Structuring Insurance Contracts to Qualify Under Sec. 1033

T axpayers frequently enter into insurance contracts to protect their businesses from a variety of problems. Typically, insurance policies are purchased to protect against fire, flood or other natural disasters, as well as strikes or other manmade disasters that can halt a business. In addition to policies to insure the value of a particular business asset, other policies, known as "use and occupancy insurance" and " business interruption insurance," may be designed to compensate a business for lost profits during a disaster period. The tax treatment of the insurance proceeds received from one of these types of policies varies, depending on what the payments are compensation for.

The tax treatment of insurance proceeds received for damage to a taxpayer's business depends on whether the proceeds compensate for lost profits or for the damage to (or loss of the use of) an asset used in the taxpayer's trade or business. Amounts received as recovery of lost profits are included in the taxpayer's income and subject to income tax in their entirety. These amounts do not qualify for the Sec. 1033 deferral provisions. "Lost profits" include compensation for services that the business has rendered and reimbursement of lost anticipated profits.

Generally, under Sec. 1033, insurance proceeds received as a result of damage to a taxpayer's property can be reinvested in qualified replacement property without recognizing income. Sec. 1033 states "if property (as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation) is converted into property similar or related in service or use to the property so converted, no gain shall be recognized." The taxpayer has two years after the close of the first tax year in which any part of the gain on the conversion is realized to elect to invest the insurance proceeds received in property similar or related in service or use; the two-year period for reinvestment increases to three years for real property. Sec. 1033 relates only to gains; losses related to the destruction of property are recognized in the year of the destruction. Regs. Sec. 1.1033(a)-2(c)(8) states that the proceeds of a use and occupancy insurance contract (that by its terms insures against an actual loss of net profits of the business) are not proceeds from an involuntary conversion, but are income in the same manner that the profits for which they are substituted would have been. Therefore, payments received under an insurance contract that insures against this type of loss do not qualify for Sec. 1033 treatment.

In most circumstances, it is simple to determine whether an insurance policy compensates for the loss of property use or lost profits. However, depending on how the policy is drafted, a taxpayer may incur unintended tax results. In Shakertown Corp., 277 F2d 625 (1960), the Sixth Circuit held that insurance proceeds determined on a per-diem basis and subject to a limit based on a decline in the insured's net profits, were proceeds from a policy compensating for the loss of use of property. Thus, Sec. 1033 applied to allow a deferral of the resulting gain. In response to this decision, the IRS issued Rev. Rul. 73-477, stating that Shakertown Corp. would not be followed.

Rev. Rul. 73-477 was based on a type of policy that provided for per-diem payments of $x whenever specified causes suspended business operations. It also provided that the insurer could reduce the per-diem coverage whenever the insured's per-diem net profits, plus fixed charges for the preceding 12 months, fell below $X. According to the Service, this type of policy will be taxed as a reimbursement of lost profits. Additionally, for use-and-occupancy policies, the IRS stated in Rev. Rul. 86-12 that it will look at the underwriting and actuarial criteria (and any other information used in writing the policy) to determine if the insurance is designed to reimburse for a loss of profits and fixed charges.

Assuming that the Service's current view is consistent with Rev. Ruls. 73-477 and 86-12, the gain from reimbursement of the loss of property use not based on profits should qualify for Sec. 1033 deferral. The correct tax treatment will turn on whether a policy compensates for loss of property use or loss of profits. In Marshall Foods, Inc., 393 F Supp 1097 (DC Minn 1974), the court set forth various factors it considered in determining if a policy is designed to compensate for loss of profits or of use:

1. In addition to the business interruption insurance policies, additional insurance contracts compensated losses sustained from direct damage to physical properties in the taxpayer's plants;

2. Suspension of business, not destruction of the asset, was the event that triggered payment;

3. The policy was extended to cover another plant that supplied material to the taxpayer's plant, which could only mean coverage for a loss of the plant's earnings from failure to have a market for its production;

4. The insurance contract was written on underwriting information based totally on gross earnings; and

5. On the business interruption worksheet requested by the insurer, the actual loss-sustained figures were equated with the loss of net profits.

When structuring insurance contracts for clients, advisers should consider having the client purchase loss-value coverage to the extent that asset value loss would result. To the extent remaining potential losses are to be insured, the policy should compensate on a flat per-diem basis, perhaps adjusted for inflation without regard to profits and fixed charges of the business. Neither of these types of policies should make reference to (or be limited by) historic profits. This type of strategy should maximize the amount of insurance proceeds available for Sec. 1033 rollover treatment.

From Tracy J. Monroe, CPA, MT, Cohen & Company, LLC, Cleveland, OH