By Mark E. Battersby
Aside from the unwarranted fear that the Internal Revenue Service might occasionally label a small, money-losing business as a hobby and reject all the write-offs it has claimed, many businesses are actually profiting from their losses. That’s right: Handled properly, those inevitable losses can generate badly needed funds for a troubled mattress manufacturer or supplier.
Losses can result from natural disasters, dishonest employees or customers, bad business decisions and a poor economy. Insurance provides protection from some types of losses, and tax laws help reduce the bite of others, but planning for or reacting to the losses of a business can mean survival and, in many cases, even profits.
Although so-called business continuation insurance covers the expenses of a company temporarily forced to close its doors after a natural disaster, it’s critical to anticipate other possible losses and develop strategies for coping or seeking affordable insurance protection for any possible contingency.
Losses from theft
Losses resulting from theft are tax deductible in the year the loss was sustained. Tax laws say, however, that theft losses are actually sustained in the year in which they are discovered—not necessarily in the year in which they occurred. In other words, a theft loss is not deductible in the tax year in which the theft actually occurs unless that’s also the year in which the company discovers the loss.
Going one step further, if, in the year of discovery, a reasonable possibility of reimbursement for that theft loss exists, the deduction cannot be taken until reimbursement is actually made or ruled out as a probability. Remember: The basic rule states that for losses to be deductible, there must be a “closed transaction.”
Involuntary conversions
There are other occasions when business property is taken. The government can, for example, legally take property by the simple act of condemnation. A new law, ordinance or regulation may be passed that permits a local government to seize assets that are no longer permitted within their jurisdiction.
The loss of any business property by actions outside the control of the manufacturer or supplier is usually labeled as an “involuntary” conversion.
These actions are unusual in that they frequently result in a gain. The local government that condemns your parking lot is required to reimburse you. That reimbursement frequently exceeds a company’s book value or basis in that property, resulting in a taxable gain.
Fortunately, the rules governing involuntary conversions permit the property to be replaced with property of a “like kind,” eliminating the need to report and pay taxes on that gain. Instead, the basis of the old “lost” property is transferred to the new, which postpones the taxable gain to some date in the future.
The IRS treats gains and losses from thefts, seizures or condemnation as Section 1231 gains or losses. Under Section 1231, if gains from the sale of property used in a trade or business exceed any losses, then each gain or loss is treated as if it were from the sale of a long-term capital asset. If, however, losses exceed the gains, all gains and losses are classified as ordinary gains and losses.
Business losses from a disaster
To help cushion losses suffered by a company, the tax laws contain a special rule for disaster losses in an area subsequently determined by the president of the United States to warrant federal assistance. For those losses, the executive, business owner or manager has the option of:
- deducting the loss on the tax return for the year in which the loss occurred or
- deducting the loss on the tax return for the preceding tax year.
In other words, a mattress manufacturer or supplier has the option of deciding whether its loss would be more beneficially used to offset the current year’s tax bill or better used to reduce the previous year’s tax bill and generating a refund of previously paid taxes.
Gaining from a loss
Surprisingly, a number of businesses have profited from casualty losses. If, for instance, the amount of the insurance reimbursement received is more than the book value or adjusted basis of the destroyed or damaged property, there actually may be a gain. The fact that a gain exists doesn’t necessarily mean it will be taxable right away. Most manufacturers and suppliers are able to defer the gain to a later year, or perhaps indefinitely, simply by acquiring qualified replacement property.
In calculating that gain, any expenses incurred in obtaining the reimbursement, such as the expenses of hiring an independent insurance adjuster, are subtracted. Then, if the same amount as the rest of the insurance money received was spent either repairing or restoring the property or purchasing replacement property, tax on the gain may be postponed. But the replacement must occur within two years of the tax year in which the gain was realized.
Abandonment
Finally, there are those losses that every company can control—a loss allowed for the abandonment of an asset. All a manufacturer or supplier needs to do is “manifest an intent to abandon the asset and make some affirmative act of abandonment.” The resulting loss is generally the adjusted basis or book value of the abandoned property.
If a depreciable business or income-producing asset loses its usefulness and is abandoned, the loss is equal to its adjusted basis. Obviously, the abandonment loss must be distinguished from anticipated obsolescence.
If a nondepreciable asset is abandoned after a sudden termination of its usefulness, a loss also is allowed in an amount equal to its adjusted basis. This applies to the abandonment of an enterprise, as well as to intangible assets, such as contracts.
Too many losses
When the expenses of a business exceed its income, it suffers a loss. If a mattress manufacturer or supplier has too many tax deductions and too little income, a net operating loss usually results. Many businesses are using losses incurred during the economic downturn to reduce income from prior tax years, providing a refund of previously paid taxes. The IRS recently clarified the procedure for reaping the benefits from the expanded loss carryback option.
Almost everyone is allowed to carry back a net operating loss from a trade or business, applying it as a deduction against prior income and to deduct from succeeding years’ income any unabsorbed loss. The relief provided under the Worker, Homeownership and Business Assistance Act of 2009 gave companies the option of choosing to carry back a net operating loss for a period of three to five years, which offsets taxable income in those preceding tax years. A net operating loss or a loss from operations carried back five years can offset no more than 50% of taxable income in that fifth preceding year.
For net operating losses that occurred outside the window of Dec. 31, 2007, to Jan. 1, 2010, the carryback period is usually two years preceding the loss year and then forward to the 20 years following the loss year. A three-year carryback period exists for so-called eligible losses, including the portion of a net operating loss relating to casualty and theft losses, but not federally declared disasters.
Unfortunately, net operating loss deductions are not permitted for partnerships or S corporations, although S corporation shareholders and partners in partnerships may use their distributive shares of any net operating loss to calculate individual net operating losses.
Losses that are shrinkage
When is a theft loss not a theft loss? Consider the tax laws labeling it as inventory shrinkage and denying a theft-loss tax deduction. The supplies maintained by a mattress manufacturer or supplier obviously cost money. That cost, however, will not be taken into consideration or deducted until the goods are sold, used or disposed of.
Naturally, if the goods are lost or stolen, the difference between the cost of all goods purchased and the amount received from the sale of the remaining goods will be less. There is no loss, however, because when it comes to goods or supplies, their purchase is reflected in the cost of the company’s inventory. The adjustment on their books and tax return for inventory shrinkage is permitted regardless of whether that shrinkage resulted from shoplifting, employee theft or because the item is simply missing.
Insurance does provide protection from some types of losses, although the government—in the form of tax laws—provides a financial cushion for many of the losses suffered by a company.
Unfortunately, recoveries via tax law are not always smooth, often requiring professional assistance or, at the very least, an understanding of how those tax rules work. Could your company profit from its losses?
LEARN MORE
For more information about various corporate losses and their tax status, visit these Internal Revenue Service websites:
Casualty, disaster and theft losses
Casualty losses can result from the destruction of or damage to your property from any sudden, unexpected or unusual event, such as a flood, hurricane, tornado, fire, earthquake or even volcanic eruption.
Disaster losses for businesses kit
A kit to help businesses claim casualty losses on property that has been destroyed by a natural disaster. Contains tax forms needed to claim a casualty loss.
Net operating loss
Questions and answers about the Worker, Homeownership, and Business Assistance Act of 2009.
