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10 Certain Business Deductions and Losses Solutions to Tax Research Problems 10-30 Section 165(a) provides the general rule for losses, stating, "there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise." Subsection 165(c)(3) further limits losses sustained by individuals regarding nonbusiness property to losses arising "from fire, storm, shipwreck, or other casualty, or from theft." Several court decisions have dealt with the issue of whether or not a casualty loss is deductible by a taxpayer if it is covered by insurance, but the taxpayer does not claim insurance benefits for the loss. The controversy is focused on the meaning of the phrase in § 165(a), "... any loss ... not compensated for by insurance or otherwise." The Internal Revenue Service takes the position that the word "compensated" means "covered" by insurance. In the cases where the issue has been examined, taxpayers have taken the position that the word "compensated" means actual payment of insurance benefits, and that the taxpayer is not "compensated" [i.e., within the meaning of § 165(a)] even though he has insurance to cover the loss, when he elects not to file an insurance claim. The Tax Reform Act of 1986 addressed this problem with respect to personal casualties. Section 165(h)(4)(E) now provides that a personal casualty loss is not deductible unless the taxpayer files a timely insurance claim with respect to damage to that property. This requirement applies to the extent any insurance policy would provide reimbursement. The new law, however, does not address business and nonbusiness casualties. By implication, it might appear that such a requirement does not extend to such casualties. The discussion herein reviews the case law existing prior to the 1986 Act. The issue was examined in Kentucky Utilities Co. v. Glenn, 68-1 USTC ¶9361, 21 AFTR 2d 1263, 394 F. 2d 631 (6th Cir. 1968), aff’g. 250 F. Supp. 265 (W. D. Ky. 1965). There the taxpayer, Kentucky Utilities Co., sustained a loss when a generator built by Westinghouse, Inc. was damaged. Although the taxpayer had insurance coverage through Lloyd's of London, the taxpayer elected not to claim the insurance because this would have allowed Lloyd's of London to bring suit on behalf of the taxpayer against Westinghouse, Inc. for breach of warranty. The taxpayer indicated that such litigation would have adversely affected business relations between itself and Westinghouse, Inc., and thus the taxpayer opted not to claim the insurance. The taxpayer did seek to deduct the amount of the loss on its income tax return as a casualty loss. The U.S. District Court stated that the taxpayer's loss was one which was compensated (i.e., covered) by insurance within the meaning of § 23(f) of the Internal Revenue Code of 1939 [the predecessor of present § 165(a)], and thus the taxpayer could not deduct any loss by reason of the damage to its generator. The U.S. Court of Appeals for the Sixth Circuit upheld the decision of the District Court by merely

stating that it was not clearly erroneous (i.e., meaning that the Appellate Court did not closely scrutinize the lower court's decision). In Axelrod v. Commissioner, 56 T.C. 248 (1971), the facts of the case made it unnecessary for the Court to confront the pertinent issue; however, in the concurring opinions of the Court decision, several judges examined the issue. Judge Quealy indicated that the term "compensated" encompassed "covered" regarding insurance and casualty losses, pointing to Regulation § 1.165-1(d)(2)(ii) which refers to allowance of a deduction for a loss in which there is a reasonable prospect of recovery. According to Judge Quealy, this language indicated that if a reasonable prospect of recovery existed (e.g., via insurance coverage), then the loss was a compensated one and no deduction should be allowed. Judge Quealy also made the analogy that no bad debt deduction would be allowed a creditor where the facts indicated that the debt could be collected, and the creditor chose not to collect the debt. He stated that there was no substantive difference between that situation and the situation where a taxpayer chooses not to collect insurance on a loss, and that no casualty loss deduction should be allowed a taxpayer with an insured (i.e., covered) casualty loss. In the same case, Judge Fay wrote in a separate concurring opinion that a taxpayer with a loss that is covered by insurance should be allowed a deduction despite his failure to claim the insurance. Judge Fay stated that given the realities of the insurance world where a taxpayer might have his insurance policy canceled or have the policy rates increased substantially if he turns in a claim, he should be allowed a casualty loss deduction where he relinquishes his right to a claim for such a valid, practical reason. In Henry L. Hills v. Commissioner, 82-2 USTC ¶9669, 50 AFTR 2d 82-6070, 691 F. 2d 997 (CA-11, 1982), reh'g denied 1-17-83, aff’g. 76 T.C. 484 (1981), the U.S. Tax Court and the U.S. Court