For businesses experiencing financial difficulty in 2020 due to the COVID-19 crisis, utilizing all methods to sustain cash flow is imperative. One option to be considered for businesses experiencing financial losses is to apply IRC Sec. 165(i) to accelerate those losses to the 2019 tax year instead of waiting until the 2020 tax year.
IRC Sec. 165(i) states “any loss occurring in a disaster area and attributable to a federally declared disaster may, at the election of the taxpayer, be taken into account for the taxable year immediately preceding the taxable year in which the disaster occurred.”
On March 13, 2020, the President of the United States declared COVID-19 to be a federal disaster under the Robert T Stafford Disaster Relief and Emergency Assistance Act, which makes certain losses incurred due to the COVID-19 crisis eligible for IRC Sec. 165(i) treatment.
This means the taxpayer has a choice as to whether they want to take the loss in the year of the loss, or in the year prior to the year of the loss. Making this election results in all disaster losses arising from that event being deductible on the prior year (2019) return.
Cash Flow Impact
The impact of this provision on a taxpayer’s cash flow could include the following:
- Reduce the tax owed for 2019 and therefore reduce an extension or balance due payment for tax year 2019 if one was otherwise due by July 15, 2020.
- For corporate taxpayers it could result in a tax overpayment for tax year 2019 and therefore eligible to request a quick refund of the overpaid estimated taxes using Form 4466 ‘Corporation Application for Quick Refund of Overpayment of estimated tax’. Taxpayers requesting a quick refund would need to file Form 4466 by the tax return due date (July 15, 2020).
- Increase of 2019 net operating loss (NOL), which may be eligible to be carried back to prior profitable years and generate a refund.
Which Losses Qualify?
Not all losses will qualify for acceleration. To be able to claim a loss under IRC Sec. 165(i) all of the following must be true:
- The loss cannot have been otherwise compensated for, by refund, insurance or other means;
- The loss must be caused by an identifiable event;
- The loss must be evidenced by closed and complete transactions; and
- The loss must be directly related to the disaster event and sustained during the year of the event.
The following are examples of potential losses that could be claimed in 2020, but accelerated into 2019, if directly attributable to the COVID-19 federally declared disaster.
- Inventory scrapped due to spoilage during government shutdown;
- Worthless securities (but not bad debts);
- Permanent closure costs of store and facility locations (e.g. costs associated with the disposition of inventory and/or fixed assets);
- Complete abandonment of leasehold improvements;
- Permanent retirement of fixed assets;
- Abandonment of pending business deals for costs otherwise capitalized;
- Termination payments to cancel contracts, leases or licenses;
- Prepaid events, travel, conference space, hotel rooms, etc. when taxpayer is not provided a refund or credit;
- Prepaid raw materials or other items to fulfill a contract and the contract has been cancelled;
- Mark-to-market securities; or
- Losses from the sale or exchange of property.
Note, the taxpayer bears the burden of proving the existence of the casualty and that the loss was as a direct result of the COVID-19 disaster.
What Does Not Qualify?
Some losses generally would not qualify to be accelerated to 2019 under IRC Sec. 165. The following are examples of potential losses that would not qualify:
- A decline in fair market value of the property due to economic obsolescence attributable to buyer resistance which attached to the property;
- An appraisal reflecting a potential buyer resistance which represents speculative estimates of rental loss;
- Lost revenues; or
- Goodwill losses, for which the facts and circumstances would need to be analyzed closely.
Calculating the Loss
The loss amount will be calculated as the taxpayer’s basis in the asset, less any amount realized on its disposition. The loss cannot exceed a taxpayer’s basis in the damaged property.
Who Can Make the Election?
Any taxpayer. See ‘Making the Election’ below for who should make the election if the loss is from a passthrough entity.
Making the Election
A taxpayer must make the election within six months after the due date of the taxpayer’s federal income tax return for the disaster year (determined without regard to any extension of time to file). This means that for a taxpayer to accelerate the loss on their 2019 calendar year tax return, they would have until Fall of 2021 to file an original or amended tax return to make this election.
No extension request is needed in order to make the election after the original due date of the return for the year in which the loss occurred.
The election can be revoked by filing an amended return that contains a revocation statement for the preceding year on or before 90 days after the due date for making the original election.
- If the taxpayer originally deducted the loss in the year of disaster, but then decides they want to accelerate the loss into the prior year, the taxpayer would need to file an amended return for the disaster year to remove the loss and then file the original or amended return for the prior year to take the loss in the prior year.
- If the taxpayer originally made the election to accelerate the loss in the prior year, but then decides to take the loss in the disaster year, the taxpayer would need to revoke the election within the 90-day period to remove the loss from the prior year return and take the loss in the disaster year.
For partnerships and S-Corporations, it is an entity-level election if the property is trade or business property or held for investment. If the property is not trade or business or investment property, the loss must be separately stated on each partner’s or shareholder’s Schedule K-1 and the election is made at the partner or shareholder level.