Silver lining

Entrepreneur, Oct, 1998 by Joan Szabo

Due to the severe weather conditions caused by El Nino, many businesses suffered costly property and casualty losses in recent months. At press time, the number of federally declared disasters in 1998 had already reached 41 - compared to 45 for all of 1997. This year is shaping up to be a serious one for disasters, says the Federal Emergency Management Agency's Marc Wolfson.

The government tracks the impact of disaster losses on businesses by the number of disaster loans it makes to business owners. In the first nine months of this fiscal year, the SBA's disaster assistance program approved more than 4,000 business loans, totaling almost $224 million.

If your business was unlucky enough to suffer a loss from a natural disaster, especially in a federally declared disaster area, take heart: You're probably eligible for some tax relief. If the president declares a specific location a federal disaster area, business owners can receive federal assistance, such as low-cost disaster loans and special tax benefits. While the deductions won't replace what a natural disaster or other mishap has taken away, the tax benefits may make your disaster-related problems a bit easier to endure.

Even if your business hasn't yet experienced a disaster, it's important to know what you're entitled to in case you're not so lucky next time around.

DOES YOUR DISASTER QUALIFY?

If you've suffered a financial loss due to a natural disaster, the IRS lets you deduct it on your tax return for the year in which the disaster took place or in the immediately preceding tax year if certain requirements are met. First, the loss must have taken place in an area the president declares in need of federal assistance. Second, the tax return for the preceding year must be amended by the date it's due or, if that date has already passed, by the tax return due date for the year of the disaster. Tax experts say the best way to determine which year to claim the disaster loss is to calculate for each of the years the tax effects of claiming the loss. Then select the one that is most beneficial to you.

Business owners should also be aware of a recent change in the Small Business Act of 1996 regarding losses caused by natural disasters. Under the act, business property damaged by a natural disaster is eligible for what's called "nonrecognition of gain." This means that qualified replacement property can be bought and the gain deferred.

"The law is designed to provide relief to businesses forced to suspend operations for a substantial time due to the property damage," says Mark Luscombe, principal federal tax analyst for CCH Inc., a Riverwoods, Illinois-based provider of tax and business law information. Often when a business needs to close temporarily, it loses customers and eventually folds.

As a result of the 1996 change, if a company loses customers during a suspension and goes out of business, the owner can reinvest capital from that business in an entirely new venture. This change is significant, says Luscombe, because in the past, a business owner had to reinvest in an identical business. Now he or she can start fresh with a different business. This provision applies retroactively to presidentially declared disasters made after December 31, 1994, in tax years ending after that date.

DEFENDING YOUR DEDUCTIONS

While you're able to take tax deductions for disaster losses, keep in mind that the IRS wants to see evidence that a loss actually occurred and that it was caused by a disaster.

What kind of documentation will support your claim with the IRS? You'll need details about the nature of the disaster, a written description of the damaged property and the date the damage occurred. You must also explain how the loss was the direct result of the disaster. It's a good idea to have photos of the area before and after the disaster as well as newspaper articles that explain the damage in your neighborhood.

You must also supply the IRS with proof, such as a deed or other ownership information, that shows you own the damaged property and are legally responsible for it. Another requirement is proving your tax basis in the property. The basis is the amount you paid for the property plus the cost of improvements, less depreciation. Also keep in mind that before you take your deduction, you must reduce the amount of your loss by any insurance proceeds you receive.

Be sure to show proof of the value of the property before and after the loss so you can show the amount of loss the property's value suffered. To fulfill this requirement, you may have to have an appraisal done. You'll want to get it in writing, usually in the form of an estimate.

If you repair or replace the damaged property, the IRS generally allows you to prove the value with receipts that show the cost of replacement or repairs. If your computer operation suffers losses, for example, be sure to keep track of the repair or reconstruction costs involved in getting your computers back up and running.

On a positive note, Congress also recently changed the rules regarding appraisals required to establish a disaster loss. The IRS may now accept an appraisal used to secure a loan or a loan guarantee from the federal government to establish the disaster loss for tax purposes, says Luscombe. This change makes it easier to establish the value of your property both before and after the damage, he says.