Overview of Casualty Loss Taxation

A General Overview to Casualty Loss Taxation in a Manufacturing Business Setting or: How I Learned to Stop Worrying and Love the Tax System

I. Introduction

II. Background

III. Single, Identifiable Property Rule

IV. Inventory

V. Deferral of Gain: Involuntary Conversions

VI. Client Analysis

VII. Code Analysis

I. Introduction

One important question for the taxpayer is always going to be “How can I reduce my tax burden?” In the case of a business the Code provides numerous tax aids to help businesses of all sizes hopefully grow and prosper. For the topic of this paper, the aids demonstrated will be limited to those strictly pertaining to casualty and inventory losses suffered by a business. A casualty loss is a loss by fire, storm or shipwreck, treated as sustained during the taxable year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year.[1] The inventory discussion will relate to a fictional client and show the different methods of allowable inventory valuation under the Code.

For this paper I will introduce a scenario involving a business client who has suffered a terrible loss to its manufacturing business.[2] The terms “casualty loss” and “involuntary conversion” will be used interchangeably throughout the discussion in this paper. I am choosing to use the terms interchangeably despite the fact that a casualty loss is only one type of involuntary conversion under the Code in order to streamline the discussion and lessen confusion when switching between different Code sections which use different language but are addressing the same general concept.

Manufacturing Business Casualty

Client runs a manufacturing business comprising of an office facility, manufacturing facility and a warehouse. The office and the warehouse facility are located adjacent to each other surrounded by some trees and shrubs and a parking lot. The actual manufacturing facility is located one block away and is surrounded by a loading dock area and a parking area, with no trees, shrubs or grass.

During a severe storm lightning struck a transformer located near the office and warehouse which sent a power surge down the lines into the manufacturing facility and blew out the light fixtures located within the warehouse and caused some small fires within the warehouse which quickly spread to engulf a large portion of the inventory within the warehouse. Ultimately, the grounds in the area were not badly damaged, however, a large portion of the inventory, and most of the warehouse itself were damaged.

There was insurance on the warehouse and the inventory. The client wants to know what can be done to off-set any losses not covered by insurance and what the business can do to replace any portion of the inventory, the warehouse and fix the fire damaged property. The following explains which areas of the tax code could provide relief to the Taxpayer. Throughout this paper I will be introducing many of the Code sections that may affect this Taxpayer and breaking down how each of these sections functions individually. At the end I will bring all of the sections together to explain how they may benefit this Taxpayer depending on certain circumstances.

II. Background

Chapter 26 U.S.C.A. sets out the tax code for the United States (“Code”). Statutory authority is the only way to take a deduction under the Code and Section 165 is one such section which defines the types of losses which the code drafters have designated as allowable deductions. One of the allowances, in Section 165, is for “losses incurred in a trade or business,”[3] losses incurred by casualty, or any other means, to a business or profit seeking enterprise are “deductible regardless of cause.”[4] A deductible loss to business or income-producing property is not sustained if there has been a mere decline in market value. [5] However, in regard to our client Taxpayer, if a business sustains a casualty loss to property, this type of loss is sufficiently definitive to permit a deduction under Section 165(a).[6]

One advantage a business has in regard to casualty losses under the Code is the fact that it does not need to jump over the hurdles that an individual would need to overcome in order to deduct the casualty loss. As long as there is a loss to of trade or business property, the Code allows for more favorable treatment of such a loss. A business (or an individual who owns a business) does not need to “comput[e] taxable income of the business to allow the deduction only of those losses which may be considered extraordinary, nonrecurring losses, and which go beyond the average or usual losses incurred by most taxpayers in day-to-day living.”[7] When a business sustains casualty losses, even if these losses are to be expected frequently in that type of business, they, or the resulting expenses, may be treated broadly as business expenses. In contrast, individual, “personal” loss taxpayers would have to meet addition casualty loss requirements of Section 165 before they would be allowed to take a deduction.[8]

Business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business, except items which are used as the basis for a deduction or a credit under provisions of law other than Section 162.[9] To be deductible as an ordinary and necessary business expense, an expenditure must be paid or incurred during the taxable year, must be made to carry on a trade or business, must be an expense, must be a necessary expense and it must be an ordinary expense.[10] Whether an expense is an “ordinary expense” deductible in computing net income is “affected by time, place, and circumstance, and nature of expense depends, not upon the fact that an obligation to pay has arisen, but upon the kind of transaction out of which the obligation arose and its normalcy in the particular business in which it was incurred.”[11]

For a business, the key difference regarding the applicability of Section 162 or 165 is whether the Taxpayer has suffered a loss or incurred an expense. Although in some circumstances the loss may create additional expenses for the company.

A. Mechanics and Examples

Below is a basic introduction of when Section 165 would be applicable and how it functions:[12]

In 1958, A purchases land containing an office building for the lump sum of $90,000. The purchase price is allocated between the land ($18,000) and the building ($72,000) for purposes of determining basis. After the purchase A planted trees and ornamental shrubs on the grounds surrounding the building. In 1961 the land, building, trees, and shrubs are damaged by a hurricane. At the time of the casualty the adjusted basis of the land is $18,000 and the adjusted basis of the building is $66,000. At that time the trees and shrubs have an adjusted basis of $1,200. The fair market value of the land and building immediately before the casualty is $18,000 and $70,000, respectively, and immediately after the casualty is $18,000 and $52,000, respectively. The fair market value of the trees and shrubs immediately before the casualty is $2,000 and immediately after the casualty is $400. In 1961 insurance of $5,000 is received to cover the loss to the building. A has no other gains or losses in 1961 subject to Section 1231 and Section 1.1231–1. The amount of the deduction allowable under Section 165(a) with respect to the building for the taxable year 1961 is $13,000, computed as follows:

Value of property immediately before casualty 70,000

Less: Value of property immediately after casualty 52,000

Value of property actually destroyed 18,000

Less: Insurance received 5,000

Loss to be taken into account for purposes of Section 165(a): Lesser amount of property actually destroyed ($18,000) or adjusted basis of property ($66,000) 18,000

Less: Insurance received 5,000

Deduction allowable 13,000

The amount of the deduction allowable under Section 165(a) with respect to the trees and shrubs for the taxable year 1961 is $1,200, computed as follows:

Value of property immediately before casualty 2,000

Less: Value of property immediately after casualty 400

Value of property actually destroyed 1,600

Loss to be taken into account for purposes of Section 165(a): Lesser amount of property actually destroyed ($1,600) or adjusted basis of property ($1,200) 1,200

Now, let’s take a step back and see how the Code applies the rules to the taxpayer’s situation, and see what the Code actually says.

The first consideration in the determination of a loss deduction for business or investment property due to damage resulting from a casualty is whether the property is partly or fully destroyed. “No casualty loss deduction is available for a mere diminution in the value of property that is not physically damaged even if the diminution is indirectly related to damage caused to other property.”[13]

In the case of a casualty that partially damages property used in a trade or business, or held for the production of income (see example supra), Section 165 determines the amount of the loss through the calculation below. The easiest way to calculate the amount of the loss is to determine the lesser of two different values: the lesser of[14]

(i) The amount which is equal to the fair market value of the property immediately before the casualty reduced by the fair market value of the property immediately after the casualty[15] (including any salvage value[16]); or

(ii) The amount of the adjusted basis prescribed in Section 1.1011–1 for determining the loss from the sale or other disposition of the property involved.

The “flush language” of Treasury Regulation Section 1.165-7(b)(1) states, in the case of property used in a trade or business which has been totally destroyed and the fair market value of such property immediately before the casualty is less than the adjusted basis of such property, the amount of the adjusted basis of such property shall be treated as the amount of the loss for purposes of Section 165(a).

Once the amount of loss has been determined through the above calculation, it is necessary to “subtract the amount of any insurance or other compensation received” from the amount of the loss.[17] All insurance proceeds are subtracted so that the taxpayer does not “double dip” by receiving insurance compensation for the loss, and then treating the loss as an “expense” in addition to the insurance received.

