The continuing ecological disaster in the Gulf of Mexico has been the subject of a lot of discussion. A tax lawyer, however, will also start thinking about the tax consequences that may flow from the disaster.
In the past several weeks, it was announced that BP would establish a substantial fund to ensure that all parties with legitimate injuries would be able to make a claim against the fund in an effort to make them whole. On June 25, the IRS announced how they would treat these payments unless Congress changed the rules.
The IRS explained that any payments from the BP claims fund would be taxable if the claim originates from a taxable event. That is, where the payment constitutes a substitute for lost income, that payment would be subject to taxation in the same manner as the replaced income would have been. As much as it pains me to say, the IRS is correct on this point. The IRS is simply applying current law to these payments.
Under the U.S. tax system, the IRS will look to the origin and nature of a claim to determine whether any recovery on the claim is taxable. For example, in an employment law context, if an individual successfully recovers back pay from a former employer the recovery (for tax purposes) will be treated as wages and subject to income tax withholding and FICA. That is, the origin of the claim is an action to recover wages and the amounts recovered should, logically, be treated as wages.
In the context of the payments from the BP Claims Fund, a shrimp boat captain that recovers on a claim for lost income should, under current law, be subject to tax on that income.
Someone that receives funds for damaged property may only have taxable gain if the amount received exceeds the tax basis in that property. Someone that receives a payment for physical personal injury will not have taxable income. These are the rules, but these are not where the real problems lie.
Certain industries operate largely on a cash basis. This means that, to state it courteously, sometimes certain tax obligations may be overlooked. Perhaps not all revenues find their way onto a tax return or returns are not filed at all. Perhaps this has occurred year after year. Now assume that one of these people makes a legitimate claim against the BP fund to recover for lost income. This is where the trouble starts.
When the BP fund pays a claim for lost income to an individual or non-corporate entity, it will also be required to file a 1099 (possibly W-2) with the IRS reflecting that payment. If the IRS compares the social security number on the 1099 to its tax return records it may either see that the payment is out of line with the person’s filing history or that no returns exist for a number of years. This is when the notices start flying and suddenly the oil spill victim finds him or herself embroiled in an audit or facing a criminal tax investigation.
The innocent oil spill victim will then likely feel victimized yet again.
While currently there is no specific mechanism to allow these people and businesses to avoid the penalties and interest that could stem from the failure to report income accurately or to file returns, the IRS follows a policy that can prevent criminal sanctions in these cases. If a person comes forward and makes a truthful, timely and voluntary disclosure of past tax transgressions, the IRS will forgo criminal sanctions. The benefits of a mea culpa under the IRS Voluntary Disclosure program include that the disclosure can be made anonymously until accepted into the program (subject to certain confirmations) and the filing requirements will be limited to the past six years.
There are, of course, certain caveats. A person or business cannot come forward under the program after the IRS is already investigating them. That is, the disclosure must be truly voluntary. Additionally, the tax, interest and penalties will still have to be paid. However, the payment of the bill is ordinarily well worth the cost where the upside is avoiding prison.
Unless Congress provides some sort of tax amnesty to allow these people back into the tax system on more favorable terms, we may see an increase in the number of Voluntary Disclosures coming out of the Gulf Coast region. Certainly individuals and business owners described above should consider doing so. In the meantime, when the IRS Commissioner says that they will do everything they can under current law to help taxpayers affected by the oil spill, BP claimants should remember that current law also provides for penalties, interest and possibly criminal sanctions.
Robert B. Teuber is a tax attorney with Weiss Berzowski Brady LLP in Milwaukee. He works with individuals and businesses in resolving tax audits, appeals, litigation and collection actions brought by the IRS and Department of Revenue. Rob can be reached at 414-270-2538 or at firstname.lastname@example.org.