The Experts: Lee Kelley, Kandyce Korotky, and Jeffrey Zink
With the global pandemic COVID-19 upending business operations worldwide, companies are incurring unexpected—and often large—costs. Some of these costs may ultimately be covered by insurance. Given the unprecedented circumstances, however, there are bound to be questions and disagreements about which of those costs are covered by companies’ insurance policies. When a claim is resolved in the same taxable year that the cost was paid or incurred, it should be clear whether or not a company will be out of pocket for a particular expenditure. When a claim crosses tax years, however, the question arises whether the company will be out of pocket and whether the costs are deductible, despite the possibility of future reimbursement. In this article, we discuss the different types of costs that taxpayers may be incurring (losses versus expenses) and the various considerations that apply when determining whether to deduct a cost that might be reimbursed by insurance.
Question 1: What is the difference between a loss and an expense?
Companies are likely to incur various costs during crises. How those costs are categorized—as losses or expenses—determines whether and when those costs can be deducted. Section 162 provides that business expenses are generally deductible if they are both ordinary and necessary. The case law defines “ordinary” as customary and usual within the relevant industry, and does not rely on the frequency with which the expense is incurred.1 “Necessary” means appropriate and helpful, rather than absolutely necessary or indispensable.2 Section 165, on the other hand, provides a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.”
The standard for distinguishing expenses from losses for tax purposes has been described as “self-evident” and “found primarily in the nature and occasion of the expenditure.”3 The Tax Court has observed that, in practice, “this distinction is often difficult to apply.”4
Amid murkiness, however, some concepts have emerged from the case law. For example, costs related to property that is not owned by the taxpayer immediately prior to the expenditure (such as property sold to a customer for which the company has provided a warranty) generally do not give rise to a loss but instead generally give rise to Section 162 expenses.5 Expenditures to maintain business reputation or to retain customers’ patronage and goodwill also typically give rise to ordinary and necessary business expenses,6 but expenditures related to goodwill associated with business property may instead give rise to losses under Section 165.7 In the event that an expenditure qualifies as both a deductible expense under Section 162 and a deductible loss under Section 165, the expenditure is generally deductible under Section 162.8
Question 2: Why does it matter whether an expenditure qualifies as a loss or a deduction?
The timing and amount of a deduction turn on whether a particular cost is a loss or an expense.9 Determining when a Section 165 loss is deductible can be more difficult than determining when a Section 162 expense is, in that a Section 162 expense is deductible in the year of payment or accrual. The Section 165 regulations provide that a taxpayer’s loss is not deductible until the year in which the loss is evidenced by a closed and completed transaction and fixed by identifiable events occurring in such taxable year.10 Furthermore, a loss is deductible only up to a maximum amount equal to the taxpayer’s adjusted basis in the affected property,11 whereas an expense is generally deductible in the amount paid or accrued. As discussed in the next sections, standards differ for deducting losses and expenses reimbursable by insurance.
Question 3: What are the standards for deducting an expenditure potentially reimbursable by insurance as a Section 165 loss?
Section 165 specifically precludes a deduction for any loss that is “reimbursed by insurance” or otherwise. Courts have interpreted “reimbursed by insurance” broadly to preclude a deduction if the taxpayer has a “reasonable prospect of recovery,” meaning that the taxpayer has a bona fide claim for reimbursement and there is a substantial possibility that the taxpayer will prevail.12 This standard is generally considered a higher bar to deductibility than the standard for Section 162 expenses is.
Under this relatively high bar, even an insurer’s denial of a claim will not necessarily be enough to support a deduction where the taxpayer continues to pursue the claim. Rather, courts tend to hold that a taxpayer’s initiation of litigation pursuing a claim for recovery suggests that the possibility of recovery is reasonable, unless such claim for recovery is “specious, speculative, or wholly without merit.”13 The Ninth Circuit’s opinion in Dawn v. Commissioner characterizes courts’ typical approach to determining whether there is a reasonable prospect of recovery.14 In that case, the court reasoned that the taxpayer’s willingness to file a lawsuit “goes far toward showing the reasonableness of their prospect of recovery” and that the taxpayer’s failure to offer specific facts negating that inference was decisive.15
Question 4: What are the standards for deducting an expenditure potentially reimbursable by insurance as a Section 162 expense?
