Knowing the intricacies of the tax code can help take a big bite out of a business loss
Losses come in many shapes and forms. There are loses that result from natural disasters, losses caused by dishonest employees and customers, and financial losses from bad business decisions or a poor economy, to name only three. Although insurance, such as so-called business continuation insurance, provides protection from some losses, it is our tax laws that can really help reduce the bite of losses. Surprisingly, many shooting sports businesses may actually profit from their losses. That’s right, taking full advantage of and correctly using tax laws that apply to the losses of a firearms business can mean business survival and, in many cases, profits. Navigating the often confusing welter of IRS rules and regulations can be a daunting challenge, though. Here are some guidelines to help you plot your course.
Today, cyber fraud, theft, and embezzlement appear to be taking a backseat to storm- and wildfire-generated casualty losses. Casualty losses are the damages or complete destruction of property caused by fire, theft, vandalism, floods, earthquakes, terrorism, or some other sudden, unexpected, or unusual event.
In order to be tax-deductible, there must be some external force involved. What’s more, a casualty-loss deduction can be claimed only to the extent that the loss is not covered by insurance or otherwise reimbursed. In other words, if the loss is fully covered, no tax deduction is available.
The IRS uses a very conservative yardstick to measure the amount of damage to property. A shooting sports business must use the lesser of the property’s adjusted tax basis immediately before the loss or the property’s decline in fair market value as a result of the casualty.
Disaster Business Losses
Generally, casualty losses must be deducted in the year in which the loss event occurred. However, to help cushion losses suffered by a business, 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 shooting sports business owner or manager has the option of deducting the loss on the tax return for the year in which the loss occurred or choosing to deduct the loss on the tax return for the preceding tax year: In plain English, the business has the option of deciding whether the loss would be most beneficial used to offset the current year’s tax bill or better used to reduce the previous year’s tax bill, thereby generating a refund of previously paid taxes.
In order to accomplish this, the business simply files an amended tax return for the preceding year, figuring the loss and the change in taxes exactly as if the loss occurred in that preceding year. Although this choice must be made by the due date (not including extensions) for the tax return of the year in which the loss actually occurred, the resulting refund can go a long way to helping the damaged business.
Proof of Loss
After each disaster, the IRS reminds taxpayers of the need for records to support loss claims. In order to claim a casualty-loss deduction, a gun shop owner or manager must be prepared to prove not only that business property was lost in a casualty, but the amount of the loss. This requires a knowledge of, and documentation to support, a number of factors, including that the dealer or firearms business owned the property, the pre-disaster value of the asset, the reduction in value caused by the disaster, and the lack or insufficiency of reimbursement to cover the loss. In addition, the owner must prove the amount of the book value, the “basis” in the property. Adjusted basis for property is generally equal to the cost of acquiring it, plus the cost of any improvements and minus any depreciation deductions or earlier casualty losses.
Obviously, the best way to document a loss, especially disaster losses, is to file an insurance claim. However, even insurance companies require documentation. To help when records have been lost or destroyed, the IRS has an excellent tool, “Disaster Assistance Self-Study-Record Reconstruction”.
Gaining From a Loss
As mentioned earlier, some businesses may actually profit 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 may actually be a gain. However, the fact a gain exists does not necessarily mean that it will be taxable right away. Most businesses 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 in purchasing replacement property, any tax on the gain may be postponed. The replacement must occur within two years of the tax year when the gain was realized.
Handle With Care
Losses come in many forms—even from excessive tax deductions. If a firearms dealer or business has too many tax deductions and too little income, a net operating loss (NOL) results. Many businesses have used losses incurred during the economic downturn (or casualties) to reduce income from prior tax years, providing a refund of previously paid taxes.
The NOL 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 NOL relating to casualty and theft losses.
There are also losses that can be controlled. Quite simply, a loss is allowed for the abandonment of an asset. If a depreciable business asset or income-producing asset loses its usefulness and is subsequently abandoned, the loss is equal to its adjusted basis. Best of all, this type of loss applies to the abandonment of a business.
Far more common are those occasions when business property is taken, often as a result of a natural disaster. The government may also legally take property by the simple act of what’s known as “condemnation.” The loss of any business property by actions outside the control of the firearms retailer is usually labeled as “involuntary conversion.”
These actions are unusual in that they frequently result 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.
Owners of unincorporated businesses who are forced to sell or liquidate their businesses at a loss are allowed to deduct those losses against their ordinary income. Owners of incorporated firearms businesses who sell or liquidate their operation at a loss are required to deduct those losses against their capital gains. If their capital losses exceed their capital gains, they are allowed to divide the loss into increments of up to $3,000 per year and deduct that amount against their ordinary income. At that rate, depending on the amount of the capital loss, it may be many years before the entire loss is deducted.
Too Much Loss
A number of unfortunate business owners, particularly those whose businesses operate as a pass-through entity, have discovered that there can be such a thing as too much loss. Under the tax rules, a partner or S corporation shareholder cannot take a loss in excess of the amount invested in the firearms business.
For S corporations, a shareholder’s “basis” includes equity investments and direct loans. That basis is increased by profits and reduced by losses and distributions. Once the basis is reduced to zero, additional losses are suspended.
Answers to questions about the complex and, often confusing, casualty loss tax rules can be found in the IRS Publication 547, Casualties, Disasters and Thefts (irs.gov/pub/irs-pdf/p547.pdf).
Unfortunately, recoveries via tax law are not always smooth. They often require professional assistance or, at the very least, an understanding of how the tax rules work. As always, consultation with a tax professional is the best way to go.
—Mark E. Battersby
—Illustrations by Adofo Valle