Employer Penalty Alert for Reimbursing Employee Health Coverage

The Affordable Care Act (ACA) established a number of so-called “market reform” restrictions on employer-provided group health plans, starting with plan years beginning in 2014. These restrictions generally apply to all employer-provided group health plans — including those furnished by small employers with less than 50 workers. Even worse, there’s a punitive penalty for running afoul of the market reform restrictions. The penalty, under Internal Revenue Code Section 4980D(b)(1), equals $100 per-day per-employee, which can amount to up to $36,500 per-employee over the course of a full year. Yikes!

In fact, according to the IRS and the Department of Labor (DOL), the market reform restrictions can penalize employers for offering plans that simply reimburse employees for premiums paid by them for individual health insurance policies. We will call such plans employer payment arrangements. This article explains what you need to know to avoid the punitive market reform penalty on such arrangements.

But first, let’s cover some necessary background information.

Employer Payment Arrangement Basics

Employer payment arrangements have long been a popular way for smaller employers to help their employees to obtain health coverage without the hassle and expense of furnishing a full-fledged company health insurance plan. Another advantage is that employees are free to select coverage that meets their specific needs instead of being stuck with a one-size-fits-all company plan.

Under an employer payment arrangement, the employer reimburses participating employees for premiums paid for their individual health insurance policies. To qualify for tax-free treatment under the federal income tax rules, the employer must:

1. Make the reimbursements under a written Section 105 medical reimbursement plan; and2. Verify that the reimbursements are spent for health insurance coverage. (The sources for this are Internal Revenue Code Sections 105 and 106 and IRS Revenue Ruling 61-146.)

Market Reform Restrictions and Recent Government FAQ

IRS guidance issued last year (Notice 2013-54) stipulates that tax-free employer payment arrangements are considered group health plans subject to the ACA market reform restrictions. With a few limited exceptions, such plans fail to meet ACA requirements because, among other reasons, group health plans that are used to purchase coverage in the individual market cannot be integrated with individual market policies.

However, many business owners hoped that plans that reimburse employees on an after-tax basis (instead of on a tax-free basis) would not be treated as employer plans that are subject to the market reform restrictions and the punitive penalty. Those hopes have now been dashed.

According to frequently asked questions (FAQ) posted on the DOL website in November, an employer arrangement that reimburses employees for individual market policies is considered to constitute a group health plan, subject to the market reform restrictions and the punitive penalty, whether the reimbursements are treated as tax-free or after-tax (meaning taxable).

More specifically, the FAQ states:

If an employer arrangement provides cash reimbursements to employees for the purchase of individual market policies, the arrangement will be considered for ACA purposes to be a plan established or maintained for the purpose of providing medical care to employees. It doesn’t matter if the employer treats the premium reimbursements as a tax-free benefit or as additional taxable wages.

As stated earlier, such an employer payment arrangement doesn’t comply with the ACA market reform rules because cash payments from an employer cannot be integrated with an individual market policy. Therefore, an employer payment arrangement can trigger the punitive penalty under Internal Revenue Code Section 4980D, whether the arrangement is treated by the employer as tax-free or taxable. The FAQ can be viewed by clicking here.

Impact on S Corporations   

Many S corporations have set up employer payment arrangements to reimburse employees who own more than 2 percent of the company stock (more-than-2 percent shareholder-employees) for their individual health insurance premium costs. Under existing IRS rules, the reimbursements are treated as additional taxable wages that are not subject to the Social Security or Medicare taxes. Qualifying more-than-2 percent shareholder employees can then deduct their premiums on their individual federal income tax returns under the special break for self-employed health insurance premiums. The company can deduct the reimbursements as compensation expense.

Unfortunately, such employer payment arrangements run afoul of the ACA market reform restrictions and can therefore trigger the punitive penalty. Therefore, unless and until something changes, such arrangements need to be reconsidered.

