WHY CAN’T IT JUST BE DONE RIGHT THE FIRST TIME?
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.
THE LAWSUIT WAS FILED!
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.