Industry Director’s Directive #2 on Casualty Loss IRC 165
June 19, 2009
Impacted IRM 4.51.2
INDUSTRY DIRECTORS, LMSB
Keith M. Jones /s/ Keith M. Jones
Industry Director’s Directive # 2 Examination of IRC Section 165 Casualty Losses
This memorandum provides field direction on the Tier II Issue involving the Examination of IRC Section 165 Casualty Losses impacting electric utility transmission and distribution properties. The issue owner executive is Keith Jones, Industry Director, Natural Resources and Construction.
This memorandum provides guidance to the field in determining the single, identifiable properties (SIPs) that may be used by an electric utility for its transmission and distribution properties, in calculating its casualty losses under IRC§ 165.
Industry Director’s Directive #1 (IDD#1) was issued on April 27, 2007, alerting the field of a growing trend in the utilities and telecommunications industries whereby some taxpayers are deducting casualty losses under IRC§ 165 and also deducting the cost of restoring the damaged property as repair expenses under IRC§ 162.
As noted in IDD#1, the Service’s position is that a taxpayer cannot take a casualty loss deduction and a business repair deduction as a result of the same casualty. Instead, the casualty loss is deductible under IRC§ 165, and the cost of restoring the property to its pre–casualty condition must be capitalized under IRC§ 263(a), rather than being currently deductible under IRC§ 162. Examiners are advised, however, to fully develop the restoration versus repair (IRC§ 263(a) versus IRC§ 162) determination through audit techniques, such as an analysis of invoices and work orders, and discussions with taxpayer personnel responsible for the restoration work. Through this analysis, the examiner should determine whether any of the expenditures claimed as repair expenses are required to be capitalized irrespective of the Service’s position that taxpayer is not entitled to a deduction under both IRC§§ 165 and 162 with respect to the same casualty event.
Industry Director’s Directive #1 also identified a corollary issue related to the adjusted basis of the utilities transmission and distribution properties used in calculating the amount of the allowable casualty loss. This Industry Director’s Directive (IDD#2) addresses this corollary issue.
Business casualty loss deductions are limited to the lesser of (a) the difference between the fair market value (FMV) of the property before and after the casualty or (b) the adjusted tax basis of the property immediately before the casualty. The deduction limitation is determined by reference to the reduction in FMV and the adjusted tax basis of the SIP damaged or destroyed (Treasury Regulation 1.165-7(b)(1)).
Some taxpayers have designated their entire utilities transmission and distribution system or their entire telecommunication system as the SIP. Because taxpayers’ damaged or destroyed properties have been subject to accelerated write-offs and may have been in service for significant periods of time, taxpayers often have a low tax basis in these assets. The determination of SIP is significant because the amount of casualty loss may exceed adjusted tax basis, depending on the size of the SIP involved. By defining their entire transmission and distribution system or telecommunications system as the SIP, the taxpayers have a larger tax basis in computing their casualty loss deduction.
The rationale of the "single, identifiable property" rule is to arrive at a logical, reasonable, and practical unit for valuation and accounting purposes, while preventing the borrowing of basis from unharmed property, without segregating the damaged property into artificially small subunits. The Service has determined that taxpayers’ treatment of their entire utilities transmission and distribution system as the SIP is inconsistent with this rationale and is unacceptable.
Industry Director’s Directive #2 addresses the SIPs that may be used by an electric utility for its transmission and distribution system. Note that the determination of SIP for casualty loss purposes may not necessarily be the same as the determination of the unit of property for capitalization purposes. The Service will issue separate guidance regarding the determination of SIP associated with the telecommunications industry.
Any cases having this issue should use the following Uniform Issue List (UIL) and Standard Audit Index Number (SAIN) codes:
Capitalization versus Repair: 00162.16-04
Casualty Losses: 00165.07-00
Accuracy-related Penalty: 6662.00-00
Capitalization versus Repair
Primary SAIN:110: 2nd Tier: Casualty Loss 390
Primary SAIN: 409: 2nd Tier: Single Identifiable Property 391
Accuracy-related Penalty: 624-01
Planning and Examination Guidance:
Section 165 does not allow the taxpayer a full deduction for every loss in FMV that its property suffers by reason of a casualty. Rather, the deduction for the loss is limited to the taxpayer’s adjusted tax basis in the property damaged. This limitation prevents a deduction for a loss of value in excess of basis, such as unrealized appreciation. Rosenthal v. Commissioner, 416 F.2d 491, 497 (2d Cir. 1969). Furthermore, the SIP rule ensures that a taxpayer may not borrow basis from unharmed property to increase the amount of a loss deduction for an injury to other property. Id. at 497-98. Keefer v. Commissioner, 63 T.C. 596, 600 (1975).
Determining the SIP involves the application of a number of factors, none of which is dispositive. In a series of cases, mostly involving timber, the courts have developed some of the factors that should be used in the SIP determination. The Service, in TAM 200902011, summarized these cases and some of the factors that should be considered, noting that the nature of the casualty and the facts and circumstances of the particular case must be taken into account.
Based on the analysis in these cases, the Service has determined an acceptable SIP classification for the utility transmission and distribution system. For transmission property, the single, identifiable properties are each transmission line and each transmission substation. For distribution property, the single, identifiable properties are each distribution circuit and each distribution substation.
There may be additional SIP classifications that the Service considers reasonable. In making these determinations, the field should consider the specific facts and circumstances of the taxpayer, taking into account the factors utilized by the courts as summarized in TAM 200902011.
Furthermore, in certain cases, utilities may not have assigned a specific tax basis to each of the SIPs identified. The Service believes, however, that taxpayers working with the field should be able to arrive at a reasonable allocation of tax basis.
The field is instructed to coordinate all SIP classifications and tax basis allocation determinations with the Utility Technical Advisor (Utility TA).
Additionally, all Forms 5701 must be approved by the Utility TA prior to issuance.
If you have any questions, please contact the Utility Technical Advisor..
This LMSB Directive is not an official pronouncement of the law and cannot be used, cited, or relied upon as such.
cc: Commissioner, LMSB
Deputy Commissioner, LMSB Operations
Deputy Commissioner, LMSB International
Division Counsel, LMSB
Directors, LMSB Field Operations
Director, LMSB Performance, Quality and Audit Assistance