Limited Exception for One-Employee Employer Arrangements

About the only good news here is that that the ACA market reform restrictions and the punitive penalty do not apply to employer payment arrangements, including S corporation arrangements, that have only one participating employee. Therefore, according to IRS Notice 2013-54, such arrangements can still be used to reimburse one employee for his or her individual health insurance premiums without triggering the expensive market reform penalty.

Warning: Employer payment arrangements generally must cover all full-time employees in order to avoid IRS nondiscrimination rules, under Internal Revenue Code Section 105(h). That said, the nondiscrimination rules under Treasury Regulation 1.105-11(c) allow employers to exclude workers who:

1. Have less than three years of service;

2. Have not attained age 25; or

3. Meet the definition of part-time or seasonal employees.

Conclusions

The ACA market reform restrictions penalize the use of employer payment arrangements to subsidize or reimburse employees for individual market health insurance policies — if more than one employee participates in the arrangement. Similarly, employers cannot directly pay premiums for individual market policies on behalf of their employees without triggering the penalty.

The bottom line is that the market reform penalty is so punitive that employer payment arrangements are basically off limits unless they only cover one worker. However, employers can still choose one of the following options without triggering the market reform penalty.

• Provide a tax-free fringe benefit by paying for an ACA-approved employer-sponsored group health plan. Small employers with 50 or fewer employees can provide a group health plan through the SHOP Marketplace. Under Internal Revenue Code Section 125, employers can also set up cafeteria benefit plans to allow employees to pay for their shares of the cost of coverage with tax-free salary reductions.
• Increase employees’ taxable wages to help them pay for individual health insurance policies. However, the employer cannot require that the funds be used for that purpose. In these cases, the employer can claim compensation deductions for the additional wages, but the wages will be subject to federal income tax at the employee level and federal employment taxes at both the employee and employer levels. Qualifying employees can claim itemized medical expense deductions for the premiums, subject to the tax-law limitations on those write-offs.

If you have questions about your company’s health coverage and the tax implications under the ACA, consult with your tax or benefits adviser.

© Copyright 2015. Thompson Reuters.  All rights reserved. Brought to you by: Gordon Advisors, P.C.

Tax Implications of Restricted Stock Awards

Restricted stock awards are a popular replacement for stock option grants.

The reason is that the awards typically retain their value if the price of the stock drops. The company simply needs to award additional restricted shares. Stock options on the other hand lose most or all of their value if the underlying stock goes down in price.

However, there are federal income and employment tax have implications for restricted stock awards.

Restricted Stock Basics

In a typical restricted stock arrangement, an executive receives company stock subject to one or more restrictions. The most common restriction is a requirement for continued employment through a designated date. Often, the stock is transferred at no or minimal cost. The right to keep the shares is forfeited if the executive fails to fulfill the terms.

Tax-wise, the executive’s recognition of taxable income and the employer’s right to claim the related compensation deduction are both generally deferred until vesting, or when ownership of the shares is no longer restricted.

Timing of Income Recognition

When the restricted stock is received, the recipient recognizes income for federal tax purposes in one of two ways:

1. Without Section 83(b) Election: The restricted stock award results in the recognition of ordinary compensation income in the year the restriction causing the substantial risk of forfeiture lapses. The amount included in compensation income is the excess of the stock’s value when the restriction lapses over any amount paid for the stock. Federal income tax and federal employment taxes must be paid on the amount treated as compensation.
2. With Section 83(b) Election: A recipient can make a Section 83(b) election to recognize income on the date the restricted shares are received. This accelerates the tax effects for both the executive and the employer.

The election results in the immediate recognition of ordinary compensation income equal to the excess of the stock’s value over any amount paid for the stock. Federal income tax and federal employment taxes must be paid on the amount treated as compensation. The election must be made either before the share transfer or within 30 days after the share transfer.

Weighing Tax Deferral vs. Preferential Long-term Capital Gain Treatment

When no Section 83(b) election is made, the stock’s value less any amount paid for it is recognized as taxable compensation for income and employment tax purposes when the stock becomes fully vested. Any stock appreciation between the date of the award and the date of the vesting is treated as high-taxed ordinary income from compensation.