In the case of a total loss, the loss is measured by the basis rather than a drop in FMV because there is no more property to which the basis can be attached for future use, and the Taxpayer should receive a deduction for lost investment (basis) at some point.[18] In the case of a Taxpayer who suffers a loss from a destruction of market value greater than the cost of the property to him, that excess in value destroyed represents unrealized appreciation, and he may not claim a deduction for such a loss because he never recognized or paid a tax on the gain.[19] In either case, the casualty loss deduction is limited by the property’s adjusted basis.[20] If the property is fully depreciated (resulting in a basis of zero), the code does not allow for a casualty loss deduction.[21]

One critical piece of advice for the taxpayer is to maintain adequate records in order to determine the value of the property, and to be able to establish the amount of the adjusted basis, as required by Section 1.165-7(b)(1)(ii), in order to properly claim a loss deduction.[22] The taxpayer, however, is allowed to use the cost-of-repairs method for purposes of quantifying a casualty loss under Section 1.165-7(b)(1).[23] This method is delineated by Section 1.165-7(a)(2)(ii), which states:

The cost of repairs to the property damaged is acceptable as evidence of the loss of value if the taxpayer shows that (a) the repairs are necessary to restore the property to its condition immediately before the casualty, (b) the amount spent for such repairs is not excessive, (c) the repairs do not care for more than the damage suffered, and (d) the value of the property after the repairs does not as a result of the repairs exceed the value of the property immediately before the casualty.

A taxpayer has the choice of electing how to calculate their loss by choosing either the calculation from Section 165 above, (which requires either an appraisal of the FMV of the property before and after the casualty or a known basis in the property) or the cost-of-repairs method. The taxpayer who does not have clear records of depreciation, or the basis in the property is unknown, would want to choose the cost-of-repairs method of valuation because there is no need for an appraisal and the limitation in Section 1.165-7(b)(1)(ii) is less of a factor.[24] Section 1.165-7(a)(2)(i) provides, in part, that in determining the amount of the deductible loss, the fair market value of the property immediately before and immediately after the casualty shall generally be ascertained by competent appraisal. However, just the use of an estimate of what the cost of repairs would be is not usable for a deduction amount, because the repairs must actually be performed. [25]

As shown in the Code, any repairs must be necessary to restore the property to its condition before the casualty and the repairs cannot fix more than the damage suffered, resulting in an increase of the value of the property. This may be a limitation to some taxpayers who would rather choose to improve the damaged property after it was destroyed rather than merely bringing the property back to where it started. Also, if the property destroyed was not in good condition or was very old, then it will be difficult to perform repairs which would not create added value.[26] If all of these elements are met by the Taxpayer then the cost of the repairs may be submitted as the amount of the casualty suffered instead of the basis of the property.[27]

So, going back to the example above, it becomes more apparent why each of the specific values in the table is used. The taxpayer needs to establish the value of the property before the casualty, usually by appraisal,[28] and this is why the taxpayer’s calculation starts with the $70,000 value of the office building. Then the taxpayer needs to determine the difference between the value before and after the casualty, in this case $52,000. Resulting in a difference which equals the amount of the casualty, (70,000 – 52,000 =) $18,000. However, this is not the amount of money the taxpayer actually “lost” in the hurricane and, thus, is not the allowable deduction. This is because he was reimbursed by insurance in the amount of $5,000. Therefore, the taxpayer must subtract the $5,000 of insurance from the $18,000 of “loss” resulting in the allowable deduction for the damage to the office building: $13,000.

The calculation for the shrubbery starts out the same, but is slightly different because of the lack of insurance proceeds and because the adjusted basis is lower than the amount of damage incurred. Other than that the taxpayer needs to determine the value of the shrubbery before the hurricane ($2,000), subtract the value of the shrubbery after the hurricane ($400) to find the casualty sustained ($1600). Then, based on Reg Section 1.165-7(b)(1), the taxpayer needs to merely determine which amount is lower, the amount of the adjusted basis ($1200) or the amount of casualty sustained ($1600). This determination results in the allowable deduction of $1200 for the damaged shrubbery.

B. The Effect of Insurance Proceeds

Almost every business related loss will have some sort of insurance coverage because businesses of all sizes are highly risk averse and need to protect against any sizeable losses which could damage the business and anger owners and shareholders. So, realizing how insurance proceeds from a casualty loss will affect the overall tax picture of the business is very important. There are a limited number of outcomes from the reimbursement of insurance. Either the insurance proceeds are greater than the adjusted basis of the property (resulting in an “insurance gain”), or the insurance proceeds are less than the adjusted basis of the property (resulting in an “insurance loss”). There is a third outcome where the insurance proceeds exactly equal the adjusted basis of the property, but then there would be no insurance gain or loss and the reader/taxpayer could skip to the next section of this discussion.

The Treasury Regulations state, “In determining the amount of loss actually sustained for purposes of Section 165(a), proper adjustment shall be made for any salvage value and for any insurance or other compensation received.”[29] The Tax Court has held that for these purposes, basis is measured at the time of the casualty; thus, an increase in basis resulting from use of the proceeds to restore or rebuild the property will not enhance the deduction.[30] If the amount of insurance recovery exceeds the tax basis of the damaged property, there is no casualty loss—even though there may have been a financial “loss” in the sense that the insurance proceeds were less than the reduction in the property’s fair market value.[31] If the amount of insurance recovery does not exceed the tax basis of the damaged property, there is a casualty loss, which is deductible. Therefore, if the insurance recovery exceeds the adjusted basis then there is a realization event for the taxpayer. However, it is possible for the Taxpayer defer realization of the insurance recovery to a certain extent and it is this information which ultimately drives the motivation for this research.

II. Single, Identifiable Property Rule

Under the Treasury Regulations for Section 165, a business or investment loss is determined by reference to the “single, identifiable property damaged or destroyed.”[32] The determination of what constitutes a single identifiable property is important to prevent taxpayers from “borrowing” the basis of unharmed assets to increase the loss deduction on property suffering a casualty.[33] The loss deduction is limited to the basis of the specific property damaged because of the limitations set out above[34]. What constitutes the single identifiable property (“the SIP”) damaged or destroyed in any particular casualty event is necessarily a question of fact.[35] There are a number of factors which go into the determination of the SIP; however, “[t]he only source or flicker of guidance as to what constitutes a SIP in a specific set of circumstances comes from the various court decisions on the issue.”[36] Therefore, none of these factors examined in the determination of the SIP, on its own, is dispositive.[37]

The Internal Revenue Code and its Treasury regulations contain a complex and curious blend of “bright line” rules and vague standards known as “facts and circumstances” tests.[38] To arrive at a reasonable unit of property, the court must take into account the nature of the casualty and the facts and circumstances of the particular case. In a self-policing tax system, the existence of many facts and circumstances tests produces a broad continuum of responses from the professionals who represent taxpayers.[39] Under most facts and circumstances tests, there is no authoritative end to the posing of such questions. Only the constraints of time, “cost, and intellectual capacity govern” when and how an analysis will be terminated.[40]

Many of the cases used to develop these factors have arisen from cases involving timber companies’ inventory of damaged timber. I cite to these cases because it shows even if you would expect a single tree to be the SIP the assumption could be incorrect. One of the first, and largest, cases was Westvaco v US, where the court was asked whether the single identifiable property damaged or destroyed was all of the timber in the area primarily affected by each casualty or just the merchantable units of timber representing the trees totally destroyed.[41] The court in this case decided on using the “depletion district” or “block” as the method for determining the SIP in regard to timber lands.[42] This method was later reaffirmed and held as controlling in Weyerhaeuser Co. v. United States.[43] In another tree related case, involving a citrus grove, the court tried to formulate a more “bright line” rule: “[T]he economic unit by which a taxpayer’s casualty losses are measured should be of a nature and scope that make practical sense.”[44] In two recent Technical Advice Memoranda the factors listed below were suggested as a starting point when determining the SIP:[45]

  • whether the nature and scope of the unit chosen is reasonable and practical;
  • whether it reflects all the physical damage caused by the casualty;
  • whether it remains constant and identifiable for tax purposes, and has a cost or adjusted basis that is not changed except by elimination of an asset or by injection of capital;
  • whether it is consistent with the taxpayer’s other tax accounting practices (for example, depletion in the timber cases);
  • whether it is accounted for and identifiable as a unit for non-tax accounting purposes;
  • whether it is a unit whose utility derives from its functioning as a whole;
  • whether it is separately treated for operational and management purposes;
  • whether it is a “commercially segmentable” unit likely to be bought or sold as such; and
  • whether it is consistent with industry practice.

