The explosion of the Deepwater Horizon oil rig and subsequent oil spill into the Gulf of Mexico has led to substantial damages and has generated many questions about the tax character of the payments made by British Petroleum (BP), and those likely to be made from a newly established claims fund. A new Congressional Research Service (CRS) study surveys the tax character of payments under current law, as well as the tax relief that may be available through Presidential or Congressional action.
BP has already begun to make interim payments to compensate for lost income resulting from the oil spill, particularly in the form of lost wages and income. And some $20 billion will be paid out to businesses and individuals through an Independent Claims Facility. Earlier this month, IRS issued Q&A interim guidance on the tax treatment of payments from BP. The CRS study takes a broader view. It surveys the tax treatment of oil spill related payments under current law, what the tax treatment might be if the event is designated a Presidential disaster, and some tax relief options that Congress might explore.
Current tax treatment. Payments received for lost business income, lost wages or lost profits are includable in income, but a payment made from BP to an individual to compensate for lost wages will not be wages for purposes of the social security tax and Medicare tax because it is not an actual payment for employment within the meaning of the law. These payments will also generally not be subject to income tax withholding, unless backup withholding applies. However, if a payment is made by an employer to its own employees, or by a third party to employees of another employer in satisfaction of an obligation of that employer to its employees, the payment may be subject to social security tax, Medicare tax, and income tax withholding.
In its Q&As, IRS concluded that self-employed individuals who receive a payment that represents compensation for lost income must include the amount of the payment in net earnings from self-employment for purposes of the self-employment tax.
The CRS study reviews other subjects covered in IRS Q&A guidance relating to the tax treatment of payments received for property damage, physical injuries or sickness, and emotional distress. It also covers issues not mentioned in the Q&As, including the following:
… Taxpayers for whom oil spill payments are taxable might be able to deduct costs (e.g., legal expenses) incurred in obtaining the payment. Business taxpayers may generally deduct these costs as ordinary and necessary business expenses under Code Sec. 162 (although if a payment yields capital gain, then the expense should be capitalized). Individuals who are subject to tax on the payments may be able to deduct the costs as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income floor.
… The Code requires all persons who, in the course of a trade or business, pay another person amounts totaling $600 or more in a single tax year to file an information return with IRS regarding such payments. The definition of person in this context includes a corporation and includes payments for compensatory damages for which the payer is liable. As a result, BP must file a Form 1099 for each claimant who receives more than $600.
… BP payments won’t be eligible for the Code Sec. 102 gift exclusion since “BP’s intent in making payments is not, on the whole, charitable.”
… The BP payments also won’t be eligible for the “general welfare exclusion.” To qualify for this exclusion, a payment must (1) be made from a governmental fund; (2) be for the general welfare, which essentially means it must be based on individual or family needs; and (3) not represent compensation for services. ( Rev Rul 2003-12, 2003-1 CB 283 ) The CRS study says that it appears the interim payments made by BP would not qualify for the exclusion because they represent replacement income and are not made from a governmental fund or based on need.
Presidential disaster designation. There is no precedent for a man-made disaster to result in a Presidential disaster designation. But if the oil spill were to receive this designation, the CRS report points out that relief would become available under provisions such as Code Sec. 139 , which excludes qualified disaster relief payments from gross income, Code Sec. 198A , which provides for expensing of qualified disaster expenses, and Code Sec. 1033(h) , which deals with certain involuntary conversions.
Legislative relief. The CRS study lists a number of different ways Congress could provide relief for victims of the Gulf oil spill, including these:
The Emergency Economic Stabilization Act of 2008 (EESA; P.L. 110-343 ) temporarily changed some of the rules associated with claiming casualty losses for taxpayers in federally declared disaster areas. For the 2008 and 2009 tax years, (1) all taxpayers, including non-itemizers, could claim a disaster loss deduction; (2) the 10% AGI limitation on disaster losses was suspended; (3) a five-year NOL carryback was available for disaster losses; and (4) the amount by which individual taxpayers were required to reduce their personal casualty losses per event was increased from $100 to $500 for deductions claimed in 2009. As an additional benefit for losses in federally declared disaster areas, taxpayers may elect to take losses in the previous tax year. Congress could enact provisions similar to those provided under EESA, allowing all taxpayers to deduct losses and suspending AGI limits.
Congress has responded to disasters in the past by modifying the NOL carryback rules (e.g., for the Katrina, Wilma, and Rita disaster areas) and could do so again by extending the default two–year NOL carryback to five years for businesses negatively affected by the oil spill.
As jobs losses resulting from the oil spill continue to mount, Congress could consider adopting provisions encouraging the hiring of those unemployed due to the oil spill. For example, as was done following the 9/11 terrorist attacks or Hurricane Katrina, the work opportunity tax credit (WOTC) could be modified to include oil-spill-displaced Gulf employees as a targeted group for hiring.
Following Hurricane Katrina, victims located in the disaster area were allowed enhanced access to retirement funds. Penalties for early withdrawals from individual retirement accounts (IRAs) and 401(k)s were eliminated, and the income tax on these distributions could be spread over three years rather than being due in the first year. Any replacement contributions made in the three years following the distribution could be treated as a rollover. The limits on borrowing from qualified employer plans were also increased. Allowing Gulf Coast oil spill victims greater access to retirement savings could help affected individuals smooth their income and consumption during the crisis.
Mark Fly, CPA
Price CPAs, PLLC
3825 Bedford Avenue, Suite 202
Nashville, TN 37215
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