WHAT...? YOU DID NOT REPORT INSURANCE PROCEEDS ON YOUR TAX RETURN!
You received significant insurance proceeds from your claim for reimbursement for a loss of property and you failed to report the receipt in the required manner on your income tax return for the year of receipt.
What are the implications of your failure?
There is some good news, but a lot of potentially bad news.
Over the years I have talked to several people who assert:
“The insurance company does not issue a Form 1099, reporting. The IRS does not “know” I have received any insurance reimbursements. I am not telling the tax collector I received this money.”
It is interesting to find out that the tax code includes a provision for such taxpayer attitudes. Additionally, proper reporting probably would not involve any tax liability and would relieve ongoing anxiety of about the IRS was finding out the proceeds were not reported.
Generally, most people would assume two possible choices; report receipt of the insurance proceeds and follow all the IRS reporting rules, or fail to report and live in a state of anxiety fear that the IRS will audit your finances and find the hundreds of thousands of dollars that was deposited into your bank accounts. (For IRS examiners, such a discovery of a large, unusual deposit that has not been reported is like finding a real diamond at the bottom of the Cracker Jacks box.)
It turns out that there is a third possibility. That possibility holds out some chance for redemption, but is not a complete “get out of jail free card.” The significant relevant part of the Internal Revenue Code was enacted into law in 1954. The IRS issued corresponding regulations in 1957. The rules have been around for a long time. Those 1957 regulations includes the following sentence:
“A failure to so include such gain in gross income in the regular manner shall be deemed to be an election by the taxpayer to have such gain recognized only to the extent provided in subparagraph (1) of this paragraph even though the details in connection with the conversion are not reported in such return.” (Emphasis added, Regulation 1.1033(a)-2(c)(2), sentence #4)
This sentence is generally referred to as the “deemed election.”
The significant portion of paragraph (1), referred to in the above excerpt, states:
“Gain, if any, shall be recognized, at the election of the taxpayer, only to the extent that the amount realized upon such conversion [receipt of insurance proceeds for lost property] exceeds the cost of other property purchased by the taxpayer which is similar or related in service or use to the property so converted.” (From Regulation 1.1033(a)-2(c)(2), sentence #4)
In other words, if the taxpayer does not report the receipt of the insurance proceeds, the IRS (through its regulations) assumes that the taxpayer has made an implicit election to reinvest the proceeds in qualified replacement property. For a taxpayer that does not reinvest the proceeds and the total proceeds received exceed the cost basis of the lost property, this IRS position does not provide any relief of anxiety. Nor does it relieve the taxpayer of any potential tax liability.
It appears that the taxpayer who realized proceeds in excess of the cost basis of the asset lost has received a “gift” from the IRS as a result of the “deemed election.”
But there is still a problem?
The “deemed elections” is a two edged sword. There are two parts to the reporting process. The first part is the initial reporting of the insurance proceeds, the IRS has provided relief here with the “deemed election.” But the second is where the taxpayer gets into trouble. The taxpayer must still report the actual reinvestment of the insurance proceeds. The IRS does not provide relief for this part. In 2007 the IRS issued an interpretation of the regulation. In that interpretation, the IRS burst a bubble that many professionals lived in. Up to that time many accountants who read the “deemed election” sentence quoted above, assumed that it covered both the election to replace and the actual reinvestment of the proceeds. The 2007 IRS interpretation said NO to the second part.
According to the IRS, the sentence only covers the election to replace. The taxpayer still has the responsibility to report the reinvestment. Further, if a tax return is filed for a year in which proceeds are reinvested but the reinvestment is not reported, the IRS assumes that the taxpayer has decided that those acquisitions are excluded from being part of a qualified reinvestment. The IRS takes the position that only those reported acquisitions (replacements) are the ones that the taxpayer wants to include as reinvestments. This would seem to be a rational conclusion for taxpayers who report the receipt of the proceeds. But, if you are relying on the “deemed election” should you be allowed to make a “deemed replace?” Unfortunately the IRS does not agree with that possibility. It is interesting that the IRS took fifty years to take a position on the situation. Also, it is interesting that the IRS took that position in a Field Service Advice (FSA) instead of a change to the actual regulation or a Revenue Ruling both having a higher level of authority than a FSA.
In any case, if no reinvestment takes place, the gain is taxable.
Therefore, the “deemed election” is of minor value. It is essentially useless in the event where a taxpayer reinvests the proceeds in the same year as the proceeds are received but makes no reporting of the receipt or the reinvestment.
If the proceeds are reinvested in a subsequent year and the reinvestment is properly reported, the taxpayer must also amend the tax return for the year that the proceeds were received to make a definitive election to reinvest the proceeds. This takes care of an innocent oversight on the return for the year of proceeds were received.
However, the IRS does not permit an amended return to “correct” the oversight of reporting a qualified reinvestment / replacement.
If you need to discuss this situation with your tax adviser, you can tell them to check out IRS Field Service Advice (FSA) 200747053. The IRS was so sure of their conclusions that they actually issued the FSA twice.
The rules are generally structured to be “taxpayer friendly.” Failing to follow the rules can create a lot of trouble for taxpayers who are otherwise dealing with enough stress in their process of recovering from a catastrophic event. Income taxes are one area that can be handled reasonably easy if the assistance of a knowledgeable professional is sought.
There is one possible consolation if this situation describes your situation. If the gain does not exceed $500,000, the taxpayer and spouse may be eligible to use the provision of the tax code that applies to the exclusion of gain, up to $250,000 ($500,000 for a married couple), on the disposition of a primary personal residence.
Once again, we see the application of the tax code in disaster recovery situations is not simple. A knowledgeable tax professional is invaluable.
All rights to reproduce or quote any part of the chapter in any other publication are reserved by the author. Republication rights limited by the publisher of the book in which this chapter appears also apply.
Certified Public Accountant
2975 E. Hillcrest Drive #403
Thousand Oaks, CA 91362
(805) 497-4411 E-mail John@TrapaniCPA.com
It All Adds Up For You
This material was contributed by John Trapani. A Certified Public Accountant who has assisted taxpayers since 1976, in analyzing and reporting transactions of the type covered in this material.
Internal Revenue Service Circular 230 Disclosure
© 2012, John Trapani, CPA,