Also, the basis limitation of the regulation on the allowable deduction for the loss is calculated separately with regard to each SIP and is not an aggregate of the basis in all property destroyed.[46] Improvements to property destroyed or damaged are considered an integral part of the entire property so the Code and the Tax Court do not allow for a separate basis in those improvements when determining the loss sustained.[47]

I find the tax treatment of an asset which is depreciable and also bears a yearly crop, such as trees, to be very interesting and I include this discussion as an example of how the SIP rule may not apply to all of the pieces of the SIP. When fruit-bearing trees used in a trade or business are damaged, the loss is measured by the value of the trees alone, not including the value of the unharvested fruit.[48] Section 1.165-6(c) of the regulations provides that the total loss by frost, storm, flood or fire of a prospective crop being grown in the business of farming shall not be allowed as a deduction under Section 165(a) of the Code. The cost of growing the fruit is deductible by the Taxpayer as a business expense, “and he therefore has no basis in the ripening fruit.”[49] Furthermore, “the difference between the cost of a growing crop and its prospective sales price is only anticipated income and the loss of anticipated income is not deductible.”[50] Therefore, the value of the fruit is excluded when determining the amount of the casualty loss deduction under Section 165(a). However, with respect to the citrus trees damaged, the amount of the deductible loss is measured by the difference between the fair market value of the trees (not including the fruit) immediately before the casualty and the fair market value of the trees (not including the fruit) immediately after the casualty, and again that amount may not exceed the adjusted basis of the trees for determining loss.

Example situation for a Taxpayer who owns orange trees:

The taxpayer owns an orange tree grove and is engaged in the business of growing the selling oranges. In 1995 a hurricane damaged all of the orange trees in the grove and totally destroyed the fruit ripening on the trees.

Taxpayer’s basis in the trees 100 Trees’ value (including the value of the fruit) before the casualty 200 Trees’ value immediately after the casualty 120 Value of the fruit immediately before the casualty ___ 20

FMV of Trees before Casualty 200

– Minus Value of the fruit 20

– FMV of the trees immediately after casualty 120

Amount deductible for the damage to the trees is 60

IV. Inventory

This section provides a general overview of inventory rules and the basic methods of inventory valuation, and treatment, under the Code as an examination of where a business taxpayer would need to start in determining the value of its goods. I also address inventory because our client Taxpayer has a loss of inventory as well as business property, it will be necessary to discuss how the Code treats inventory and examine some different measures of tracking and valuing inventory.

The casualty loss provisions are inapplicable to losses reflected in a taxpayer’s inventory.[51] Instead, losses to inventory are governed by Section 471 and deducted as a cost of goods sold (“COGS”). Otherwise, a taxpayer sustaining a casualty loss to inventory would receive a double benefit by reflecting the loss as an increase in the cost of goods sold and receive a casualty loss deduction. The general rule in the tax code regarding inventories is found in Section 471:

(a) Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.

It is very important for the system that there are standardized practices in income and inventory accounting and, how to determine what is “inventory” in the first place.[52] In order to clearly determine income, inventory shall be taken by taxpayer on the basis which may be prescribed by the commissioner as conforming as nearly as possible to the “best accounting practice” in the trade or business, the phrase “best accounting practice” is synonymous with “generally accepted accounting principles.”[53] An objective of the Internal Revenue Code is to “match” income to expenses and it is very important that the method used is a clear reflection of income.[54] Therefore, there are guidelines to the limits to how the taxpayer may calculate his or her income.

“Ordinarily, when there are inventories to consider, the accrual basis is the only method which will properly reflect taxpayer’s income.”[55] There is also a difference in treatment if the “inventory” is actually a supply used in the services of the business and not actually “inventory” for tax purposes. [56] The Commissioner has the power to make the determination regarding whether the taxpayer’s inventory accounting method sufficiently reflects the taxpayer’s income from that inventory. If the Commissioner deems the taxpayer’s accounting method to be deficient in that regard, the Commissioner can force the taxpayer to change his or her method of accounting.[57]

The Code provides for the general rules for accounting in Section 446: “Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.”[58] One important factor for a business is keeping proper accounting records, to track the cost to the business in sell its products.

Certain items may be totally excluded from inventory, and thus excluded from the COGS for the year. The taxpayer may exclude certain goods from inventory when such goods have become entirely “unsalable.”[59] However, the Taxpayer must exclude these “unsalable” goods when he first learns of the goods’ unsalability, and must make and item-by-item determination.[60] An arbitrary reduction in values, by eliminating a certain percentage as representing a true fall in value, is not allowed because approximations are not allowed. [61]

A. Inventory Accounting

This information is taken as an illustrative example from the case of Huffman v. C.I.R [62] the situation here did not arise out of any time of casualty. The court went to great lengths analyzing certain inventory accounting methods and made some findings that are illustrative of the issues being analyzed here. Namely the court defines some rules which pertain specifically to businesses and merchants. The Huffmans owned a number of car dealerships and the court needed to determine whether the business changed its accounting methods and whether the value of its inventory needed to be adjusted.

In the case of a merchant that sells a large number of essentially similar or fungible items, the cost of the goods sold during any period is computed in steps, using inventories and an accrual method of accounting, along with various assumptions as to the manner in which the actual costs incurred in acquiring or producing items of inventory are allocated among the items so acquired or produced. To compute the cost of goods sold during a year, the steps are as follows: First, the costs of the items acquired or produced during the year are aggregated. That total is then combined with the aggregate cost of the items on hand at the beginning of the year to produce the total cost of the goods available for sale during the year. That last total is then allocated among items on hand at the end of the year (cost of ending inventory) and items sold during the year (cost of goods sold). The formula for determining cost of goods sold is essentially as follows:

Cost of beginning inventory

+ Purchases and other acquisition or production costs

= Cost of the goods available for sale

Cost of ending inventory

= Cost of goods sold

Various cost-flow assumptions are used to allocate the cost of goods available for sale between goods sold during the year and goods remaining on hand at the end of year. Two assumptions generally used for financial accounting and tax purposes are first-in, first-out (FIFO) and last-in, first-out (LIFO).[63] Under FIFO, it is assumed that the first goods acquired or produced are the first goods sold and that the goods remaining in ending inventory are the last goods acquired or produced.[64] Under LIFO, it is assumed that the last goods acquired or produced are the first goods sold.[65]

LIFO and FIFO are totally different, and alternative, assumptions on how inventory will be valued on a moving basis.

B. Last-In, First-Out.

Section 472 allows every taxpayer to adopt LIFO as a matter of right. Only three statutory conditions must be satisfied: (1) There must be a valid election of LIFO; (2) there must be no violation of the LIFO conformity requirement; and (3) LIFO inventories must be valued at cost (i.e., there must be a restoration of prior market write-downs, and subsequent market write-downs are not permitted).[66] Under LIFO, the costs associated with changing prices are generally reflected in the cost of goods sold. In effect, these costs are treated as period costs and excluded from income.[67]


Assume that a taxpayer with a beginning inventory of 10 units of product at a cost of $1 per unit acquires additional units of product at the following times and costs:

Date Number Unit cost Total
Beg. inv. 10 1.00 10.00
April 1 15 1.02 15.30
July 1 15 1.04 15.60
October 1 10 1.06 10.60
50 51.50

Assuming that twelve units of product remain on hand at the end of the year, it is necessary to determine what portion of the $51.50 aggregate cost should be allocated to these twelve units. Under LIFO, the ending inventory would be deemed to cost $12.04 (consisting of a layer of ten units at $1.00 per unit and a layer of two units at $1.02 per unit). The balance of $39.46 would be allocated to cost of goods sold.

Use of the LIFO method provides a number of benefits in rising markets. Most obvious is the improvement in cash flow, which results from reduced state and federal income taxes. As the newer, more expensive-to-acquire units are sold, the business will be taking in more money, but will have a higher COGS at the end of the year. Then the higher COGS will be deducted against the income of the business lowering the business’ tax burden and leaving the business with the less expensive-to-acquire inventory on hand. The taxpayer obtains increased funds for replenishing inventory without having to borrow “profit.” In other words, the profit that is reported for financial or tax purposes is true profit meaning that the COGS more closely represents the cost of the inventory being sold and results in a more accurate profit level. These are profits which may be distributed to owners without reducing the level of operations or used to pay debts, to make new investments, or otherwise to expand the business.[69] There is less accounting “trickery” using this method due to the representative COGS reflecting the inventory sold today.