Alternatively, the executive can make a Section 83(b) election to be taxed when the stock is awarded. In that case, the executive is taxed on the stock’s vale when it is awarded minus any amount paid for the stock.

Any subsequent appreciation is treated as capital gain, which will qualify for preferential tax rates if the stock is held for more than one year. The tax rates will be much lower than the maximum rate on ordinary income from compensation. The downside is that the executive must recognize taxable income at the time of the restricted stock award even though the restricted stock may later be forfeited or decline in value.

Requirements for Restricted Stock Treatment

For federal income and employment tax purposes, stock is considered to be restricted (meaning not vested) when both of the following conditions are met.

1. Subject to a Substantial Risk of Forfeiture: This condition is met if full ownership of the stock depends on the future performance, or refraining from the performance, of substantial services by the recipient executive.
2. Not Transferable: This condition is met if the recipient transfers any interest in the stock to any person or entity other than the employer. The new holder’s rights to the stock are still subject to the same substantial risk of forfeiture.

For instance, stock meets the not-transferable requirement if the recipient can sell it, but the new holder must still forfeit the stock upon the occurrence of the event causing the substantial risk of forfeiture. That typically is premature termination of the executive’s employment. To ensure that any subsequent holder is aware of the restriction(s) and the non-transferable requirement is met, the shares are commonly stamped with a legend that discloses that information.

Substantial Risk of Forfeiture

Stock is subject to a substantial risk of forfeiture if the rights to full ownership depend (directly or indirectly) on either.

• The future performance of substantial services by the recipient, or
• The satisfaction of a condition related to the award. For example, the recipient may be required to obtain an advanced educational degree, or a specified professional designation, or attain a certain job status within the company for the restricted stock to become vested.

Example: Your employer transfers 10,000 shares to you. You pay nothing for the stock, which is valued at $20 per share on the date of the transfer. Under the terms of the deal, you must forfeit the shares back to your employer if you leave the company for any reason before three years after the date of the transfer.

If you sell the shares, whoever buys them must also forfeit them if you leave the company before the magic date. Since you must perform substantial services over the next three years to gain full ownership of the stock, the shares are considered subject to a substantial risk of forfeiture. As a result, the shares are considered restricted stock and are subject to the income and withholding tax considerations.

Employer’s Compensation Deduction

Assuming the income related to the transfer of restricted stock is properly reported to the recipient on forms W-2 or 1099, the employer is allowed to claim a compensation deduction equal to the amount included in the executive’s income.

The tax rules for restricted stock are fairly straightforward. The major tax planning consideration for the executive is deciding whether or not to make a Section 83(b) election.

In many cases, the risks of making the election will be perceived as greater than the potential tax-saving benefit, but you should consult your tax adviser before making that call.

© Copyright 2014. Thompson Reuters.  All rights reserved. Brought to you by: Gordon Advisors, P.C.

How College Financial Aid Benefits Are Taxed

There’s no doubt about it … college is expensive. At top-rated private universities, the annual cost can be $55,000 and up. Some public schools charge out-of-state students $40,000 and up. With any luck, however, your child or grandchild will qualify for financial aid. These days, a surprisingly high percentage of students do.

If your student does score some financial aid, what are the tax implications? This article explains them.

For Tax Purposes, the Name Doesn’t Matter

The economic characteristics of college financial aid benefits, rather than what they are named, determine how they are treated under the federal income tax rules.

The first important distinction tax-wise is between gift aid and other forms of financial assistance. Gift aid is free money that the student doesn’t have to pay back or work for. It is usually described as a “scholarship,” “fellowship,” or “grant” and it’s often tax-free.

In contrast, arrangements where the student is required to work for money are also sometimes called scholarships or fellowships. This is a misnomer. Payment for work is considered compensation from employment, and it must be reported as income on the student’s tax return. The IRS also doesn’t care whether financial aid comes from a government agency, a not-for-profit organization, or a for-profit company. The tax consequences of financial aid benefits only depend on their economic nature — not their source.

Key Point: Free money is often tax-free and money you have to work for is taxable. That doesn’t sound very fair, but as the old saying goes, life is not always fair.