Unlike the statutory language of Section 165, Section 162 does not mention the implications of insurance coverage.16 Section 162 has been interpreted to preclude a deduction if there is a “right of reimbursement,” including through insurance. In that case, the taxpayer is not viewed as incurring an expense but rather as advancing a loan to the reimbursing party.17
Courts have not always been consistent in their phrasing of the standard to be applied in determining whether a taxpayer has a right to reimbursement. Generally, courts have looked to whether a right to reimbursement is “fixed” or “sufficiently fixed,”18 such that the expenditure more closely resembles a loan than a business expense.
A right to reimbursement has been described as sufficiently fixed when “such right has matured without substantial contingency.”19 The determination of whether a taxpayer’s right is subject to a substantial contingency requires a facts-and-circumstances analysis.20 The denial of an insurance claim by the carrier—even when the taxpayer ultimately received insurance proceeds in a later year—has been sufficient to prove the absence of a right to reimbursement.21
Further, where payment is contingent upon the outcome of litigation, taxpayers have been permitted to deduct the corresponding expense in the year of payment or accrual.22 Even where a taxpayer has a general right to reimbursement, such as a claim covered by the terms of an insurance policy, reimbursement is not necessarily fixed if the taxpayer must take additional steps to pursue its claim, such as taking part in negotiations or mediation or taking legal action. That is, even if the taxpayer has a facially valid right to reimbursement, circumstances arising after the taxpayer attempts to assert its right may establish a substantial contingency.23
In other (i.e., noninsurance) contexts, courts have denied a deduction where there was an expectation of—rather than a right to—reimbursement. Notably, these cases generally involve attorneys advancing funds to carefully selected clients likely to win their cases, or situations where a payee was unconditionally obligated to return the funds. Despite different phrasing (“expectation of” rather than “right to” reimbursement), at bottom these cases share the same concern—whether the substance of any contingency means that the expenditure is more like a loan than like a business expense. As discussed below, however, the Internal Revenue Service has interpreted these expectation-of-reimbursement cases broadly in the insurance context.
Further, potential reimbursement in a future year generally should not preclude a deduction so long as the amount of reimbursement cannot be ascertained with reasonable accuracy. In determining whether the amount of reimbursement is ascertainable, courts have asked whether a taxpayer could, using its own books and records, calculate the amount of reimbursement “within reasonable limits.”24 As the Tax Court has explained, “[e]ven if the right to reimbursement is fixed, the related expense deduction cannot be disallowed unless the taxpayer has sufficient information and data at his command so as to be able to ascertain within reasonable limits the quantum of the reimbursement.”25
Question 5: What factors support a Section 162 deduction for an expenditure that is subject to a pending insurance claim?
As discussed in the previous section, an insurance company’s denial of a claim generally should establish that a taxpayer does not have a right to reimbursement and therefore should support a Section 162 deduction for the year in which the expense is paid or incurred.26 This is true even if the taxpayer receives insurance proceeds in a later year.
Formal denial of coverage, however, is not necessarily required to establish a substantial contingency. In informal guidance, the IRS has set forth a list of facts and circumstances that it will weigh to determine whether an expenditure is deductible under Section 162, specifically:
“(1) the terms of the insurance policy (for example, does the policy cover the types of claims at issue, under what circumstances may coverage be denied),
“(2) a copy of any insurance claims,
“(3) correspondence from the insurance company indicating the likelihood of coverage,
“(4) past history of insurance coverage of similar claims,
“(4) [sic] standard industry practice with claims of a similar nature,
“(5) opinions of insurance adjusters or other insurance company representatives,
“(6) notes or correspondence from any legal counsel as to whether the insurance claims are collectible, and
“(7) whether the taxpayer has pursued legal action against the insurance company.”27
There is no guidance as to what quantum of evidence (from this list or elsewhere) is necessary or sufficient to demonstrate entitlement to a deduction. Rather, the inquiry is fact-intensive and certain to involve a good amount of subjectivity.