In a falling market, this method would really only affect the final COGS[70] because the unit cost for each additional unit would be lower. This would result in lower sales and lower COGS at the end of the year. But, if the sales numbers from the previous example still held, the resulting inventory value would not change drastically because you would still have the beginning inventory which cost one dollar, plus two units of the April inventory.

C. First-In, First-Out.

In most of the research, this method of valuation is used often with sales of corporate stock. This is due in large part to the applicable capital gains taxes, where long-term holdings are taxed at a lower rate than short-term holdings. Therefore, if the first batch of stock had been purchased one year and a day ago, and the last batch of stock was purchased less than one year ago, it would be more advantageous for the Taxpayer to sell the first stock first, rather than the last stock first.

When applying FIFO to inventory valuation the assumption is that inventory purchased or manufactured first is sold first and newer inventory remains unsold. Thus, cost of older inventory is assigned to cost of goods sold and that of newer inventory is assigned to ending inventory. The actual flow of inventory may not exactly match the first-in, first-out pattern because only the cost of acquiring the “first” inventory is used in this method and does not physically require the “first” inventory to be sold.

FIFO Example

Date Number Unit cost Total
Beg. inv. 10 1.00 10.00
April 1 15 1.02 15.30
July 1 15 1.04 15.60
October 1 10 1.06 10.60
50 51.50

Assuming that twelve units of product remain on hand at the end of the year, it is necessary to determine what portion of the $51.50 aggregate cost should be allocated to these twelve units. Under FIFO, the ending inventory would be deemed to cost $12.68 (consisting of a layer of ten units at $1.06 per unit and a layer of two units at $1.04 per unit). The balance of $38.82 would be allocated to cost of goods sold.

D. Election to use dollar-value method.[71]

LIFO and FIFO both have their advantages and disadvantages. The key question still is: “How does one value the inventory?” One method of valuation which is available to businesses through the Code is the dollar-value method and, based on the research, this method would be helpful for a business to fairly and accurately value its inventory. Any taxpayer may elect to determine the cost of his LIFO inventories under the so-called “dollar-value” LIFO method, provided such method is used consistently and clearly reflects the income of the taxpayer in accordance with the rules of Section 472. The dollar-value method of valuing LIFO inventories is a method of determining cost by using “base-year” cost expressed in terms of total dollars rather than the quantity and price of specific goods as the unit of measurement. Under such method the goods contained in the inventory are grouped into a pool or pools. In most instances the pool will consist of all the items entering into the entire inventory investment for a natural business unit of a business enterprise.[72] So, looking back to the cases involving timber, the trees in a certain area are called a “depletion block” and this represents the pool of inventory.[73]

The term “base-year cost” is the aggregate of the cost (determined as of the beginning of the taxable year for which the LIFO method is first adopted, i.e., the base date) of all items in a pool. The taxable year for which the LIFO method is first adopted with respect to any item in the pool is the “base year” for that pool. Liquidations and increments (increases) of items contained in the pool shall be reflected only in terms of a net liquidation or increment for the pool as a whole. Fluctuations may occur in quantities of various items within the pool, new items which properly fall within the pool may be added, and old items may disappear from the pool, all without necessarily effecting a change in the dollar value of the pool as a whole.

An increment in the LIFO inventory occurs when the end of the year inventory for any pool expressed in terms of base-year cost is in excess of the beginning of the year inventory for that pool expressed in terms of base-year cost. So, when the inventory in a pool holds a higher value at the end of the year than the inventory in that pool at the beginning of the year the ratio of the total current-year cost of the pool to the total base-year cost of the pool must be computed.[74] This would be the case in a rising market, with rising raw material costs. The ratio of the value of the end of year inventory over the beginning of year inventory, when multiplied by the amount of the increment measured in terms of base-year cost, gives the LIFO value of such increment. The LIFO value of each increment must be separately accounted for and a record maintained as a separate layer of the pool, and may not be combined with a layer of increment occurring in a different year.[75] On the other hand, when the end of the year inventory of the pool is less than the beginning of the year inventory of the pool, liquidation occurs in the pool for that year. Which would be the case in a falling market with lower prices for raw materials, or due to having less inventory on hand.

The liquidation shows and example of what would happen to a taxpayer who has suffered a casualty loss to inventory, because there is less inventory on hand at the end of the year than at the beginning. Such liquidation is reflected by reducing the most recent layer of increment (the most recent year’s increment) by the excess of the beginning of the year inventory over the end of the year inventory of the pool.[76] However, if the amount of the liquidation exceeds the amount of the most recent layer of increment, the preceding layers of increment in reverse chronological order are to be successively reduced by the amount of such excess until all the excess is absorbed. This type of “carry-back” is similar to the net-operating-loss carry-back except the taxpayer is not limited to 2 years in this instance. The base-year inventory is to be reduced by liquidation only to the extent that the aggregate of all liquidation exceeds the aggregate of all layers of increment. In determining the inventory value for a pool, the increment, if any, is adjusted for changing unit costs or values by reference to a percentage, relative to base-year-cost, determined for the pool as a whole.

This method of valuing inventory makes it simpler for the taxpayer to come to a fair and accurate value of the inventory for the taxable year. Also, in the case of a disaster loss, the taxpayer does not need to have any independent appraisal performed because of the accounting data would show the inventory’s value and how much loss could be carried back. Section 472 provides for a simpler calculation of the value of inventory because the taxpayer only needs to value their inventory pools at two times of the year, the beginning and end (with the “end” also being at the time of a disaster or involuntary conversion). Then, at the end of the year, the taxpayer needs to calculate whether the end-of-year inventory is worth more than the beginning-of-year inventory and create a simple ratio of those two initial totals in order to ascertain the LIFO value of any increment or liquidation. This is the important step because the LIFO value of the increment (or liquidation) is necessary in computing a future liquidation, which is helpful to the taxpayer because it creates a dollar amount for a possible future deduction. The calculated deduction amount is necessary for the business to correctly and fairly value the inventory which was destroyed or involuntarily converted.

V. Deferral of Gain: Involuntary Conversions

It is very important for clients who have suffered involuntary conversions to business assets to know there are provisions of the Code which will allow them to defer any gain from insurance proceeds which would be immediately taxed as ordinary income. From a public policy standpoint, Congress has made it easier for businesses to defer this “gain” because the taxpayer should not be burdened by the Code for the consequences of an unforeseeable occurrence.

A. Section 1033

Section 1033 of the Code is on the opposite end of the spectrum of Section 165, because 1033 involves gains and allows for non-realization of any gain if certain criteria are met.

If property (as a result of its destruction in whole or in part. . .) is compulsorily or involuntarily converted—

(1) Into property similar or related in service or use to the property so converted, no gain shall be recognized.

(2) Into money or into property not similar or related in service or use to the converted property, the gain (if any) shall be recognized except to the extent hereinafter provided in this paragraph:

(A) Nonrecognition of gain.–If the taxpayer, for the purpose of replacing the property so converted, purchases other property similar or related in service or use to the property so converted . . . at the election of the taxpayer the gain shall be recognized only to the extent that the amount realized upon such conversion (regardless of whether such amount is received in one or more taxable years) exceeds the cost of such other property.[77]

The limitations period of this Section is described in subsection (a)(2)(B) of 1033 and states, the period shall be the period beginning with the date of the disposition of the converted property, or the earliest date of the threat or imminence of requisition or condemnation of the converted property, whichever is the earlier. Because timing under this Section can begin at two different points, either when the property in question is disposed of or when there is an imminent threat of requisition or condemnation by a governmental authority, it is possible to imagine a scenario where the start date could come into question. However, the Section allows for the Taxpayer to elect when the start time will take effect, so if the Taxpayer wishes to defer the start to the later date of disposition then that is allowed.