Gift Aid (Free Money) Is Often Tax-Free

Free-money scholarships, fellowships and grants are generally awarded based on either financial need (for example, federal Pell grants) or academic merit (for example, National Merit Scholarships). Such free-money gift aid is tax-free as long as:

1. The recipient is a degree candidate, including a graduate degree candidate.
2. The funds are designated for qualified expenses (which include tuition; mandatory enrollment fees; and mandatory books, supplies, and equipment) or the funds are unrestricted. To be tax-free, however, the funds cannot be specifically designated for things that are not qualified expenses (like room and board or travel expenses).
3. The recipient can show that his or her qualified expenses equaled or exceeded the financial aid benefits. To pass this test, the student apparently must incur enough of these expenses within the time frame for which the aid is awarded.

If free-money gift aid exceeds qualified expenses, the excess is taxable income to the student.

Free-money gift aid that comes directly from the university is often called a “tuition discount,” “tuition reduction” or “university grant.” These forms of financial aid fall under the same tax rules as free-money scholarships, fellowships and grants.

Example 1: Tax consequences of free-money gift aid. Your gifted daughter scores a completely free ride for her first year of college. The initial academic year begins in August of 2014 and ends in May of 2015. Your daughter’s free-money scholarships, grants, and tuition discounts total $40,000 for the academic year ($20,000 is awarded for the first semester which begins in August of 2014 and $20,000 is awarded for the second semester, which begins in January of 2015). Her qualified expenses for the two semesters total $30,000. The remaining $10,000 of gift aid is intended to cover your daughter’s room and board, travel and incidentals for the academic year. The $10,000 is taxable income. Since half of the $10,000 is awarded for the first semester that begins and ends in 2014, your daughter should report $5,000 on her 2014 tax return. The remaining $5,000 for the second semester that begins in January of 2015 should be reported on her 2015 return.

Payments for Work Are Taxable

Under college work-study programs, students are given jobs to help cover their education costs. The employer may be the college or another entity. Either way, work-study earnings count as taxable wages for federal income tax purposes. As explained below, however, having some taxable income doesn’t necessarily mean the student will actually owe any tax.

Sometimes financial aid that is described as a “scholarship,” “fellowship,” “grant” or “tuition reduction” is actually contingent on the student providing services to the school (for example, teaching or research services). Such payments are taxable compensation — regardless of the description and regardless of whether the work gets done before, during, or after the academic period for which the aid is awarded.

Key Point: It’s not the student’s problem to figure out how much is taxable. The financial aid payer should determine the taxable amount and report it to the student on Form W-2 (if the student is considered an employee) or Form 1099-MISC (if the student is considered an independent contractor).

Taxable Income Doesn’t Always Mean Tax Is Owed

Receiving taxable financial aid doesn’t necessarily mean owing anything to the IRS. Here’s why. The student can offset taxable amounts with his or her standard deduction ($6,200 for 2014, assuming the student is unmarried, up from $6,100 in 2013). In addition, a student who is not another taxpayer’s dependent can offset taxable amounts with his or her personal exemption ($3,950 for 2014, up from $3,900 in 2013). So, for 2014 a non-dependent student can shelter up to $10,150 of taxable gross income with the standard deduction and personal exemption ($6,200 plus $3,950 equals $10,150).

If your child is still your dependent, however, he or she is not entitled to a personal exemption. Instead, you claim the child’s exemption on your return. But the child’s standard deduction will still shelter up to $6,200 of 2014 taxable gross income from the federal income tax.

Taxable financial aid in excess of what can be offset by the student’s standard deduction and personal exemption (if any) will often be taxed at only 10 percent. For 2014, an unmarried non-dependent student can have gross income of up to $19,225 and still be in the 10 percent bracket. The first $10,150 is sheltered by the student’s standard deduction and personal exemption. The next $9,075 is taxed at 10 percent. Any additional 2014 income will probably be taxed at only 15 percent.