of Appeals for the Eleventh Circuit squarely addressed the issue. In that case, the taxpayer's home had been burglarized several times. On the fourth such occurrence, the taxpayer did not file an insurance claim because he feared cancellation of the policy for numerous claims; however, the taxpayer did deduct the loss as a casualty loss on his income tax return. In deciding the issue, the Court considered the legislative history of the casualty loss provisions and concluded that the phrase "losses not compensated for by insurance" was intended to embody all losses, whether or not the insurance was claimed. The Court also addressed the statutory construction of § 165(a), stating that the word "compensated" means "to pay" or "to make up for." Thus, the Court concluded that an insured loss which was not (claimed by the insured and) paid should nonetheless be deductible. The Court did not agree with the IRS argument that a taxpayer's failure to file for an insurance claim signifies that the loss results from that election and not the loss event or transaction. The Court paid particular attention to Regulation § 1.165-1 (d)(2)(I) which states that the year in which a loss deduction may be taken depends on certain facts, including when the taxpayer produced evidence of abandonment of a claim. Although that regulation appears to be directed toward a litigation context, the Court said that it would be

equally applicable to an insurance claim. The Court thus inferred from this regulation that abandonment of a claim, including an insurance claim, should not preclude a taxpayer from taking a casualty loss deduction where such a loss has been sustained. Finally, the Court overruled the results of Kentucky Utilities v. Glenn, supra, due to its failure to deal in any depth with the issue. Axelrod, supra, was dismissed by the Court as not having dealt sufficiently with the issue, and the case of Bartlett v. U.S., 75-2 USTC ¶9648, 36 AFTR 2d 75-5574, 397 F. Supp. 216 (D. Md. 1975), which had held that taxpayers were not entitled to claim a casualty loss deduction when they voluntarily elected not to pursue their insurance claims, was expressly disagreed with by the Court. It should be noted that in 1978 the IRS issued Rev. Rul. 78-141, 1978-1 C.B. 58, which dealt with the pertinent issue. It precluded a taxpayer (here an attorney) from deducting as an ordinary business expense under § 162 an amount which he paid to reimburse a client for faulty advice that he gave the client, where the taxpayer could have, but did not, submit a claim to a malpractice insurer. The payment was also disallowed as a casualty loss under § 165. In this ruling the IRS addressed the issue of whether or not a taxpayer may deduct as a loss an amount that the taxpayer incurs as a loss but does not claim under insurance where an insurance claim could be pursued. The IRS stated that no such loss deduction would be allowed in such circumstances. In that ruling, the IRS cited most of the cases that had dealt with the issue and concluded that the loss in such a situation would not be deductible under §§ 162 or 165. The above Revenue Ruling was cited by the IRS in the Hills case, supra, in its argument for disallowance of a casualty loss deduction where the taxpayer seeks to deduct a casualty loss which is insured but for which the taxpayer claims no insurance. As noted above, the IRS did not prevail in the Hills case, supra. A petition for a rehearing of the latter case was filed by the IRS to the U.S. Court of Appeals for the Eleventh Circuit, and the decision was upheld; the rehearing of the appeal was denied January 17, 1983. Thus, it appears that while the IRS maintains its position enunciated in Rev. Rul. 78-141, supra, the taxpayer in the pertinent situation could rely on the Hills case, supra, if he sought to deduct an insured casualty loss for which he made no insurance claim. The Court of Appeals carefully scrutinized the language of the statute with specific reference to two areas. The court found (1) that the words "sustained loss" do not mean that a taxpayer must exhaust insurance claims before a loss is considered as having been sustained; rather, a loss is sustained for purposes of § 165(c)(3) when the loss event (meaning the fire, storm, shipwreck, etc.) occurs. The court also found (2) that the phrase "not compensated by" does not mean "not covered by" insurance; instead, it was found that "compensated" is a word distinct from "covered," and that "compensated" means actual receipt of indemnification from insurers. See D.F. Miller v. Comm., 84-1 USTC ¶9451, 53 AFTR 2d 841252, 733 F. 2d 399 (1984), aff’g. 42 TCM 665, T.C. Memo 1981-431. Thus, the