The end of the period in most cases will be 2 years after the close of the first taxable year in which any part of the gain upon the conversion is realized. This provision is very favorable to the taxpayer who suffers an involuntary conversion early in the year, because the rest of the year becomes a sort of “grace period” to deal with the insurance, find similar property to be acquired, or arrange for repairs or reconstruction. Then the two year limitations period begins to run. It is also possible to extend the two year period subject to terms and conditions which may be specified by the Secretary. Any application for extension “shall be made at a time and in such a manner as the Secretary may by prescribe through the regulations.”[78]

Section 1033 boils down to three main elements, (1) if property is destroyed through an involuntary conversion, (2) the Taxpayer can avoid having to pay any tax on the gains from insurance as long as the Taxpayer uses the proceeds to purchase property similar, or related in service or use, to the property converted, (3) within 2 years after the year of the involuntary conversion. Destruction of property followed by reimbursement and replacement can be treated as involuntary conversion, upon which gain is realized only to extent reimbursement exceeds replacement cost, and replacement property assumes basis equal to that of destroyed asset.[79]

There is a particular situation where a Taxpayer may not want to defer the realization of the gain under this Section. For instance, if the Taxpayer has had significant losses for the year and he or she would like to recognize the gain in the converted property to offset some of the losses and to receive a stepped up basis in the new property.

B. Section 1231

Section 1231 is a section of the Code which is used to characterize transactions under other Code sections, such as Section 1033. For the purposes of Section 1231, a “gain” would exist if insurance proceeds from a casualty where not completely used up in a conversion from cash to “similar property”. For example, Taxpayer has a building worth $100,000 which has been destroyed. Taxpayer receives $100,000 from insurance but only uses $95,000 to construct a new building. There has then been a $5,000 gain. A “loss” would exist if insurance proceeds covered less than the basis of the property.

If, in any year, gains realized in transactions involving Section 1231 assets (e.g., property used in trade or business) exceed realized losses, all the Section 1231 gains and losses are treated as capital gains and losses (except to the extent of recapture, infra).[80] If losses on those assets exceed gains, all Section 1231 gains and losses are ordinary gains and losses as treated by Section 165(c)(1).[81] Under this section, the Taxpayer does need to compute the holding period of the business property which was destroyed in order to determine whether long-term capital gains rates are applicable.[82] There is a separate calculation from the pool of voluntary dispositions of assets by the business for involuntary disposition, and this separate pool is sometimes called the “small hotchpot”.[83] Once the “small hotchpot” of involuntary conversions has more gains than losses, all of the gains and losses from the involuntary conversions spill over into the general “hotchpot” of Section 1231 dispositions. Then these involuntary conversion gains and losses are calculated among the total gains and losses of the business for the entire taxable year and affect the overall characterization of these transactions.


(1) the sale, exchange or involuntary conversion of depreciable property used in the taxpayer’s trade or business and was held for more than 6 months at the time of its disposition;

  1. then long-term capital gains rates apply to any excess (or deficient) insurance proceeds.

(2) the involuntary conversion (but not sale or exchange) of capital assets held for less than the 6 month holding period;

  1. then, the ordinary income rates apply.

Next, the Taxpayer needs to total all of the Section 1231 transactions. The first step is to combine all the gains and losses realized during the year from all Section 1231 transactions. Section 1231 gain is reduced by the amount of recaptured depreciation, if any.[84] In netting gains and losses, gains are included only to the extent they are includible in gross income, and losses are included only to the extent they are includible in computing taxable income (without regard to the capital loss limitation).[85]

If the gains exceed the losses, all the gains and losses are treated as long-term capital gains and losses (subject to recapture). These gains and losses are combined with any regular capital gains or capital losses to determine the net capital gain or loss for the year.[86] If the losses equal or exceed the gains, all the gains and losses are treated as ordinary gains and losses.[87]


1 30000 30000
2 40000 40000
3 (14000) (14000)
4 (15000) (15000)
5 (25000) (25000)
6 5000 5000
7 (4000)
TOTAL 75000 54000 75000 (54000) Net LTCG 23,000 (4000) Net STCL (4000)

In this example, the Taxpayer has had several 1231 transactions associated with property held for more than six months resulting in a total of 75,000 in gains and 54,000 in losses. Due to the fact that gains outweigh losses, and their long-term nature, these Section 1231 transactions result in all of the transactions having the preferred long-term capital gains treatment.

Section 1231 is very friendly to businesses in how any disposition of assets is characterized. This section would characterize all gains and losses in the sales of business assets and is not just limited to involuntary conversions. If there are gains from dispositions they are treated most favorably as long term capital gains; if there are losses they are treated most favorably as ordinary losses. In the case of an involuntary conversion of property used in the trade or business, subsection (a) does not apply to such a conversion if the recognized losses from involuntary conversions during the taxable year exceed the recognized gains from such conversions.[88]

This Section is favorable to businesses suffering losses from involuntary conversions, whatever the final characterization, as long as the losses are greater than the gains, all losses are treated as ordinary.

1. Nonrecapture:[89]

The net Section 1231 gain is treated as ordinary income to the extent it doesn’t exceed nonrecaptured net Section 1231 losses.[90] Net Section 1231 gain means the excess of the Section 1231 gains over the Section 1231 losses.[91] Net Section 1231 loss is the excess of the Section 1231 losses over the Section 1231 gains.[92]

The term “nonrecaptured net Section 1231 loss” means the aggregate amount of net Section 1231 losses for the five most recent preceding tax years that has not been offset by a net Section 1231 gain under I.R.C. § 1231(c)(1).[93] Losses of the taxpayer, or taxpayer’s predecessor, are recaptured in the chronological order they arose.[94]


A calendar-year taxpayer has the following net Section 1231 gains and losses:

Net Section 1231
Year Losses Gains
1 10,000
2 0 0
3 0 0
4 25,000
5 30,000
6 100,000

At the start of Year 6, taxpayer’s nonrecaptured net 1231 loss is $65,000, the sum of the Years 1–5 net losses. Thus, $65,000 of the $100,000 net gain for Year 6 is treated as ordinary income. The $35,000 balance is treated as capital gain.

Recognized gains and losses from fire, storm, shipwreck or other casualties or theft are included in the capital gain-ordinary loss computation.[95] This applies to all casualty property which is a capital asset held for the long-term holding period, in connection with a trade or business or a transaction entered into for profit.

VI. Client Analysis

The client who was presented at the opening of this paper has had a warehouse storing inventory burn to the ground. The warehouse was properly insured for fire damage up to $250,000, has been depreciated to a value less than its cost, and has been used by the business for warehousing purposes for more than a year. The inventory destroyed is final product awaiting sales and shipping and is not insured and is not materials used to make the final goods sold. Below will be a discussion following courses of action the client could take, and some analysis on how those outcomes will affect the client’s tax liability. This Section will not go into the effect of insurance which covers any lost profits of the business, only insurance purely for any loss or damages sustained to business property.

Scenario 1 Full Insurance Reimbursement

This scenario contemplates a total destruction of the warehouse property and contents leaving a salvage value of $0. The inventory destroyed will be valued at $40,000 based on the regulations, as this is the value of the bona fide selling price of the inventory less cost of disposition.[96] This inventory was the only finished inventory of the client not currently being shipped to customers. There was a total loss to the client and insurance will payout the maximum of $250,000.

Value of property (excluding inventory) immediately before casualty 200,000

Less: Value of property immediately after casualty 0

Value of property actually destroyed 200,000

Less: Insurance received 250,000

Loss to be taken into account for purposes of Section 165(a): Lesser amount of property actually destroyed ($300,000) or adjusted basis of property ($200,000) 200,000

Less: Insurance received 250,000

Deduction allowable 0

In this scenario, the client Taxpayer has not suffered a “casualty loss,” per the regulations,[97] because the entire “loss” was compensated in the eyes of the Code. This situation does present the taxpayer with $250,000 of income for the taxable year upon the receipt of the insurance proceeds. It would certainly be in the best interest of the client to defer any taxes on this new “income” especially due to the fact that a large portion of the business has been critically damaged.

The client has suffered an involuntary conversion in Year 0 as contemplated by Section 1033 and has received insurance proceeds to compensate for this loss. It makes no difference under Section 1033 how the money is allocated, whether to the warehouse or to the inventory inside, because the Section just mentions “property” converted into “property similar or related in service or use.” Therefore, the client has until the end of Year 2 to convert all of the money into “such property.” Upon the timely conversion of all money into such property there will be no gain which is taxable.