Finally, if you don’t claim your child as a dependent on your return, he or she can probably reduce or eliminate any federal income tax bill by claiming the American Opportunity tax credit (worth up to $2,500) or the Lifetime Learning tax credit (worth up to $2,000).

Example 2: Tax consequences of work-study and wage income. Your grandson, a college sophomore, is paid $4,000 in 2014 under his school’s work-study program. Because he’s a talented programmer, your grandson earns another $20,000 in 2014 by working part-time for a software company on weekends and over the summer. Because he has $24,000 of income, he pays more than half of his own support and is therefore not a dependent of his parents. Your grandson’s taxable income is $13,850 ($24,000 minus $6,200 standard deduction minus $3,950 personal exemption). His federal income tax bill is $1,623.75 (the first $9,075 times 10 percent plus the remaining $4,775 times 15 percent). However, if your grandson qualifies for the $2,500 American Opportunity tax credit (he almost certainly will if he carried at least half of a full-time course load during 2014), he can completely offset his $1,623.75 tax bill. Since any unused American Opportunity credit is partially refundable (up to a maximum of $1,000), your grandson would actually receive a check for $846.25 from the government ($2,500 credit minus $1,623.75 tax bill equals $876.25 refundable amount). In other words, he will get an $876.25 check from the government in exchange for filing his 2014 Form 1040. The moral: Having taxable income doesn’t necessarily equate to owing anything to the IRS.

© Copyright 2014. Thompson Reuters.  All rights reserved. Brought to you by: Gordon Advisors, P.C.

Advice for Snowbirds Buying a Second Home

If you’re contemplating buying a second home by the ocean, mountains or warmer surroundings, you’re not alone. Approximately 717,000 vacation homes were purchased in 2013. That equals about 13 percent of the total homes bought last year — their highest market share since vacation home purchases peaked in 2006, according to the 2014 Investment and Vacation Home Buyers Survey published by the National Association of Realtors (NAR).

Unlike traditional home sales, which generally slow down during the holidays, the prime seasons for buying and selling vacation homes are fall and winter — when snowbirds flock to warmer weather and ski bunnies head to the slopes. Before you dive into vacation home ownership, here are some financial issues to consider.

Why Are You Buying?

When deciding whether a vacation home purchase is a smart financial move, first consider your motives. The No. 1 reason people plan to purchase a vacation home is for personal vacations and family retreats. If that’s your motive, realistically evaluate how much you’ll use it and whether you (and your family members) will want to return to the same locale, year after year.

Other buyers plan to use their vacation homes as their principal residences when they retire. If that’s your motive, evaluate the location’s medical care facilities, wheelchair and walker accessibility, proximity to children and grandchildren in your golden years, and state death tax laws that may be applied to your estate. Also consider whether the home itself is senior-friendly. Stairs, big yards and pools might appeal to a 43-year-old (the average age of vacation homebuyers in the 2014 NAR study). But these features can be too much for senior homeowners to manage independently.

Another reason for buying a vacation home is the investment opportunity, both in terms of monthly rental income and price appreciation. Online vacation rental sites make it easier than ever to rent a vacation home. And when you’re tired of renting, you can eventually sell the property, which should generally appreciate in value over the long run. The key to investing in real estate is to know local market values and trends. Ideally, you want to buy low and sell high.

Where Should You Buy?

Hot spots for vacation homes include Florida, Colorado and Arizona. You might prefer a less touristy, off-the-beaten-path locale to relax with family members. Or you might opt to be near the action to entice family members to visit — or to attract renters. Don’t rely on gut instinct. Let your motives for buying a vacation home and personal preferences guide your decision. Shoppers looking for a family retreat often bring relatives on house tours for a second opinion on their purchases.

Also factor rising travel costs into your feasibility analysis. Although 46 percent of vacation homes are within 100 miles of the owner’s principal residence, 34 percent are more than 500 miles away from home, according to the 2014 NAR study. If vacation homes are too far from principal residences, some buyers (and their family members) can’t justify the cost of airfare or gas to travel to the vacation home — then the property is underutilized and too often maintenance is neglected.

