas Fault is due for a large eruption. It has been relatively quiet for over three hundred years and is at least 150 year “overdue.” Many aware families and companies have developed disaster plans. These usually include preparing disaster kits to help survive the first few days and even weeks after a catastrophic event bestows its wrath. Each event is different, preparation and warnings are not the same. Usually there is some time to react before a fire destroys a home, but there is no effective warning for an earthquake. A fire may destroy the whole home and its contents, while an earthquake may cause severe damage, even destruction, but there may be debris that can be searched for valuables. Unfortunately, in California we have to prepare for at least these two distinct possibilities. Yet we cannot forget windstorms, mudslides, freezes and more.

The Red Cross is a valuable resource to get help on preparing for the physical and personal safety aspects of a catastrophic event. The Federal Emergency Management Agency (FEMA) has an excellent website for preparing family disasters plans and emergency kits (www.Ready.Gov).

But, there is more to being ready. Sit back and think, your kit is prepared, you have a kit in the car and one at work also. You have prepared your family disaster plan. Everyone in the family knows where to meet. Out of town contacts have be set up for all family members to call. Now what will actually occur after the catastrophe strikes? Your plan works flawlessly. Everyone is safe. Now recovery starts. What do you need for the recovery process? When does that process start?

Here is a list to consider. It has the answers to the questions that you will be asking after the catastrophe strikes. The list includes the items that you can assemble today that will be of assistance in the recovery process. These are items that you already have, but maybe disbursed and stored in many places. These items are what people will ask you for after the event. Bringing them together, in the manner described, will speed your recovery, relieve anxiety, and relieve some of the stress that you will be experiencing due to the situation.


Once you have built your kits and prepared your family disaster plan, every six months:
Check your “kit” - replace any perishable items as needed. Check your “plan” – update any information as needed.

Now is a good time to review or prepare a will or create your living trust. You should also update and maintain an “Advance Health Directive.”

1. Phone service:
a. 911 calls from many cell phone locations may go to the Highway Patrol or State Police first, not the local 911 dispatch.
b. Keep a roll of quarters in each of your disaster kits to use in pay phones.
2. Maintain a compact digital camera and battery charger to record damage and the recovery.
3. Maintain a blank journal and pen to document every post-event conversation and discoveries.

a. Set aside enough cash for your family for at least three days purchases of food, shelter and fuel in the event you cannot get home, or to a bank / ATM; power may be out and ATMs may not be operational.
b. Maintain an active credit card that has no balance due that can be used in case of an emergency.

5. Assemble the original documentation and store it in a watertight, fire safe at an offsite location, not a bank safe deposit box that may not be accessible after a disaster.

6. If you have significant valuables that are subject to appraisal, have an appraisal prepared at least every three to four years.
a. Have the appraisal prepared in both hard copy and as a PDF (digital) copy.

Assembling Evidence You Will Need:
7. Cost records for real property and major items of contents, including jewelry, cameras, electronics, computers, tools and art works.
a. Extensive photographs of all the items for the cost records.
b. Have the photos in both hard copy and in digital form.

8. PERSONAL DOCUMENTS: Financial documents to consider securing and recording in digital form:
 Cost records for real property (escrow statements) and major items of contents, including jewelry, cameras, electronics and art works.
a. Record the cost of significant assets in every room of your home and office in a ledger or journal.
 Make copies of wills, and living trust documents, grant deeds and property escrow settlement statements.
 List of emergency contacts, including doctors, financial advisers, and family members.
 Birth, death, and marriage certificates.
 Copies of drivers’ licenses.
 Copies of power of attorney, living will / medical powers.
 Trust documents.
 Copies of important medical information, including your health insurance card, doctor’s name and phone number, immunization records, and prescriptions (including prescriptions for glasses and contacts).
 List of insurance policies (life, health, disability, long-¬term care, auto, homeowners, renters), including the type, company, policy number, and name of insured, agent contact information, claims contact information.
 Adoption papers.
 Passports.
 Social Security cards.
 Divorce and child custody papers.
 Military records.
 Mortgage/property deeds.
 Stock and bond certificate-s.
 Vehicle and boat title documents.
 Inventory of your possessions.
 Warranties and receipts for major purchases Credit card records.
 Retirement account records.
 Recent checking, savings, and investment account statements.
 Recent pay stubs and employee benefits information.
 Rental agreement/lease and/or mortgage documents.
 Safe deposit box information (location, contents, and key number).
 Store negatives of photographs, protected in plastic sleeves, separate from the prints.