Question 6: What standard might the IRS apply?
The IRS has applied the foregoing principles in a variety of situations where the taxpayer had a right to reimbursement. In most of this guidance, the application of the principles is unsurprising: a taxpayer with an unconditional right to receive a fixed, knowable sum was denied a Section 162 deduction.
In General Counsel Memorandum (GCM) 37204 (July 28, 1977), the IRS addressed a scenario in which a corporation would repay funds to its investors if the research that it was conducting resulted in an operational product. The GCM described the relevant inquiry as a spectrum, with a virtually certain likelihood of reimbursement at one end and a mere possibility of reimbursement at the other. In that situation, the GCM concluded that a deduction was allowable because “the facts in the present case indicate that the possibility of reimbursement is not absolute or virtually certain.” It therefore appeared that, under the IRS’ view, anything less than a virtually certain right of reimbursement could support a deduction.
In a 2007 Chief Counsel Advice (CCA), however, the IRS appeared to depart from this position and denied a deduction for a taxpayer’s expenditures subject to an outstanding insurance claim under its view that “[a]n expectation of reimbursement . . . may be sufficient to preclude a deduction under section 162.”28
The CCA addressed a taxpayer, a manufacturer, whose customers sought damages attributable to alleged defects in the taxpayer’s products. The taxpayer opened a claim against its liability insurance coverage and deducted the amounts paid to customers (which were the subject of the claim) under Section 162. The CCA first stated: “If the right to reimbursement is not fixed, the deduction may be allowed.”29 The CCA then concluded that “if the taxpayer has an insurance policy that, on its face, covers the item in question, and there is no indication that an exception to coverage applies, then a deduction under section 162 should be disallowed, as the taxpayer would have a fixed contractual right to reimbursement.”
To reach this conclusion, the CCA relied on cases holding that an expectation of reimbursement precludes a Section 162 deduction. Those cases, however, addressed situations where the third party was “unconditionally obligated to reimburse”30 the taxpayer or where an attorney had advanced funds to carefully selected clients who had a high chance of winning their cases. In other words, in those cases there were clear indications that a taxpayer would be reimbursed—or, in the parlance of the GCM, that reimbursement was “virtually certain.” To the extent that the CCA can be interpreted as having concluded that a mere expectation of reimbursement is sufficient to preclude a Section 162 deduction, its legal conclusion is not supported by case law.31 The CCA does serve, however, as potential insight into how the IRS might approach such deductions on audit.32
Given the different standards that apply to Section 162 expenses and Section 165 losses, determining whether an expenditure is an expense or a loss is the first step in determining deductibility. Establishing the deductibility of both expenses and losses subject to a pending insurance claim requires a fact-intensive analysis.
Taxpayers that are considering taking a Section 162 deduction for an expense subject to an insurance claim should gather and maintain all indicia that a claim may be denied or may require further steps (e.g., arbitration or litigation), including reservation-of-rights letters and other formal or informal communication from the carrier. In cases in which taxpayers have “layers” of insurance coverage—each with its own terms—that require multiple insurance carriers to approve or deny claims, support for a deduction may be stronger because of the presence of multiple insurers with the ability to deny a claim.
Lee Kelley is of counsel, and Kandyce Korotky and Jeffrey Zink are associates at the law firm of Covington & Burling LLC.
- See Welch v. Helvering, 290 U.S. 114 (1933).
- Welch, 290 U.S. at 111, 113; see also, for example, Commissioner v. Tellier, 383 U.S. 687, 689 (1966).
- See Holt v. Commissioner, 69 T.C. 75, 78 (1977) (citing 4A J. Mertens, Law of Federal Income Taxation Section 25.15 (1972); Hubinger v. Commissioner, 36 F.2d 724, 726 (2d Cir. 1929)).