How Much Can You Afford?

Many vacation homebuyers want to take advantage of historically low mortgage interest rates. Interest rates, down payments and other mortgage terms vary depending on the property’s location and the borrower’s creditworthiness. Nationally, the current interest rate for a 30-year mortgage is near 4 percent on a 30-year mortgage (see right-hand box). Compared to first home buyers, second home buyers are expected to contribute a higher minimum down payment. The average down payment among vacation home buyers in the 2014 NAR study was 30 percent.

In addition, changes to the home mortgage lending regulations that were enacted by the Consumer Financial Protection Bureau in January 2014 generally limit a borrower’s total applicable payments (including student loans, credit card and car payments, housing costs, utilities and other recurring expenses) to 43 percent of pretax income.

Talk to a financial professional about your vacation home budget. They can help you crunch the numbers and get you prequalified before your search for the perfect vacation property starts.

What Operating Costs Will You Incur?

Surprisingly, 38 percent of vacation homebuyers pay cash, according to the 2014 NAR study. So mortgage costs are a moot point to many shoppers. But every wannabe vacation homeowner should consider ongoing costs, such as:

Property insurance. Typical homeowners insurance covers damages from fire, theft, vandalism and sometimes wind. Because of their locations — often near beaches and mountainsides — vacation homes may require special insurance coverage for location-specific risks, such as sinkholes, hurricanes, wind and floods. Modern homes that are made of more durable materials — such as cinder block, stucco and masonry — may be less expensive to insure.

Property taxes. A significant cost of owning real estate is property taxes. These vary substantially depending on where the property is located. Look up a home’s property tax history before making an offer. Taxes are usually based on a percentage of the home’s assessed value and paid in arrears, when the year that they cover is past or almost over. So if you’re buying new construction, ask your realtor about the taxes paid on nearby comparables to get an idea of how much your future property taxes on the home will be.

Homeowners association (HOA) dues. Many vacation home communities charge association dues, especially if they have a pool, guard house, golf course or health club facility. Most HOA dues also cover routine maintenance and insurance on common areas. Beware that some associations reserve the right to charge special assessments for unusual repairs and upgrades, however.

Property maintenance and management. Like all real property, vacation homes need to be maintained and monitored. Some vacation home owners pay a professional property manager (or simply a retired neighbor) to look after the property and help with renters while they’re away. There are also licensed, bonded and insurance home watch companies, which regularly visit and inspect properties. Other ongoing maintenance expenditures include repairs to structural components (roofs, windows and doors) and HVAC and electrical systems, utilities, landscaping and cleaning service fees, furniture and appliances, home décor, and upgrades to align the property to your evolving needs and preferences.

What Are the Other Tax Considerations?

If you use the vacation home strictly as a second home, not a rental property, and you itemize deductions on your personal tax return, you can generally deduct interest expense on up to $1.1 million of debt to acquire, build or substantially improve your first and second homes combined. This includes acquisition debt and home equity loans on these properties. You can also deduct property taxes on both homes, if you itemize deductions.

Important note: For 2014, the AGI thresholds for the itemized deduction phase-out rule are $254,200 for singles, $305,050 for married joint-filing couples, and $279,650 for heads of households. The total amount of your affected itemized deductions is reduced by 3 percent of the amount by which your AGI exceeds the applicable threshold. However, the total reduction cannot exceed 80 percent of the total affected deductions you started with.

When you sell a home, IRS rules allow an unmarried seller of a principal residence to exclude (pay no federal income tax on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000 of gain. To qualify for this tax break, you generally must:

• Own the property for at least two years during the five year period ending on the sale date (the “ownership test”), and
• Use the property as a principal residence for at least two years during the same five year period, but periods of ownership and use need not overlap (the “use test”).

To be eligible for the maximum $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test. Additionally, if you excluded gain from an earlier principal residence sale, you generally must wait at least two years before taking advantage of the gain exclusion deal again. If you are a married joint filer, the $500,000 exclusion is only available if neither you nor your spouse claimed the exclusion privilege for an earlier sale within two years of the later sale.