There is significant flexibility in this situation for the client. If the client had enough cash to stay in business and possibly rent another warehouse in order to facilitate continued production, then the client could take the entire $250,000 and have a new warehouse constructed or purchase a new warehouse for the entire $250,000. This new warehouse would have the same basis as the old warehouse which was destroyed. Then, under the rules governing inventory, the client would be able to add the $40,000 value of the lost inventory to its cost of goods sold for the tax year and deduct those costs as an ordinary business expense under Section 162 against the LIFO increment and carry back the loss. Therefore, even though the client suffered a $240,000 loss, there is no recognition of the $250,000 which was timely converted and the client will be able to recoup some of the sunk cost of the lost inventory through a tax deduction at the end of the year.

However, if the client does not have the cash to stay in business, because there is no finished product to be sold, then a portion of the insurance proceeds may need to be put toward more production and a rental warehouse for a period of time. In this case, any insurance money used to pay for rental and production needs would not be put toward a new warehouse and would be characterized as a “gain” under Section 1231. Because there are no offsetting losses in this scenario, the client’s 1231 gains would outweigh the losses and all of the gains would be characterized as long-term capital gains receiving favorable treatment. Therefore, even though the client may have suffered a setback to the business, the Code provides for ample relief to the client Taxpayer.

Scenario 2 Inadequate Insurance Reimbursement

This scenario contemplates a total destruction of the warehouse property and contents leaving a salvage value of $0. Again the inventory destroyed will be valued at $40,000 for the same reason set out in Scenario 1. This was a total loss to the client but insurance will not payout the maximum of $250,000.

Value of property (excluding inventory) immediately before casualty 200,000

Less: Value of property immediately after casualty 0

Value of property actually destroyed 200,000

Less: Insurance received 150,000

Loss to be taken into account for purposes of Section 165(a): Lesser amount of property actually destroyed ($300,000) or adjusted basis of property ($200,000) 200,000

Less: Insurance received 150,000

Deduction allowable 50,000

In this scenario the client is in a very difficult position because there has been a complete loss to the business of the warehouse and the goods it housed; however, the insurance company will not pay the maximum insured value of the building for one reason or another. As a result, the client has less money in his pocket than the building’s basis meaning that there has been a clear loss suffered.

Right from the start, the $150,000 of insurance proceeds will be treated in the same way as Scenario 1, where the client should use all of this money in the purchase or construction of “property similar or related in service or use.” Again, by timely converting the $150,000 into another warehouse type facility by the end of Year 2 there will be zero recognition of the insurance proceeds. Any money not used in this way will be characterized as a gain under Section 1231, however this scenario provides for an offset to those gains. Because the insurance proceeds did not cover the adjusted basis of the warehouse there has been a loss suffered under Section 165(c)(1) and Section 1231(a)(4)(C) characterizes this loss as ordinary.[98]

Therefore, even though the client was not sufficiently reimbursed for the loss suffered, the Code still provides some help. The client does not need to realize any gain on the insurance proceeds, the $50,000 loss is deductible against ordinary income of the business, and the inventory is still includable in the cost of goods sold and deductible as well. Therefore, in this scenario, the client does not come out of the situation with as much tax savings as in the first example because the deductible loss is not going to be dollar for dollar and the insurance proceeds did not cover the value of the structure lost which will require a significant capital outlay to remedy.

VII. Code Analysis

When I started this research I immediately noticed that businesses do not claim “casualty losses” in the same way that an individual would have to claim a casualty loss. I immediately found that Section 165 was not really applicable in the way that I thought it would be when analyzing business casualty losses. However, my ultimate conclusion is that the Code is more accommodating to businesses and business losses, than to individuals who suffer casualty losses.

Since businesses do not need to jump the same hurdles of Section 165, such as having a loss which is greater than $100 and greater than 10% of gross income, businesses are not as hindered in their ability to realize casualty losses when compared to individuals. This would seem to make sense from a policy point of view however, because individuals’ losses involve personal property which would be consumable for their personal benefit and not for the benefit of running a larger entity. Businesses also receive the benefit of being able to treat casualty losses as a business expense even if these losses are to be expected frequently in that type of business. This does appear to be a fair outcome because Congress chose to offset a portion of the capital intense nature of running a business.

One of the few limitations on how a business may compute any losses suffered is the recognition of the single, identifiable property. As far as I am aware, individual taxpayers do not need to worry about this limitation. The Internal Revenue Commissioner, in the cases cited for the single, identifiable property rule, is very strict in identifying a single, identifiable property, even though in some cases the single property was an aggregate of multiple pieces of property (trees, crops). The Taxpayer running the business may want to lump all of the damaged property into one, say a road, building, machinery and crops, in order to maximize the loss due to possible variances in deductions and basis. For instance, if the machinery has an adjusted basis of zero, then there would be no “loss” under the code. But, if the zero basis machinery could be lumped in with the high basis new building that housed the machinery, the Taxpayer would be trying to receive a larger possible deduction. So, by separating all of the property that is single and identifiable, the business taxpayer is forced to prove the basis of the property destroyed. Therefore, low basis property may not be deductible in the case of a loss but, this is a fair conclusion, because the taxpayer has already received the benefit of depreciation and recovered the basis in that property.

While researching this paper I was initially confused by some of the rules regarding certain property and losses, especially the rule regarding depreciated property and basis. If depreciable property has been fully depreciated to a zero basis, and that property is subsequently destroyed or damaged, there is no “loss” under the Code. When I first started thinking about this rule I was not totally sure why this should be the case, however, upon further reflection, it does make sense. Taxpayers should only receive a deduction for lost investment basis because this value represents future deductible value of the depreciable property. When the deductible value of the property has been used up the Code is not going to allow the Taxpayer to “double dip” and receive a further deduction for property which has already been fully deducted under the Code.

In the case of a Taxpayer who suffers a loss from a destruction of market value greater than the cost of the property to him, that excess in value destroyed represents unrealized appreciation. The unrealized appreciation is a very different characterization from future deductible value because the unrealized appreciation is value inherent in the property which would be a taxable gain at the disposition of the property. Thus, the Taxpayer may not claim a deduction for such loss of the unrealized appreciation because he never recognized or paid a tax on this appreciation. When viewing these two ideas located on opposite sides of a coin (unrealized appreciation on one side and depreciable value on the other), but governed by the same rule of non-deductibility, it becomes clear why the Code is written in this way. If the Taxpayer had no value in the property because it was fully depreciated the taxpayer has already received the benefits of depreciation. Where the Taxpayer has value which was never taxed and was destroyed then there will be no tax on that property due to is conversion and a deduction will be allowed for the basis of the property (representing the investment cost to the Taxpayer).

To me at least, this seems like a favorable position to the Taxpayer because it does not change the financial position of the business from an accounting perspective, because depreciated property would hold no value and there was no realized capital gain on any value above basis for the unrealized appreciation. However, when substantial insurance proceeds are added to the calculation the position of the Taxpayer can change drastically. In all likelihood the Taxpayer will have insurance for all property business property, even property which is fully depreciated. Based on the Code, the insurance proceeds, which are greater than the basis of the property, becomes taxable income to the Taxpayer as either regular income or capital gains depending on the situation. This result was what this paper was seeking to overcome for the client. How can the client Taxpayer avoid, or defer, having to pay taxes on the proceeds on insured property which has been damaged?

In the case of inventory the Code builds in a slight safety net for the business holding that inventory. If the inventory is destroyed, in almost any and all circumstances, the inventory will be added to the business’ cost of goods sold for the year and deducted against the income of the business for that taxable year. The business is allowed to value that inventory at the bona fide selling price less the cost of disposition for the purposes of determining the value to place in the COGS. This is very business friendly because the business is allowed to value the inventory at a much higher price than it cost the business to acquire and manufacture the raw material into the final inventory.

Unexpectedly, most of my research boiled down to deciphering the application and effectiveness of the combination of Section 1033 and 1231 of the Code. I did not know this would be the case at the beginning of this paper but these sections ended up being the answer to deferral in nearly every situation I looked into. If the Taxpayer can convert any insurance proceeds into “similar property” within the statutory timeframe there will be zero tax liability. And Section 1033 is actually much broader than just relating to casualty losses because it applies to any type of involuntary conversion, such as a government taking, seizure, or condemnation. I think that Congress made this section broad in order to help those who have lost some property of great value and received insurance proceeds or other goods to replace the converted property.[99] Interestingly enough there is no specific language in the section stating that it only relates to property used in a trade or business, so I believe that it is possible for an individual to take full advantage of the tax deferral/avoidance provisions of this section.

