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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Tuesday, June 22, 2010

$20b Gulf Coast Disaster Payments: Income to Victims, Deductible by BP

Unless Congress enacts special tax legislation in response to the Gulf of Mexico oil spill, the $20b in disaster payments would be treated as income to the Gulf Coast residents compensated for their losses and as a deductible expense by BP:

[P]eople up and down the Gulf Coast reeling from the oil spill disaster ... are surprised — and frustrated — to find out the IRS may take a chunk of the payments BP PLC is providing to help them stay afloat. ...

Accountants have been trying to nail down the implications for thousands of taxpayers after President Barack Obama said BP would create a $20 billion disaster fund and provide another $100 million for oil workers who lose their jobs because of the six-month moratorium on deepwater drilling in the Gulf of Mexico. ...

Tax experts said generally all income is taxable under federal law unless specific exemptions are approved by Congress or the Treasury Department — and neither has acted yet on oil spill damage claims.

The IRS would not comment on whether exemptions would be made, citing a policy of not answering questions on specific tax issues. Adding to the confusion, Kenneth Feinberg, who was chosen by President Barack Obama and BP to oversee the Independent Claims Facility, said Friday it hasn't been determined if the payouts will be considered taxable income.

Some tax experts said they expected federal action soon to clarify the situation for Gulf Coast residents and business owners. ...

It's not the first time the region has dealt with whether disaster money should be taxed. In the aftermath of Hurricane Katrina, Louisiana and Mississippi residents received federal money to rebuild their homes after many claimed a casualty loss for the damage on the 2005 tax returns.

The IRS initially required people who received the money and took the deduction to add the value of the deduction to their 2007 returns as taxable income. That decision angered many residents, including some who were pushed into a higher tax bracket as a result. After residents and local leaders protested, Congress in 2008 voted to negate the IRS decision.

Without any such decision yet from federal authorities, tax experts are advising people getting BP payments to do a bit of advance planning and set aside some money. ...

BP likely will be able to deduct payments it has agreed to make to compensate those damaged by the oil spill in the Gulf of Mexico, according to a tax expert.

BP last week agreed to establish a $20 billion escrow account to compensate victims of the spill. In determining whether the fund is tax deductible, BP first must establish that it is an "ordinary and necessary" expense BP incurs as part of conducting its business, a hurdle it clears fairly easily, according to a report Monday from Robert Willens, a longtime Lehman Brothers tax expert who now heads his own consulting firm. ...

There is a question, though, about whether a BP deduction could be disallowed on public policy grounds. The IRS tried to disallow a tax deduction in one instance in which a taxpayer attempted to deduct legal fees he paid defending himself (unsuccessfully) against a criminal prosecution. In that instance, however, the Supreme Court ruled the deduction was allowable. Though the Court found that legislation could theoretically be crafted to disallow certain tax deductions on public policy grounds, absent such legislation, the Court stated it would admit such a disallowance in only "extremely limited circumstances" where the conduct was at odds with "sharply defined national or state policies," Willens states in his report.

In short, it would likely take an act of Congress to keep BP from deducting its payments, and while that can't be ruled out, given the mood of Congress toward BP, it would seem to be difficult from a legal point of view since it would likely be viewed as legislating ex post facto.

Further good news for BP is that if the payment causes BP to post a net operating loss, the oil giant would likely be able to use the loss to offset profits from the past two years.

(Hat Tip: Jeffrey Barry.)

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Unless Congress says they're not.

Posted by: Michael A. Livingston | Jun 22, 2010 2:00:57 PM

Also, since I understand the $20b is being spread out over 4 years, it is pretty unlikely that a net operating loss would occur.

Posted by: ouch | Jun 23, 2010 5:15:31 AM

Even under existing law, some of this is likley to be excluded as a recovery of capital. For example, Inaja Land Co would indicate that diminishment of good will (including going concern value, trained staff, etc) in which the taxpayer had a basis would likley be excludible up to basis given the right circumstances. Also damage to tangible assets (boats, docks, etc) in which there is basis would provide another opportunity for exclusion. Health claims from cleaners and residents are also likley to arise (subject to existing limits). This is likley to privide some nice opportunity for a young scholar on the hunt for an article topic.

Posted by: Bill | Jun 23, 2010 6:19:12 AM

Are the payments deductible to BP on payment into the escrow fund, or on payment from the escrow fund?

What is the unclaimed property treatment of the escrowed money that isn't disbursed, or that is disbursed and not spent?

Posted by: jimharper | Jun 23, 2010 11:03:09 AM