a. Have you read your insurance policies lately?
b. Do you have coverage for Earthquake damage?
c. Do you live in an area that is susceptible to mudslides or flooding? Consider the need for coverage under the National Flood Insurance Program.
d. Is your coverage consistent with your present risks?
e. Do you know what is not covered?
f. Was your home built many years ago, under a building code that is now outdated?
g. Do you know if your cost to replace your assets is adequately insured?
h. What is current replacement cost of assets, including compliance with existing building codes?
i. Do you know that the cost to replace your home in a major disaster event will rise significantly? The cost to replace a “production line built home” in a tract of homes will rise significantly when you are trying to duplicate it with a “single edition” of the same home.
j. Is your coverage for “Scheduled Property” adequate? Are all the items that you have appraisals for adequately insured?

10. Create PDF files of the documents including Federal and state income tax returns and Insurance Policies.
a. Store the PDF’s on data CDs and flash drives – create multiple copies. Send copies of the CDs to trusted individuals who will be outside of any potential hazard area.
b. Check on the efficacy of the CDs periodically.
c. Keep a copy of the CDs in your family disaster kit.
d. Update the CDs at least semi-annually.

With the possibility of fire, mudslide, earthquake, tsunami, and severe winds, all of California is subject to some form of natural disaster – Do not ignore the possibility.

Wednesday, May 26, 2010



June 2, 2010 is an important deadline fpr those who experienced the April 4, 2010, 7.2 Magnitude California Earthquake that was only declared a federal disaster on May 8, 2010.
Filing Deadline For Public Assistance Grants From FEMA And Cal EMA For Earthquake Recovery
FEMA issued the following notice Wed, 26 May 2010 01:49:24 -0500

Pasadena, CA.-June 2 is the deadline for eligible Imperial County agencies, state of California agencies and certain private nonprofit organizations to submit Request for Public Assistance (RPA) forms to the California Emergency Management Agency (Cal EMA) for federal and state disaster assistance funding following the April 4 Imperial Earthquake.

Monday, March 29, 2010



Taxpayers may have more than one loss related to a catastrophic event. Business losses are treated differently than personal losses.

The IRS Form 4684 has two pages. Page one deals with personal losses and page two deals with business and investment property casualty losses.

Personal losses reported on page one are computed in a different manner than business and investment property losses.

For personal losses, the otherwise deductible loss for each event must be reduced by $500 for 2008 and 2009 losses. Further, for non-disaster losses, the total of all losses must be reduced by 10% of adjusted gross income. The second difference is the computation of the loss on each item destroyed or damaged. The Internal Revenue Code does not allow individuals to claim losses in value that are of a personal nature. Therefore, if you have a valuable item that you paid, say $1,000 for three years before the catastrophic loss occurred, at the time of the loss, its fair market value may only be $600. The $600 amount is the limit of the amount that may be included in the computation of the loss (the lower of the actual cost or its fair market value just before the event).

For businesses and investment property, the $500 and 10% of AGI limitations do not apply. Additionally, for many of the assets lost in the category, depreciation has been claimed in past years as part of the normal tax return preparation process. Fair market value is not an issue other than in determining the fair market value of the asset after the event. Assuming the post-event fair market value is zero, the loss is limited only to the remaining cost basis that has not been depreciated.

The problem most small business owners face after a loss, when they are looking for tax relief in the form of tax deductions is the fact that they have already expensed or fully depreciated the assets lost and therefore have no deduction.

I am not going to discuss the special issues of dealing with losses related to inventory in this entry. They have their own considerations that must be dealt with that are different from the issues discussed above.



There were 59 federal disaster area declarations in 2009 that affected 30 states and American Samoa. You can view the list and get details of each declaration at ""

If you have a deductible loss related to one of these declaration, you can claim the loss on either your 2009 or 2008 tax return. By now your 2008 return should bave been filed, so yu you would claim the loss for 2008 on an amended return for that yar.

There is a looming deadline for making that election. April 15, 2010 is the deadline.

After that date you will only be able to claim the loss on your 2009 return.

Tehre are no limitations on who can make the election to deduction the disaster loss on either the 2008 or 2009 return, except that it must be one of the 59 disasters listed on the FEMA website.

If you need assistance in making the claimed deduction, IRS pub 547 can be useful.

If you still need help - send me an email.