Paul L. Caron

Wednesday, March 24, 2021

Utz: How Insurance Recoveries Are Taxed Under The IRC

Stephen Utz (Connecticut), How Insurance Recoveries are Taxed under the IRC, 98 Tax Notes State 607 (Nov. 9, 2020):

Tax Notes StateJeffrey H. Kahn, the Harry W. Walborsky Professor of Law at the Florida State University College of Law, has criticized my account of the tax treatment of insurance coverage in an article I published with Sachin S. Pandya concerning the tax treatment of litigation expenses. Sachin S. Pandya (Connecticut) & Stephen Utz (Connecticut), Designing the Tax Treatment of Litigation-Related Costs, 21 Fla. Tax Rev. 533 (2018). Kahn argues that the article was wrong to assert that the insurance payment of a claim against the insured “is not excludable [from gross income] unless the expense involved would have been deductible if paid by the insured and not reimbursed.” Jeffrey H. Kahn (Florida State), The Tax Treatment of Liability Insurance Coverage, 163 Tax Notes 1381, 1381 (May 27, 2019). ... This article defends the premise that the exclusion of insurance proceeds from the income of the insured depends on the deductibility by the insured of the covered obligation. ...

In sum, Kahn has described current federal tax treatment of liability insurance recoveries correctly in part but also incorrectly in part. He relies without exception on his own generalization that liability insurance recoveries should never be included in the insured’s gross income. This is a slight overstatement of the result of most liability insurance payments: Most of them do not result in net taxable income to the insured because they are offset by deductions the insured could claim if challenged. Virtually all insurance coverage of claims by third parties against a taxpayer’s trade or business arise from unintentional harms within the business activity. Intentional harms are not covered by insurance, and this exception excludes coverage of fines and penalties or damages from intentional misconduct like sexual harassment and assault. Third-party claimants for damages covered by insurance would lose that benefit if they challenged the injury-causing acts of an insured as intentional, and this must discourage the provision of evidence to that effect. Liability insurance also covers nonbusiness activity that causes harm, such as personal driving accidents. An uninsured driver compelled to pay damages for a driving accident could deduct the payment as a casualty loss, which need not come about within profit-seeking activity or even within activity involving the loss of the actor’s own property. The regulations provide: “To be allowable as a loss under section 165(a), a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and [with specified exceptions for disaster losses] sustained during the taxable year.” Nothing in the case law or regulations limits casualties to the loss of some identifiable tangible or intangible property apart from the money the taxpayer must give up as part of the transactions fixed by identifiable events. For example, gambling losses are deductible as casualty losses, even though the money lost is voluntarily handed over in the course of the activity.

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