Admittedly, I was very perplexed as to the exact relationship of 1033 and 1231, until I realized that 1231 is merely a characterization provision for transactions in other sections of the Code. This becomes clear when the section defines “gain” as, “any recognized gain on the sale or exchange of property used in the trade or business.” So, any and all sales and exchanges in trade or business property over the course of the taxable year come into play when characterizing those transactions, not just casualty losses or involuntary conversions. This is another section that is very friendly to businesses for a few reasons; 1) this section is only available to trade or business property transactions, 2) if there are “gains” under this section that outweigh the “losses” then all of the gains and losses are long-term and capital in nature, 3) if the “losses” outweigh the “gains” then all gains and losses are ordinary gain and losses.[100] 4) it only takes a holding period of 6 months for the property to be characterized as “long-term.”[101]

So, if a business has left over insurance proceeds after converting the money into “property similar or related in service or use to the property converted” the business will still be handed a “win” from the Code. The left over insurance proceeds will either classified by Section 1231 as a long-term capital gain, receiving favorable tax treatment, or as an ordinary loss, providing a dollar for dollar reduction of the Taxpayers gross income.[102]

The clear takeaway from my research has been one simple fact. The Code is very friendly to business casualty losses, and I think this is due to the unforeseen nature of such events. If a business owner has suffered an involuntary conversion, whether from simple theft or natural disaster, if insurance money is paid for the property the Taxpayer should turn every dollar of the insurance proceeds into similar property to that which was converted. But, even if there is no insurance payout for the converted property, the Code will help the business Taxpayer deduct that loss either through accounting measures for inventory or an allowance for a deduction against gross income. This is clearly a “win-win” for the business Taxpayer.

This article was written by Kevin Askew, Class of 2014, William Mitchell College of Law

[1] Reg. § 1.165–1(d)(1)

[2] There is no assumption made as to what entity the client business takes the form of, it is only notable to say that if the client were a corporation, or an LLC governed by the tax requirements of a corporation, any mention of long-term capital gains or losses is not applicable.

[3] 26 U.S.C.A. § 165(c)(1).

[4] ¶ 34.1 INTRODUCTORY, 1997 WL 439667, *1.

[5] Reg. § 1.165-1(b).

[6] Reg. § 1.165-7(a)(1).

[7] ¶ 34.1 INTRODUCTORY, 1997 WL 439667, *2.

[8] See 41 A.L.R.2d 691 (Originally published in 1955); 26 U.S.C.A. §165(h) provides that a loss to an individual must exceed $100 and 10 percent of the adjusted gross income of the individual.

[9] Reg. § 1.162-1.

[10] Ellis Banking Corp. v. C. I. R., 688 F.2d 1376, 1378 (11th Cir. 1982)(citing Commissioner v. Lincoln Savings and Loan Association, 403 U.S. 345, 91 S.Ct. 1893, 29 L.Ed.2d 519 (1971).

[11] Deputy v. du Pont, 308 U.S. 488, 495, 60 S. Ct. 363, 367, 84 L. Ed. 416 (1940); See Welch v. Helvering, 290 U.S. 111, 114, 54 S.Ct. 8, 9, 78 L.Ed. 212 (1933)( The transaction which gives rise to it must be of common or frequent occurrence in the type of business involved).

[12]Reg. § 1.165–7(b)(3)(Example 2).

[13] Trinity Meadows Raceway, Inc. v. C.I.R., 75 T.C.M. (CCH) 1861 (T.C. 1998) aff’d, 187 F.3d 638 (6th Cir. 1999).

[14] Reg. § 1.165-7(b)(1); Examples are contained within. Reg § 1.165-7(b)(3).

[15] Reg. § 1.165-7(a)(2)(i) provides, in part, that in determining the amount of the deductible loss, the fair market value of the property immediately before and immediately after the casualty shall generally be ascertained by competent appraisal.

[16] Reg. § 1.165-1(c)(4); See Weyerhaeuser Co. v. U.S., 92 F.3d 1148 (Fed. Cir. 1996); Also, Westvaco Corp. v. U. S., 639 F.2d 700 (1980).

[17] Reg. § 1.165-7(b)(1).

[18] Tessler v. C.I.R., 23 T.C.M. (CCH) 473 (T.C. 1964) (the property was business property and it was completely destroyed, the amount of recovery would be petitioner’s adjusted basis); I.R.S. TAM 201014052 (Apr. 9, 2010)(in determining the fair market value of the property before and after the casualty in a case where damage by casualty has occurred to a building and ornamental or fruit trees used in a trade or business, the decrease in value is measured by taking the building and trees into account separately, and not together as an integral part of the realty, and separate losses are determined for such building and trees (see example supra)).

[19] Cziraki v. C.I.R., 76 T.C.M. (CCH) 991 (T.C. 1998) aff’d, 246 F.3d 673 (9th Cir. 2000)(quoting Keefer v. Commissioner, 63 T.C. 596, 600 (1975).

[20] 7 Mertens Law of Fed. Income Tax’n § 28:99.

[21] Where taxpayer’s basis in damaged property is zero, and its entire market value represents unrealized appreciation, taxpayer is entitled to no casualty loss deduction despite size of loss, large as it may be.  26 U.S.C.A. § 165;  26 C.F.R. § 1.165–7(b)(2)(i). See Weyerhaeuser Co. and Subsidiaries v. U.S., 1994, 32 Fed.Cl. 80, affirmed in part, reversed in part 92 F.3d 1148, certiorari denied 117 S.Ct. 766, 519 U.S. 1091, on remand 39 Fed.Cl. 410. See also, C-Lec Plastics, Inc. v. Commissioner, 76 T.C. 601 (1981) (no deduction permitted because taxpayer received the property with $0 carryover basis under IRC § 362 in an IRC § 351 transaction).

[22] Tessler, 23 T.C.M. (CCH) 473 (T.C. 1964)(Taxpayer relied on “approximations” as to amounts paid for the building and improvements because he did not have an accurate memory and lost the records, held to be invalid by a court sympathetic to a 78 year old man.); Trinity Meadows, 75 T.C.M. (CCH) 1861 (Regulations require that petitioner identify each separate piece of property not only to isolate the basis in that asset, but to determine the diminution in the value of that asset.)

[23] I.R.S. TAM 201014052 (Apr. 9, 2010).

[24] Id.(when only the amount of the adjusted basis in the property is allowable as a deduction rather than some other measure); See Reg.§ 1.165-7(b)(1)(ii).

[25]Brooks v. C.I.R., 105 T.C.M. (CCH) 1832 (T.C. 2013); See Lamphere v. Commissioner, 70 T.C. 391, 396, 1978 WL 3307 (1978); see also Higbee v. Commissioner, 116 T.C. 438, 442, 2001 WL 617230 (2001).; Ashley v. C.I.R., 80 T.C.M. (CCH) 841 (T.C. 2000); Johnston v. Commissioner, T.C. Memo.1980–477, aff’d without published opinion, 696 F.2d 1003 (9th Cir.1982).

[26] This would be especially true for an older structure which may not have been up to code. By repairing the structure, any deficiencies will need to be improved and create added value. In this instance the taxpayer would not be able to use the cost-of-repairs method to value the loss.

[27] However, this does not mean that the Commissioner will automatically accept these costs as true and accurate.

[28] Reg. § 1.165-7(a)(2)(i).

[29] Reg. § 1.165–1(c)(4); This was also illustrated by the cost-of-repairs option.

[30] Estate of Boyle v. C.I.R., 82 T.C.M. (CCH) 488, *4 (T.C. 2001).

[31] 15 Mertens, Law of Fed. Income Tax’n § 59:126.

[32] Reg. § 1.165-7(b)(2)(i); See Trinity Meadows Raceway, at *4(racetrack held to be a separate, identifiable piece of property from buildings and improvements); Cziraki v. C.I.R., 76 T.C.M. (CCH) 991 (T.C. 1998) aff’d, 246 F.3d 673 (9th Cir. 2000)( road through property held to be a separate, identifiable piece of property).

