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Tax Strategies for a Bonus or Windfall March 31, 2021

Posted by bradstreetblogger in : Business consulting, General, Retirement, tax changes, Tax Rules, Tax Tip , add a comment

Nice recap below which discusses some tax saving or tax deferral options available in the event of a bonus or windfall.                                                                                                       – Mark Bradstreet

Here are 5 Tax Strategies for a Bonus or Windfall.

Yes, it’s inevitable: That cash bonus for a job well done can result in you paying a bigger chunk of money to the Internal Revenue Service (IRS). To start, the IRS considers bonuses to be supplemental wages, which means your employer is required to immediately withhold 22% of your windfall. You could get some of that back at tax time. But then again, a bonus might bump you into a higher tax bracket, which starts at 10% for low-income taxpayers and tops out at 37%.

Heed another precaution, says Rosalind Sutch, a Philadelphia certified public accountant (CPA) at the tax consulting firm Drucker & Scaccetti: “If you work in two or more states during the year, you might need to pay taxes on your bonus to each state.”

Take heart: Your tax advisor can map out a few strategies to let you keep as much of that extra cash as the IRS allows.

KEY TAKEAWAYS

1. Set It Aside For Later

Remember, Uncle Sam truly wants you to have a great retirement. He’s encouraging us all to build up our nest eggs by using contributions to qualified retirement savings accounts, such as 401(k)s and traditional IRAs, to reduce taxable income. With that in mind, a bonus or windfall can represent a great way to jumpstart your retirement savings, especially if you’re allowed to use your bonus to make a special contribution. That, of course, will depend on your plan’s rules.

401(k)s

It might make very good sense to use the extra cash to maximize your 401(k) contribution. This move may even reap an additional reward if your employer kicks in a matching sum—provided you qualify under plan guidelines. The amount you can contribute to your 401(k) or similar workplace retirement plan is $19,500 in 2021. The 401(k) catch-up contribution limit—if you’re 50 or older—will be $6,500 in 2021.

IRAs

For 2021, your total contributions to all of your traditional and Roth IRAs cannot be more than $6,000 ($7,000 if you’re age 50 or older), or your taxable compensation for the year, if your compensation was less than this dollar limit. The deduction you can take on IRA contributions, however, is subject to limits based on your income, filing status, and whether your employer has a retirement plan in place.

Roth IRA

Another strategy, says Sutch, is to make a contribution to a non-deductible IRA, then convert the account to a Roth IRA as quickly as possible—at very least before the end of the year. You will need to pay taxes on any gains made because of an increase in the value of the converted IRA, but distributions you take later will be tax-free. That’s an important consideration that can save you money if the assets of the Roth IRA increase, tax rates increase, or you end up in a higher bracket on the eve of your retirement.

The caveat is that you’ll need to walk through the paperwork carefully with your accountant to avoid tripping up and generating taxable income, especially if you already have an IRA. Also, you’ll need to fit the Roth income limitations.

2. Defer Compensation

When it comes to getting back some of that 22% withheld bonus, you have a number of options. For one, you might look into a deferred compensation plan at work, which will allow you to spread out both the money you pocket and the tax liability. If you are paid in shares of stock, you’ll want to mull over the best time to cash out of a security that has increased in value—in order to offset or limit capital gains. Long-term capital gains rates are 0%, 15%, and 20%, depending on your income level.

3. Pay Your Taxes

Yes, the heading here sounds like a no-brainer. But let’s be a bit more specific: One beneficial way to use your bonus is to “catch up” on estimated tax payments or your withholding-tax obligations and thereby sidestep an IRS penalty for coming up short.

And that’s not all you can do. Under certain circumstances, you might be able to pay next year’s real-estate taxes in advance. It all depends on when your real estate taxes were assessed. Under IRS rules, you can deduct the prepayment of property taxes for the next tax year if the assessment was received and paid in the current tax year. Any prepayment of property taxes that have yet to be assessed cannot be deducted. Taxpayers are advised to check with their accountant before trying this tack.

4. Give It Away

If you itemize your deductions on Schedule A, you can shield some of your bonus by making a charitable donation to charity. For most cash contributions, up to 60% of adjusted gross income can be deducted. The IRS maintains an online resource to help taxpayers determine the deductibility of their contributions to tax-exempt organizations.

If you are unable to decide on a charity, you might consider donor-advised funds (DAFs), a tool for high-net-worth individuals. When you contribute to a DAF, the money goes into an account with your name. You are permitted to take the full charitable deduction in the year in which it was made, even though the funds might not be dispersed to charity until later. However, as with donations to charity groups, taxpayers should be certain donations to the DAF are deductible.

