Loss of income insurance proceeds

[sdtaxman]

I have a client whose business was destroyed by fire. They have received a separate check from the insurance company called "loss of income". It would appear to me that would need to be included on the schedule c as gross receipts would you agree? I think this is true even though it was received a year after the other insurance proceeds for the building and equipment damage. I don't know that it makes any difference but they are not longer operating a business. I am just not sure they should have to pay SE tax on this.

[Roland Slugg]

Sounds like this was proceeds from a "business interruption" or "loss of use" policy and resulted from a casualty of some kind ... storm, fire, or other natural disaster. If so, the proceeds are, indeed, taxable. I'm too tired to look up a cite for you, but I'm sure you can easily find one if necessary.

If the proceeds were as described above, then I don't see how they can be excluded from SE income. The payment was intended to replace the income lost due to the business interruption.

[Koss]

Insurance Proceeds

It shouldn't be taxable income unless the taxpayer previously took a deduction for the lost income...

Okay, just kidding. LMAO

That's the kind of warped logic some of my clients would use. You can't take a deduction for lost income; you don't pay tax on income that you never received in the first place.

I agree that the insurance proceeds are taxable. I'm not sure whether it is subject to SE tax.

Did the taxpayer receive an information return? Some kind of 1099? Or something else?

Maybe it's not subject to self-employment tax because it is not earned income. You want to put it on a Schedule C, because it is "replacing" self-employment income. But I'm not sure that's where it belongs.

For example, would this type of income qualify the taxpayer for the earned income credit?

I don't care if they are otherwise ineligible for EIC because their income is too high, or for some other reason. I'm making a very important theoretical point here about the character of the income. It is not earned income. It is insurance proceeds. It is not income that they received for performing services. They were unable to perform services because the business was destroyed.

Expanding on Roland Slugg's remarks...

Maybe the proper way to report it is on Form 4684. The taxpayer suffered a casualty loss. They received a reimbursement from an insurance policy. They have a gain on the casualty loss, because...

The property in question, i.e., the lost income which the insurance proceeds are replacing...

has a basis of zero.

A gain on Form 4684, in this context, flows to line 14 of Form 4797, and then to line 14 of Form 1040. It is not subject to self-employment tax.

BMK

[Roland Slugg]

Maybe the proper way to report it is on Form 4684.

Fantastic idea! Very imaginative. Or better yet, maybe the proper way to report it is on Schedule B, as dividends, or even some other place on a return that's equally as contrived.

The taxpayer suffered a casualty loss. They received a reimbursement from an insurance policy. They have a gain on the casualty loss, because...

The property in question, i.e., the lost income which the insurance proceeds are replacing...

Lost income is not "property."

What was there in the OP to suggest that payment was for the loss of property? On the contrary, the OP explicitly says that the taxpayer's business was destroyed by fire and that THIS payment was to compensate for the loss of income. The taxpayer surely received, or will receive, another payment for the property lost by fire, and THAT payment, along with information about the property lost, is reportable on F-4684. The income in question here, though, clearly belongs on Schedule C.

Regarding the SE part of the question, I can find nothing to suggest these insurance proceeds can be excluded from SE income, and excluding it makes no sense. The insurance payment in question here was paid to compensate for income lost, which would have been included in SE income if it had not been lost. So is this.

[Burke]

I have a client whose business was destroyed by fire. They have received a separate check from the insurance company called "loss of income". It would appear to me that would need to be included on the schedule c as gross receipts would you agree? I think this is true even though it was received a year after the other insurance proceeds for the building and equipment damage. I don't know that it makes any difference but they are not longer operating a business. I am just not sure they should have to pay SE tax on this.

They may have to pay SE tax. Even though they are no longer operating a business, it is reported on Sche C as ordinary income, and if there are any expenses to deduct, they go on there as well. If there is a net profit, then -- yes, it is subject to SE tax.

[sdtaxman]

Thanks for all the input. I was feeling that it had to be on schedule c and therefore subject to SE tax but didn't want to miss some exception that I hadn't been able to find in my research. That is always what bothers me, what I don't know and can't find. The one reason that I thought it may qualify to not have SE tax computed on it is because they actually did nothing to earn it.

[Koss]

Business Interruption Insurance

I concede that my recommendation to report the income on Form 4684 may be misguided. As Roland Slugg points out, it may not be appropriate to consider the lost income as property that was insured.

But see Newberry v. Commissioner, 76 T.C. 441 (1981), in which the US Tax Court concluded that proceeds from a business interruption insurance policy were not subject to self-employment tax.

The Court found that--

- - - -
...petitioner's inability to operate the grocery store following its destruction gave rise to the
proceeds at issue. Indeed, petitioner's insurance policy is the self-employed individual's counterpart to the
supplemental unemployment benefit plan contained in Rev. Rul. 56-110, supra. Both plans are essentially
private benefit mechanisms intended to compensate an individual while he is not able to engage in his
income-producing activity. The comparable statutory terms — carrying on a trade or business and
rendering services — suggest to us that any income must arise from some actual (whether present, past,
or future) income-producing activity of the taxpayer before such income becomes subject to either FUTA,
FICA, or self-employment taxes, as the case may be. This harmonious result is particularly warranted in
view of the integration of the definition of self-employment income with the wages definition for purposes
of computing an individual's self-employment tax liability. See sec. 1402(b); sec. 1.1402(b)-1(b), Income
Tax Regs.
- - - -

The IRS argued that "since the instant proceeds were merely a substitute for the loss of profits from petitioner's grocery business, they are similarly subject to the self-employment tax." The taxpayer argued that "since an interruption in business was the sine qua non for their entitlement to the proceeds, they were not 'derived from any trade or business carried on' and thus are beyond the scope" of self-employment tax.

The Court sided with the taxpayer.

The entire opinion is only four pages, and it is directly on point. Here's a link to the complete opinion:

http://www.sgaweb.net/cbllc/newberry.pdf

Maybe the proceeds should just be reported on line 21.

You may want to do some further research to be sure that this opinion has not been superseded or otherwise rendered obsolete by a more recent opinion.

BMK

[sdtaxman]

Thanks for the help. I will review the full link. Your help is greatly appreciated.

[Koss]

Tax Court Case

What I find amazing about this case, and many other tax court cases, is the microscopic amount of money that was involved in the controversy. The insurance proceeds in Newberry were $11,000. The grocery store owner filed suit against the IRS over an $810 tax bill... and they were represented by an attorney. Even adjusting for inflation--the case is over 30 years old--it is still mind-boggling, unless they were lucky enough to have a tax lawyer in the family, or they found someone who agreed to take the case pro bono.

It is extremely difficult--though not impossible--to get an award from the Tax Court for the IRS to pay the attorney's fees of a petitioner. One has to show that the IRS position was wholly unreasonable, and this criteria is not easy to satisfy.

I can't see how anyone could justify hiring a tax attorney over an $810 dispute with the IRS--even if you tack on interest and penalties...

BMK

[Burke]

IMO, it is the same thing as back wages awarded via a settlement of discrimination, injury, etc. The TP may not have actually earned or done anything TO earn that money, but it is treated as wages, a W-2 gets issued, subject to FICA, and it goes on the tax return Line 7. It's the original character of the income which is being replaced which controls how it is treated.

[Koss]

Wages

Back wages are different. Back wages are wages that the person actually earned, but the employer failed to pay them.

In Newberry v. Commissioner, the Court reasoned that proceeds from a loss of income insurance policy were roughly equivalent to unemployment compensation for a person who is self-employed. Unemployment compensation is not subject to FICA.

BMK