[33] 7 Mertens Law of Fed. Income Tax’n § 28:99.

[34] Weyerhaeuser Co. & Subsidiaries, at 101.

[35] Id., at 100.

[36] Id, at 101.

[37]. I.R.S. TAM 201014052 (Apr. 9, 2010); See also 7 Mertens Law of Fed. Income Tax’n § 28:99.

[38] Richard J. Kovach, Bright Lines, Facts and Circumstances Tests, and Complexity in Federal Taxation, 46 Syracuse L. Rev. 1287, 1288 (1996).

[39] Kovach, 46 Syracuse L. Rev. at 1300.

[40] Id, at 1302.

[41] See Westvaco Corp. v U.S., 639 F.2d 700 (Ct. Cl. 1980).

[42] Westvaco, 639 F.2d at 718.

[43] Weyerhaeuser,92 F.3d at 1148 ( Also, the seven logging road systems and a logging railroad system each constituted separate “single, identifiable properties”).

[44] Estate of Rinaldi v. United States, 38 Fed. Cl. 341, 355 (1997).

[45] I.R.S. TAM 201014052 (Apr. 9, 2010); I.R.S. TAM 200902011 (Jan. 9, 2009).

[46] Weyerhaeuser, at 1148.

[47] Revenue Ruling, 1954-1 C.B. 58, Rev. Rul. 54-85, 1954 WL 8756 (1954).Western Products Co. v. C.I.R., 28 T.C. 1196, 1957 WL 627 (T.C. 1957), acq., 1958-2 C.B. 3; Woods v. C.I.R., T.C. Memo. 1960-72, T.C.M. (P-H) P 60072, 19 T.C.M. (CCH) 388, 1960 WL 837 (T.C. 1960); Fletcher v. C.I.R., T.C. Memo. 1970-228, T.C.M. (P-H) P 70228, 29 T.C.M. (CCH) 981, 1970 WL 1765 (1970).

[48] Rev. Rul. 68-531, 1968-2 C.B. 80 (1968).

[49] Id.

[50] Id.

[51] Reg. § 1.165-7(a)(4).

[52] See Reg. § 1.471–1

[53] Thor Power Tool Co. v. C. I. R., 439 U.S. 522, 522(1979).

[54] See John Wanamaker Philadelphia, Inc. v. United States, 359 F.2d 437, 441-442 (Ct. Cl. 1966)(Taxpayers cannot unilaterally change from one accounting method to another and the standard by which Commissioner’s broad discretion to initiate changes, and, by implication, to police taxpayer-initiated changes, is measured is the clear reflection of income).

[55] A. & A. Tool & Supply Co. v. C.I.R., 182 F.2d 300, 302 (10th Cir. 1950)(citing Aluminum Castings Co. v. Routzahn, 282 U.S. 92, 96 (1930); See also Clark v. C.I.R., 30 T.C.M. (CCH) 259 (T.C. 1971), Diamond A Cattle Co. v. C.I.R., 21 T.C. 1, 5 (1953) aff’d in part, vacated in part on other grounds, 233 F.2d 739 (10th Cir. 1956), Stern Bros. & Co. v. C.I.R., 16 T.C. 295, 322 (1951).

[56] Mid-Del Therapeutic Ctr., Inc. v. C.I.R., 79 T.C.M. (CCH) 1875 (T.C. 2000)(Taxpayers, doctor and medical corporation, were not required to use accrual method of accounting for chemotherapy drugs and other medications provided for patients, since drugs were supplies, and not merchandise, used in the course of treating patients, which were inseparable from medical services provided to patients by doctor).

[57]RACMP Enterprises, Inc. v. C.I.R., 114 T.C. 211, 219 (2000)(A prerequisite to the Commissioner’s exercise of authority to require a taxpayer to change its present method of accounting is a determination that the method used by the taxpayer does not clearly reflect income.); See § 446(b); Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26, 31, 1988 WL 64 (1988).

[58] 26 U.S.C.A. § 446(a).

[59] United States v. Cramer, 447 F.2d 210, 217 (2d Cir. 1971) cert. denied 92 S.Ct. 680, 404 U.S. 1024, 30 L.Ed.2d 674.(this determination must be done “item-by-item”).

[60]Cramer, 447 F.2d at 217.

[61] 2 Mertens, Law of Fed. Income Tax’n §16.24 at 58.

[62] This Section has been excerpted from Huffman v. C.I.R., 126 T.C. 322, 324 (2006) aff’d, 518 F.3d 357 (6th Cir. 2008) as the best judicial explanation of different accounting methods.

[63] FIFO is authorized by Reg §1.471–2(d), and LIFO is authorized by § 472. See Stephen F. Gertzman, Federal Tax Accounting, par. 6.08[2], at 6–84., (2d ed.1993).

[64] Gertzman, at 6–84.

[65] Id.

[66] ¶ 7.05 TERMINATION OF LIFO, 1999 WL 630251, 1

[67] ¶ 7.02 LIFO CONCEPT, 1999 WL 630248, 1

[68] Id.

[69] ¶ 7.02 LIFO CONCEPT, 1999 WL 630248, 1

[70] When keeping all inventory production and sales totals level and only adjusting prices paid for production.

[71] Reg. § 1.472–8(a).

[72] Reg. § 1.472–8(b).

[73] Weyerhaeuser Co. & Subsidiaries, 32 Fed. Cl. at 108 (Fed. Cl. 1994).

[74] Reg. § 1.472–8(e)(2)(iv).

[75] Id.

[76] Reg. § 1.472–8(e)(2)(iv).

[77] 26 U.S.C.A. § 1033(a).

[78] 26 U.S.C.A. § 1033(a)(2)(B).

[79] Bryan’s Estate v. C.I.R., 364 F.2d 751, 755 (4th Cir. 1966).

[80] 33A Am. Jur. 2d Federal Taxation ¶ 11401.

[81] 26 U.S.C.A. §1231; 26 U.S.C.A. § 165(c)(1) (Losses incurred in a trade or business.).

[82] 26 U.S.C.A. § 1231 (Gains and losses shall be treated as long-term capital gains or long-term capital losses, as the case may be.); Brountas v. Comm’r of Internal Revenue, 74 T.C. 1062, 1075 (1980) vacated sub nom. on other grounds, Brountas v. C. I. R., 692 F.2d 152 (1st Cir. 1982) (the gain is sec. 1231 gain if the requisite holding period has been met and, if not, is ordinary income).

[83] Term used by Professor Donna Byrne.

[84]33A Am. Jur. 2d Federal Taxation ¶ 11403.

[85] Reg. § 1.1231-1(d).

[86] Reg. § 1.1231-1(b).

[87] Id.

[88] 26 U.S.C.A. § 1231(a)(4)(C).

[89] 33A Am. Jur. 2d Federal Taxation ¶ 11403

[90] 26 U.S.C.A. § 1231(c)(1).

[91] 26 U.S.C.A. § 1231(c)(3).

[92] 26 U.S.C.A. § 1231(c)(4).

[93] 26 U.S.C.A. § 1231(c)(2).

[94] Conf Rept No. 98-861 (PL 98-369) p. 1034.

[95] 26 U.S.C.A. § 1231(a)(4)(C)

[96] Reg. § 1.471–2(c) (Any goods in an inventory which are unsalable at normal prices or unusable in the normal way because of damage should be valued at bona fide selling prices less direct cost of disposition.)

[97] 26 U.S.C.A. § 165(a).

[98] 26 U.S.C.A. § 1231 (This subsection shall not apply to such conversion (whether resulting in gain or loss) if during the taxable year the recognized losses from such conversions exceed the recognized gains from such conversions.)

[99] Research has pointed to the fact that this code section was implemented to help business owners who had their factors converted for the war efforts in the early 20th century. Once their factories were converted for government use, the Commissioner deemed this to be a realization event requiring taxation of the fair value paid to the Taxpayer by the government for the property.

[100] However, based on the arithmetic there will be more losses than gains which will create a deduction from ordinary income for the business. This deduction is more favorable than long-term capital loss treatment.

[101] This is half of the time generally used for determining “long-term” status under 26 U.S.C.A. § 1222.

[102] For corporations, and business entities taxed as corporations, there is no long-term capital gains rate, so there is no benefit here.

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