- R. Hensler, Inc. v. Commissioner, 73 T.C. 168, 178-79 (1979), acq., 1973-2 C.B. 1.
- One helpful example of the case law’s approach to distinguishing expenses and losses is that the use of liquor to entertain clients is a deductible expense, whereas the confiscation by the government of liquor held for sale is a loss. See Holt, 69 T.C. at 78 (comparing United States v. Winters, 261 F.2d 724, 726 (10th Cir. 1958) with Fuller v. Commissioner, 213 F.2d 102 (10th Cir. 1954)). Winters would likely be resolved differently today because of Section 274 and the accompanying case law, but the juxtaposition of these cases remains illustrative of the differences between an expense and a loss.
- Miller v. Commissioner, 37 B.T.A. 830, 832 (1938).
- See, for example, Massey-Ferguson, Inc. v. Commissioner, 59 T.C. 220 (1972).
- See R. Hensler, 73 T.C. at 176.
- Following the Tax Cuts and Jobs Act, the accounting treatment of potential insurance recoveries can affect the timing of including these amounts as income. See Section 451(b).
- Reg. Section 1.165-1(d)(1).
- See Reg. Section 1.165-1(c); Treas. Reg. Section 1.165-7(b)(1).
- See Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795, 811 (1974), aff’d, 521 F.2d 786 (4th Cir. 1975).
- Scofield’s Estate v. Commissioner, 266 F.2d 154, 159 (6th Cir. 1959); see also Adkins v. United States, 856 F.3d 914 (Fed. Cir. 2017).
- Dawn v. Commissioner, 675 F.2d 1077 (9th Cir. 1982).
- Dawn, 675 F.2d at 1078-79.
- Treas. Reg. Section 1.162-10(a) (providing one exception for compensation resulting from injury).
- Although it is beyond the scope of this article, we note that expenses that are otherwise deductible may have to be capitalized if the benefit extends beyond the taxable year. For example, Section 263(a)(1) provides that “permanent improvements or betterments made to increase the value of any property,” including restoring or replacing property, must be capitalized. See Treas. Reg. Section 1.263(a)-1.
- Charles Baloian Co. v. Commissioner, 68 T.C. 620, 626 (1977); Electric Tachometer Corp. v. Commissioner, 37 T.C. 158, 161-63 (1961).
- Charles Baloian Co., 68 T.C. at 628.
- at 627.
- Varied Investments, Inc. v. United States, 31 F.3d 651, 653 (8th Cir. 1994).
- See Alleghany Corp. v. Commissioner, 28 T.C. 298, 305 (1957).
- For example, in determining whether a taxpayer’s moving expenses were deductible in the year of payment, or whether the expenditures were more in the nature of a loan or advance, the Tax Court noted that “[t]he lengthy hearings and the various estimates given before the [local court] demonstrate the lack of definiteness of petitioner’s right to recover the amounts of its moving expenses” (Electric Tachometer, 37 T.C. at 162). Therefore, “even though there did exist from the time its property was condemned a general right to recover damages … the right to receive reimbursement was not sufficiently fixed to make the expenditure in the nature of an advance or something other than an expense incurred in petitioner’s business” ( at 162-63).
- Continental Tie & Lumber Co. v. United States, 286 U.S. 290, 296 (1932).
- Charles Baloian Co., 68 T.C. at 627 (citing ).
- See Varied Instruments, 31 F.3d at 653 (upholding a Section 162 deduction where three insurers had denied the taxpayer’s claim because the “record shows … that [the taxpayer] had no fixed right to reimbursement”).
- Chief Counsel Advice 200725031 (June 22, 2007), irs.gov/pub/irs-wd/0725031.pdf.
- (emphasis added).
- Emphasis added.
- Flower v. Commissioner, 61 T.C. 140, 152 (1973), aff’d, 505 F.2d 1302 (5th Cir. 1974) (emphasis added).
- Electric Tachometer Corp., 37 T.C. at 161–63.
- Notably, the CCA does not address the second requirement, discussed above, that the amount of reimbursement must be reasonably ascertainable before a deduction is disallowed.