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.
JOHN
TRAPANI
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Certified
Public Accountant
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2975
E. Hillcrest Drive #403
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Thousand
Oaks, CA 91362
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(805)
497-4411 E-mail John@TrapaniCPA.com
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Website: www.TrapaniCPA.com
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Blog:
www.AccountantForDisasteRrecovery.com
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It All Adds Up For You
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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
This
is a general discussion of tax law. The application of the law to specific
facts may involve aspects that are not identical to the situations presented in
this material. Relying on this material does not qualify as tax advice for
purpose of mounting a defense of a tax position with the taxing authorities
The
analysis of the tax consequences of any event is based on tax laws in effect at
the time of the event.
This
material was completed on the date of the posting
© 2012, John Trapani, CPA,