5. Pay Up Your Expenses

Another way to shelter a bonus or windfall is to pay upcoming deductible business or personal expenses before Dec. 31. You might consider upgrading your computer equipment or footing utility bills for your home office before year-end.

Using a credit card may make sense, provided you can pay off the additional balance in January.

Another idea: If you’re signed on for a health savings account at work, consider using part of your bonus or windfall to pay up to the contribution limit. Just be sure it’s money you can carry over to next year, or that you know you will spend in time.

The Bottom Line

As soon as you know of a bonus or windfall, book a meeting with your tax advisor to start safeguarding as much as you can.  

“Like a lot of tax issues, things can get very complicated,” says Sutch. “You don’t want to get whipsawed on some of the more intricate rules, so it’s a good time to lean on a competent tax adviser’s advice.”

The only windfall that won’t put you in that situation: the (maximum) $15,000 that someone can give you tax-free each year. Neither you nor the giver owes taxes on a gift that falls within the legal limit. Such gifts can add up: For example, if all four of your grandparents gave you the maximum, you could collect $60,000 per year, gift-tax free.

Credit Given to:  JAMES ANDERSON  Published in Investopedia on Feb 1, 2021.

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.

This Week’s Author, Mark Bradstreet, CPA

–until next week.

IRS Announces Higher Estate and Gift Tax Limits for 2021 March 24, 2021

Posted by bradstreetblogger in : Deductions, General, Retirement, tax changes, Tax Planning Tips, Tax Rules, Tax Tip, Taxes , add a comment

Many of our clients have the best of intentions of completing their estate planning. Not that I am perfect. Many of us have been fine-tuning our estate plan for decades. Granted this process is never really done. It is a work in process. But if you have a plan in place only in your head, your family may be surprised by the estate tax owed. Some rather painless steps may be taken with the help of an estate planning attorney to avoid these unpleasant surprises.


– Mark Bradstreet               

How much money should go to the tax collector when you die?

The Internal Revenue Service announced today the official estate and gift tax limits for 2021: The estate and gift tax exemption is $11.7 million per individual, up from $11.58 million in 2020. That means an individual could leave $11.7 million to heirs and pay no federal estate or gift tax, while a married couple could shield $23.4 million. 

(Speculative portion who may be our next President was omitted since this was written shortly before Election Day)

The IRS announced the new inflation-adjusted numbers in Rev. Proc. 2020-45. Forbes contributor Kelly Phillips Erb has all the details on 2021 tax brackets, standard deduction amounts and more. We have all the details on the 2021 retirement account limits, including the higher $58,000 overall 401(k) limit, too.

If you’re rich and you’re worried about the estate and gift tax exemption amounts going down, the time to start a gifting plan is now. The IRS finalized rules last year saying that it wouldn’t claw back lifetime gifts if/when the exemption is lowered.

The annual gift exclusion amount for 2021 stays the same at $15,000, according to the IRS announcement. What that means is that you can give away $15,000 to as many individuals—your kids, grandkids, their spouses—as you’d like with no federal gift tax consequences. A husband and wife can each make $15,000 gifts, doubling the impact.

Separately, you can make unlimited direct payments for medical and tuition expenses.

When you’re doing advanced estate planning—making gifts in excess of $15,000 annual exclusion gifts—you’re using your lifetime gift/estate tax exemption. With the new 2021 numbers, a couple who has used up every dollar of their exemption before the increase has another $240,000 of exemption value to pass on tax-free. For folks who are worried that that’s a lot to give, there are newfangled spousal lifetime asset trusts (aka a SLATs). They’re also IRS-tested advanced estate-freeze strategies like grantor-retained annuity trusts (GRATs) and installment sales to grantor trusts, where you give away the upside of assets transferred to the trust tax-free. For planning tips, see Trusts In The Age Of Trump.

Keep in mind the $23.4 million number per couple isn’t automatic. An unlimited marital deduction allows you to leave all or part of your assets to your surviving spouse free of federal estate tax. But to use your late spouse’s unused exemption—a move called “portability”—you must elect it on the estate tax return of the first spouse to die, even when no tax is due. The problem is if you don’t know what portability is and how to elect it, you could be hit with a surprise federal estate tax bill.

And note, if you live in one of the 17 states or the District of Columbia that levy separate estate and/or inheritance taxes, there’s even more at stake, with death taxes sometimes starting at the first dollar of an estate.