Sixth Circuit joined the Eleventh Circuit in holding that an insured taxpayer who elects to forgo filing an insurance claim is nevertheless allowed to deduct the portion of the loss which could have been compensated for by insurance. Regarding the facts of the problem, they seem to closely match the factpattern of Hills, supra. In these cases taxpayers had sustained numerous casualty losses of the type suffered, each taxpayer elected not to claim for an insured loss due to fear of some adverse change with respect to his insurance policy (e.g., a cancellation of the policy, an increase in the policy premium rates, etc.), and each taxpayer sought to deduct the loss as a casualty loss. Given the legal background of the issue in question here, it seems clear that R (taxpayer in the problem) would find opposition by the IRS if he sought to deduct as casualty loss his latest auto accident for which he claimed no insurance; however, R should prevail over the IRS, if he should choose to litigate the issue, by reliance on the Hills case, supra. 10-31 Section 165 provides the general rule governing the tax treatment of a taxpayer's losses. Under this provision, taxpayers are generally allowed to deduct any loss sustained during the taxable year for which they are not compensated by insurance. However, § 165(c) limits the deduction of losses of individuals to three types: (1) a loss incurred in a trade or business; (2) a loss incurred in a transaction entered into for profit; or (3) a casualty or theft loss. T would probably be unable to find relief under §§ 165(c)(1) or (2) because his loss was related to his personal residence rather than his business or an income-producing activity. In addition, it is unlikely that the loss could be considered a theft loss. The Code does not define theft. However, the Regulations do provide some guidance. Reg. § 1.165-8 indicates that theft includes but is not limited to, larceny, embezzlement, or robbery. Although T may believe that the contractor's actions were the equivalent of theft and should be within the reach of the Regulations definition, the courts have generally allowed a theft loss only when the alleged theft actually constituted theft under state law. In this case, the contractor's actions would not qualify as theft under state law, and, therefore, T could not claim a casualty loss deduction (nor would he probably want to, due to the severe limitations imposed on the deductions of personal casualty losses). Although the general rules governing losses provide little assistance to T, he will probably be able to claim a deduction under § 166 dealing with bad debts. Section 166(a) allows a deduction for any debt which becomes worthless within the taxable year. In order for T to claim a deduction for his loss as a bad debt under § 166, the contractor's obligation must be considered a bona fide debt. Reg. § 1.166-1(c) provides that a bona fide debt is a debt that arises from a debtorcreditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. The major issue here is whether the requisite debtor-creditor relationship exists. In T's case, he initially advanced the contractor a sum of money in return for services to be performed. A strict reading of the Regulations definition would not

extend debt status to this advance in that T does not have a valid and enforceable obligation to receive a sum of money. This view was taken in Electric Reduction Co. 275 U.S. 243 (1927). In Electric Reduction, the Supreme Court held that when a seller breaches an executory contract after the buyer prepays the purchase price for certain merchandise, the buyer's right under the agreement was not a "debt" in either the technical or the colloquial sense for purposes of § 166. However, if T could obtain a judgment to this end, T's claim would probably be elevated to the required debt status. In Rev. Rul. 69-457 (1969-2 C.B. 32), the Service considered the unfortunate circumstances of a taxpayer who had made a deposit toward the purchase of a personal residence that was to be built by a construction company under the terms of a contract. The construction company became insolvent and discontinued business without beginning construction of the residence and the taxpayer was unable to recover his deposit. There was no mention of a court action brought by the taxpayer. In this situation, the IRS believed that when the taxpayer's right under the contract for the delivery of the house became unenforceable, his claim against the construction company became a right for repayment of money, and, therefore created the requisite bona fide debtor-creditor relationship. T's situation would appear to be somewhat analogous to that of the taxpayer in the ruling. Although the facts do not indicate the terms of agreement, and, therefore, it is not known whether there is any obligation for the contractor to refund T's money under the contract, this would seem unnecessary in light of the ruling. 