Some retirees sell their principal residence and move into their vacation homes. But a gain on the sale of a vacation home that’s become a principal residence may not qualify for the federal home-sale exclusion — even if you’ve lived there for at least two of the last five years. Any period of time beginning in 2009 where you don’t use the vacation home as a principal residence is considered a period of “nonqualified use” and will require you to recognize a portion of the gain when you sell the property. The amount of the gain that’s subject to federal tax will be based on the ratio of time after 2008 that it was a second home or rental property (the period of nonqualified use) to the total period of ownership.

Complicated IRS rules and exceptions apply to calculating home-sale gains and exclusions, so be sure to consult with a tax professional when it comes time to sell your vacation home.

Is Vacation Home Ownership Right for You?

Owning a vacation home is more than a status symbol. It’s a reward for years of hard work and can be a legacy that’s handed down for future generations to enjoy. Smart vacation property investments factor in family member preferences, financing and maintenance costs, and tax issues. Consult your financial adviser for additional guidance on this important decision.

© Copyright 2014. Thompson Reuters.  All rights reserved. Brought to you by: Gordon Advisors, P.C.

Business Interruption Insurance: A Lifeline When Disaster Strikes

Despite a relatively quiet hurricane season, 2014 had its fair share of other natural as well as manmade disasters, including blizzards in upstate New York, wildfires and winter storms in California, mudslides in Washington and riots in Ferguson, Mo., and Berkeley, Calif. As we get ready to ring in the New Year, these tragedies serve as sobering reminders to always expect the unexpected.

Your business could become a victim of Mother Nature or other external forces without warning. After a disaster, an estimated 25 percent of businesses are unable to reopen. Depending on the type of business and its financial stability, a few weeks of lost income can be enough to close your doors indefinitely.

Are Business Interruption Proceeds Taxable? Insurance proceeds received for the loss of property generally aren’t taxable if you use the money to purchase replacement property. But business interruption proceeds are fully taxable to the extent that they’re used to replace lost income. When are they taxable? Cash basis entities that file an undisputed claim with the insurance carrier must pay tax when they receive payment. For accrual basis taxpayers, the general rule of thumb is: Where liability is undisputed by the insurer and the amount of the recovery can be reasonably approximated, income accrues in the year of the loss, despite the fact that the amount of the recovery may not be known at the time of accrual. For accrual basis entities, the timing of the tax liability is less straightforward when a business interruption claim is in dispute. To determine whether the proceeds should be recognized in the year that the claim is filed, the IRS considers two main issues: 1. Whether the insurer has recognized a liability for your claim; and 2. Whether your proceeds can be reasonably approximated. The timing of tax liability hinges on the facts and circumstances . Sometimes, claims aren’t includible in taxable income until the litigation between the parties is settled and the amount is set. Consult with your tax adviser when you file a business interruption claim to make sure the timing is right.

Proactive Disaster Planning

Commercial property insurance doesn’t typically pay the costs of this type of disruption. What can help you survive is business interruption coverage that allows you to relocate or temporarily close so you can make the necessary repairs — and still be provided with cash flow to cover revenues lost and expenses incurred while your normal operations are suspended.

Before the next disaster strikes, consult with your insurance agent about business interruption coverage. To determine the proper amount of coverage, your financial adviser can help forecast a worst-case scenario and ask “what-if” questions to cover all the possibilities. Of course, you don’t want to over insure, but you also don’t want to overlook critical risks, such as prolonged or multiple power outages.

Business interruption insurance isn’t sold as a separate policy. Instead, it’s added to your existing property insurance policy. There are two basic types of business interruption coverage:

Named perils policies. These cover only specific occurrences that are listed in the policy, such as fire, water damage and vandalism.

All-risk policies. These cover all disasters unless they are specifically excluded. Most all-risk policies specifically exclude damage from earthquakes and floods, but such coverage can generally be added for an additional fee.

