Are Business Insurance Claims Taxable Income?
Business insurance is essential to help safeguard against various emergencies that can effect your business. This includes natural disasters, fires, and lawsuits.
However, few business owners have adequate information about business insurance and how it works, especially regarding taxes and taxable income.
According to data, 96% of business owners lack general insurance knowledge. This can put you at risk of losing out on crucial insurance protections or getting into trouble with the IRS.
Business insurance claims are generally not taxable. However, depending on the situation or payout, the claims may be subject to taxes in the form of taxable income.
Here’s a look into insurance proceeds and when you may have to file taxes on it.
What Is an Insurance Proceed?
Insurance proceeds are the benefits paid out by an insurance policy from an insurance claim. These proceeds are paid out once the claim has been verified and financially indemnifies the insured party covered by the policy.
Depending on the situation, insurance proceeds may be paid directly to a business or care provider, as is the case with health insurance. However, it’s often sent to the insured party as a check.
How Insurance Proceeds Work
Once a business has bought an insurance policy, it pays premiums for the policy to the insurance company. As part of the arrangement, the insurance company is legally obligated to pay insurance proceeds on verified claims filed by the business.
Before the insurance company pays out the proceeds, it must evaluate the claim, the extent of the damage, and the contract and file any needed police reports.
Once the claim has been evaluated and verified, the insured party receives the proceeds as a lump sum or multiple installments issued over time, often specified by the insurance policy.
Are Business Insurance Claims Taxable?
Most business owners assume that business insurance claims and proceeds are not taxable. While this can often be the case, in some instances, it might be wrong and costly.
Dealing with tax is the last thing business owners want to deal with when recovering from a crisis. Depending on the nature of the peril, your business may even get tax relief for the period it’s been affected.
For instance, when there are emergency events and big natural disasters affecting businesses, the IRS may issue several tax reliefs to aid recovery and lift the burden of filing taxes.
However, at a broad level, the IRS enforces various tax principles for insurance proceeds received by a business.
The General Tax Principles for Insurance Claims
Three main instances exist when a business insurance claim can be considered taxable income.
First, most business interruption insurance claims are taxable for the period the interruption refers to. That’s because these proceeds are intended to recoup lost profits by the business.
Insurance claims for Trading Stock are also often taxable, especially if a deduction is taken for the damaged stock.
Business insurance claims for increased cost of operations or material damage are also taxable if there are capital gains or depreciation recovery from the proceeds.
How the Tax Accounting Generally Works
In most cases, the accounting for how much of your insurance proceeds can be considered taxable income is relatively straightforward.
When the insurance company fulfills the claim, an accountant records the total proceeds and loss amounts.
Say you had an inventory worth $15,000 destroyed by an insured peril. Two scenarios can occur as far as your insurance claims are concerned.
Assuming the insurance claim is successfully evaluated and approved by the insurance company, the insurer will reimburse the loss based on your policy and its limits.
If your policy has a limit of $10,000, in your accounting books, you’ll have a $15,000 credit to inventory to account for the loss due to the peril, a $10,000 debit to damage reimbursement, and a $5,000 debit to loss on insurance proceeds.
This means that, despite the insurer fulfilling their obligation and paying out the proceeds for your loss, your business still incurred a loss of $5,000.
Sometimes, the insurance proceeds may exceed the insured loss depending on the evaluation, policy limit, and other factors. For instance, you may get proceeds worth $17,000 for the $15,000 inventory loss.
In your accounting, you’ll make a $15,000 credit to inventory, a $17,000 debit to damage reimbursement, and a $2,000 credit to gain insurance proceeds.
This gain can be considered income, thus taxable.
The Case for Business Interruption Insurance
Business interruption insurance covers the financial losses incurred by your business when it’s forced to shut down due to unforeseen events such as a government closure or natural disaster. These shutdowns not only affect the business but also the workers.
Business interruption insurance typically covers the following:
The costs for setting up a temporary location
Profits that would have been earned under normal operations
Training costs for new equipment and commissions
Fixed costs incurred on the property
According to the IRS, insurance proceeds from business interruption insurance fall under accession of wealth. Therefore, it must be included under taxable income. That’s because the policy compensates for income your business should have earned and taxed.
However, this may not always be the case.
Sometimes, the tax from business interruption insurance proceeds may be offset by business casualty losses, which are often tax-deductible. This is to the extent that some form of insurance does not already cover the losses.
To get these deductions, your business must document and prove that the losses incurred from the event led to business disruption.
Can Business Insurance Claims be Tax Deductible?
While business insurance claims can be subject to income tax, your premiums can be tax deductible. The IRS allows business owners to deduct “ordinary and necessary cost of insurance” as a business expense.
The IRS defines ordinary expenses as those deemed to be acceptable and helpful for the business type you operate. Necessary expenses are also helpful to your business, albeit not absolutely necessary.
Often, the premiums paid for the following types of insurance are considered tax-deductible:
Workers compensation insurance mandated by the state
Business interruption insurance
Commercial property insurance
Business auto insurance
Commercial liability insurance
Medical malpractice insurance
Keep Track of Your Claims and Taxes
It can be confusing figuring out whether your insurance proceeds are subject to taxes and how much deductibles you should apply in that case. Talk to an expert and learn the tax obligations of your business insurance policy.