10-32 Under the general rule of Code § 165(a), "there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise." For individuals like Mac and Beth, who suffer losses of property used for personal purposes, deductions are limited under § 165(c)(3) to losses which "arise from fire, storm, shipwreck, or other casualty, or theft." The Internal Revenue Service (IRS) defines a casualty as "damage, destruction, or loss of property which results from an identifiable event that is sudden, unexpected, or unusual" ranging from natural calamities such as floods and hurricanes to vandalism and sonic booms. (See Nonbusiness Disasters, Casualties, and Thefts, IRS Publication 547 (1993), p. 2). Once it is determined that, under the guidelines noted above, the losses qualify as casualty losses, the amount of the loss must be determined. The general rule for determining the amount deductible is provided by Reg. § 1.165-7(b), which limits the deduction to the difference between the pre-casualty and post-casualty fair market values or the adjusted basis of the property, whichever is the lesser. Standing alone, this provision would allow Mac and Beth a deductible loss of $105,000 (the lesser of the decline in fair market value ($225,000 – $120,000) or adjusted basis ($150,000)]. Sound too good to be true? In light of Reg. § 1.1657(a)(2)(I), it is. This regulation provides that the fair market value should be ascertained by competent appraisal which "must recognize the effects of any general market decline affecting undamaged as well as damaged property which may occur simultaneously with the casualty, in order that any deduction under this

section shall be limited to the actual loss resulting from damage to the property." Herein lies the difficulty confronting Mac and Beth. What portion of this $105,000 represents "actual loss resulting from damage to the property" as a consequence of the flood? Taxpayers have tested the interpretation of Reg. § 1.165-7(a)(2)(I) on numerous occasions, as is evidenced by the volume of litigation in this area. In general, the IRS strictly limits casualty losses to the decrease in market value due to actual physical damage to the property. This position is reflected in Rev. Rul. 66-242, 1966-2 C.B. 56 which addresses a situation where a taxpayer's home was damaged in a flood and the appraisal made immediately after the flood took into account not only the physical damage to the property, but also the decline in market value due to economic obsolescence attributable to buyer resistance. The Ruling states, in part, that "the phenomenon of a decline and rise in market value which commonly occurs after a flood due to psychological resistance to inundated properties is usually short-lived and is more often than not a mere 'fluctuation' in value. In such case it does not represent an actual loss resulting from damage to property." The courts, in general, have supported the IRS in its interpretation of "damage to property" i.e., there must be actual physical damage to the property that is the immediate and direct result of the casualty. In Pulvers, 69-1 USTC ¶9222, 23 AFTR2d 69-678, 407 F.2d 838 (CA-3, 1969), the taxpayer's residence sustained no damage during a landslide, but 3 nearby houses were destroyed. The taxpayers deducted the decline in the fair market value as a casualty loss. The IRS promptly disallowed it. The court agreed with the Service, stating that "[the taxpayer's] loss is one Congress could not have intended to include in § 165(c)(3). The specific losses named are fire, storm, shipwreck, and theft. Each of those surely involve physical damage or loss of physical property. Thus we read 'or other casualty' in para materia, meaning 'something like those specifically mentioned.'" [See also Kamanski, 73-1 USTC 9371, 31 AFTR2d 73-1157, 477 F.2d 452 (CA-9, 1973) and Squirt Co., 51 T.C. 543 (1969).] The courts have made exceptions to this general rule in cases where there was little physical damage to the property but where there was permanent impairment due to other causes. In the case of Stowers, 59-1 USTC ¶9186, 3 AFTR 2d 505, 169 F.Supp. 246 (D.Ct. Ms., 1958), the taxpayer was allowed a deduction for the decline in market value of his physically undamaged property when the court determined that it was "no longer useful" because the primary means of access to the property was destroyed by a landslide and then permanently sealed off by local authorities. An exception which deserves especially close attention because of its similarity with the situation at hand, is Finkbohner, 86-1 USTC ¶9393, 57

AFTR2d 86-1400, 188 F.2d 723 (CA-11, 1986). Here the taxpayer's home received relatively minor damage from flooding in the immediate vicinity. However, the municipal authorities demolished over half of the surrounding homes and acquired the lots to be maintained as permanent open space, creating a "lonesome neighborhood," more exposed to crime and less private because of the maintenance of open spaces. In addition, the original decision to demolish the taxpayer's home was reversed after it was determined that even a serious flood, as would occur only once every 100 years, would do little damage to the taxpayer's home. The taxpayer claimed a loss of $24,900 based on the decline in fair market value. The IRS disallowed all but $1200 (representing the decline in value due to physical damage). In this instance, the District Court agreed with the taxpayer and the Court of Appeals upheld the decision, noting tha...