Business interruption insurance usually pays for income that’s lost while operations are suspended. It also covers continuing expenses, including salaries, related payroll costs and other costs required to restart a business. Depending on the policy, additional expenses might include:

• Relocation to a temporary building (or permanent relocation if necessary);

• Replacement of inventory, machinery and parts;
• Overtime wages to make up for lost production time; and
• Advertising stating that your business is still operating.

Business interruption coverage that insures you against 100 percent of losses can be costly. More often, policies cover 80 percent of losses while you shoulder the remaining 20 percent.

Once you’ve selected business interruption coverage to suit your company’s needs, secure business documents offsite so you can access them quickly if a disaster occurs.

Disaster Control

The key to business continuity after a disaster is to file the proper claims against your business interruption insurance as soon as possible. But be warned: This type of insurance is arguably one of the most complicated on the market today; submitting a claim can be time-consuming and requires careful consideration.

Follow these steps as soon as it is feasible:

1. Notification. Tell your insurer about the damage. If your policy has been water-damaged or destroyed, ask the company to send you another copy.

2. Policy review. Read your policy in its entirety to determine how to best present your claim. It’s important to understand the policy’s limits and deductibles before spending time documenting losses that may not be covered.

3. Minimize losses. Make temporary repairs if possible and hire security guards if necessary to protect the property. Then:

• Reopen as soon as practical, even if it is only for a limited number of hours.
• Block off unusable parts of the building and operate from less-damaged areas.
• Take out newspaper, radio or television ads announcing when you will reopen.
• Consider laying off nonessential support staff to limit continuing operating expenses.

4. Record losses. Maintain accurate records to support your claim. Reorganize your bookkeeping to segregate costs related to the business interruption and keep supporting invoices. Among the necessary documents are:

• Pre-disaster financial statements and income tax returns;
• Post-disaster business records;
• Copies of current utility bills, employee wage and benefit statements, and other records showing continuing operating expenses;
• Receipts for building materials, a portable generator and other supplies needed for immediate repairs,
• Paid invoices from contractors, security personnel, media outlets and other service providers; and
• Receipts for rental payments, if you move your business to a temporary location.

Be as precise as possible — or your claim may be delayed or denied. Your accountant can review the records you plan to submit and organize them in anticipation of litigation if the insurer is reluctant to pay your claim. Taking the time to prepare for that possibility — even if it is remote — can save a great deal of effort later.

Professional Assistance

The calculation of losses is one of the most important, complex and potentially contentious issues involved in making business interruption insurance claims. Depending on the scope of your loss, the insurance company may enlist its own specialists to audit your claim. So you also may want to consult an accountant who is experienced in business valuation and litigation support to help prepare your claim, quantify business interruption losses and anticipate questions from your insurer.

Here are the major roles your accountant can play in managing the claims process:

Point-person. The accountant can be the primary contact with the insurer, dealing with the typical onslaught of document requests. That leaves you free to run the business and bring it back up to speed. He or she can also keep the claims process on track by informing the insurer about your actions and dealing with requests to inspect the damaged property. It’s possible that your accountant may already have an established relationship with your insurer and knows how its claims department works.

Damage estimator. Most policies define losses based on the earnings a company would have made if the interruption hadn’t occurred. To project lost profits, the accountant will analyze, identify and segregate revenues and expenses. The insurer will cover only losses that are directly attributable to the damage, as opposed to macroeconomic or other external causes, such as an economic downturn.

Your company also will be required to detail the steps it took to mitigate losses during the business interruption period, which is the time it took your business to resume normal operations. The steps may involve having to move to a temporary location. The interruption period is critical and one of the determining factors the insurer will use when examining the total amount of your company’s claim.

Be a Survivor

No one knows what natural and manmade disasters will strike in 2015. Business interruption insurance obviously won’t solve all your problems when the next disaster strikes, but it can improve your odds of survival. Working with an attorney who can aid in the legal interpretation of the policy, your accountant can quickly and efficiently assemble the information and calculations needed for a viable business interruption claim. Filing a well-crafted business interruption claim can result in a quick and easy resolution with the insurance company — and provide much-needed cash flow to get your business back up and running again.

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