A federal emergency declaration triggers a number of tax provisions that clients can use to get financial relief while weathering the impact of the storm. While IRC Section 165(i) is most commonly accessed in the wake of an actual storm or other natural disaster, it was activated when the president declared a nationwide emergency in response to the COVID-19 pandemic on March 13, 2020.
Section 165(i) may be particularly useful to small business clients because it allows them to deduct 2020 COVID-19 losses on last year’s return—meaning that Section 165(i) could provide financial relief right now, without the need to wait and file the 2020 return, by which time it might be too late for many small business owners.
Basic Rules of Section 165(i) Disaster Relief
Section 165(i) does not allow a deduction for all general losses, but even in the absence of the physical damage caused by a natural disaster, many small business clients can benefit from current tax relief by accelerating COVID-19 losses to 2019.
When Section 165(i) is triggered, it gives taxpayers the option of taking a loss deduction for the year before the year in which the loss was actually sustained. Although COVID-19 losses were obviously sustained in 2020, the client has the option of treating those losses as though they were sustained in 2019 for tax purposes. Without Section 165(i), taxpayers would have to wait until they filed their tax return for 2020 to claim COVID-19 related losses.
To claim a loss under Section 165(i), the taxpayer must be able to show that property losses were directly caused by the COVID-19 pandemic (i.e., the “identifiable event” requirement). The client must further document that (1) the loss could not be reimbursed through insurance or otherwise, (2) the loss can be evidenced by “closed and completed transactions” and (3) the loss was related to the disaster and sustained in the year when the disaster occurred.
Section 165(i) is particularly beneficial for clients with inventories that have been impaired by COVID-19. Taxpayers have the option of choosing whether to account for those losses through inventory adjustments or the disaster loss provisions in this type of situation—they are not permitted to attempt to claim losses through both systems. Inventory sold at a loss, donated to charity or that expired or spoiled due to store or restaurant closures can all be deducted as Section 165(i) losses.
Clients who have permanently closed store locations, abandoned pending business deals (for costs already capitalized), and made termination payments based on cancelled contracts or deals can also benefit from accelerating those losses back to 2019. Similarly, a client who lost money because of pre-paid business travel, or pre-payment on materials where the contract was cancelled, may be eligible (assuming the amounts were not reimbursed from insurance or another source).
For some taxpayers, pushing the 2020 losses into 2019 could even generate a larger net operating loss (NOL), which can now be carried back to earlier tax years when the business may have been more profitable.
General lost revenue, declines in fair market value and loss of goodwill can usually not be deducted under Section 165(i)—because the provision applies to property losses, rather than general losses based on business operations interruption.
Section 165(i) Practicalities
Documentation is important in claiming a Section 165(i) loss, because the taxpayer has the burden of proof in showing that the loss deduction was justified based on the facts and circumstances at hand. However, for many clients who have scrapped inventory or closed store locations, this should not be difficult to establish given the widespread impact of the virus.
The client has two options for making the Section 165(i) election to accelerate losses sustained in 2020 into 2019. If the client has already filed the 2019 federal tax return, the client can file an amended return to make the election. The client has six months from the date when the original tax return was due (determined without taking filing extensions into account) to file the amended return.
Clients who have yet to file a 2019 return can make the election on their original tax return (remembering that the due dates for filing 2019 returns were extended in response to COVID-19, so many clients may have waited to file).
The client attaches Form 4684, Casualties and Thefts, to the return. The taxpayer is also obligated to attach an information statement providing substantiation of the taxpayer’s legitimate reliance on Section 165(i).
If the client elects to accelerate any COVID-19 losses into 2019, all losses from the disaster must be claimed in 2019.
Conclusion on Disaster Losses
Many small business clients are understandably focused on the new relief provided by the CARES Act and FFCRA. In reality, some of these clients will need more relief than is available under those laws to survive. Pre-existing IRC Section 165(i) can offer a lifeline to certain business owners who have suffered concrete losses because of COVID-19.