Here’s a look at the federal estate tax/gift tax exemption over the years, according to the Tax Policy Center:

2021: $11.7 million/$11.7 million
2018: $11.18 million/$11.18 million
2011: $5 million/$5 million
2009: $3.5 million/$1 million
2008: $2 million/$1 million
2003: $1 million/$1 million

Credit Given to: Ashlea Ebeling – a Senior Contributor for Forbes published on 10/26/20.

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.

This Week’s Author, Mark Bradstreet, CPA

–until next week.

Business Closures March 17, 2021

Posted by bradstreetblogger in : Business consulting, General, Tax Preparation, Tax Tip, Taxes , add a comment

If you can coughup $99 for the State of Ohio, you may form a business entity such as an LLC or a corporation. Granted that you must have a unique business name i.e., you may not use the same or similar name as another Ohio business. If the Secretary of State’s Office website is up and running, an official company may literally be formed online in minutes.  IRS FEINs (if needed) are free and may also be generated online. Ohio charges a nominal fee for a Vendor’s License which is used to collect Ohio sales tax. Setting-up payroll (only if you have employees) is also very inexpensive although several forms are necessary. Of course, if you have payroll you also need to register for state unemployment, worker’s compensation and city withholding if applicable. Many of these forms and applications have “trick” questions, so beware. Where am I going with all of this is – that to begin an Ohio business, it is pretty darn easy and inexpensive.

So, it would only be natural to assume that closing a business in the Buckeye State would be just as easy.  I suspicion you know where I am going with all of this.  Shutting down a business can be very difficult, cumbersome, time consuming and expensive. The state, IRS as well as any cities and payroll entities involved are all incredibly concerned that you may shutter your doors, close your bank accounts and still owe them money. So, to truly close your business, LOTS of hoops must be jumped through, forms prepared etc. Businesses are typically closed for financial difficulties which is painful enough. Adding insult to injury, you may owe taxes for many reasons such as delinquent sales taxes, past due payroll taxes and worker’s compensation, IRS taxes, Ohio taxes, city taxes and so forth and so on…  Some of these liabilities may become personal liabilities that need dealt with. 

You don’t want to run out of runway when closing down a business. It requires proper planning, finances and foresight for a proper shutdown. Professional advice is highly suggested during what may be a difficult time. 

– Mark Bradstreet     

Closing Because of the Pandemic? Beware of Potential Tax Hits.

Thousands of small businesses have shut down because of the COVID-19 pandemic. Adding insult to injury, many are facing tax hits as they wind down.

Small businesses have felt the brunt of the COVID-19 pandemic, with thousands of enterprises forced to close since the beginning of March.

As if going under because of a pandemic isn’t bad enough, some will face tax hits from their closures if they aren’t careful. Moreover, some are left wondering what to do with their COVID-19 loans and grants. As a result, instead of being able to walk away after closing up shop, they’re forced to navigate taxes and potential penalties.

“The last thing people think about when wrapping up a business is their tax obligations,” Mike Slack, senior tax research analyst at H&R Block’s The Tax Institute, told business.com. “They are running at a loss; they didn’t generate any taxable income. But there are still a lot of tax implications.”

Whether it’s filing your business’s final tax return or determining if you have to treat COVID-19 loans as income, there are several things small business owners have to consider when closing operations.

PPP loan proceeds may be taxable.

In the early days of the pandemic, the federal government released more than $2 trillion in aid under the CARES Act, with billions of dollars going to help small businesses stay afloat. Under the act’s Paycheck Protection Program, small business owners received loans that were forgivable if they used the money to keep workers on the payroll.

Despite all these efforts, thousands of small businesses couldn’t survive. Now they’re left wondering if they have to pay taxes on the money they received or, worse, pay back the loans.

“As currently written in the CARES Act, PPP proceeds are not taxable, but the IRS made a determination in notice 2020-32 that indeed it is taxable in a back-ended way,” said Mark Alaimo, who sits on the American Institute of Certified Public Accountants‘ (AICPA) Personal Financial Specialist Committee.

Under this IRS rule, PPP borrowers can’t deduct the expenses they incur to qualify for loan forgiveness. It throws murkiness into the mix and is a rule the AICPA is squarely against.

“That means if you have a $200,000 loss and if you received a $250,000 loan, you may have $50,000 worth of income,” Alaimo said. “The easiest thing people can do is assume all PPP proceeds are taxable income even if it’s been forgiven.”

According to Alaimo, most states have already indicated that they will tax any forgiven PPP loans just as they would tax any other forgiven debt. However, if your business loan wasn’t forgiven before you shut down operations, you may have to pay it back – plus taxes – unless you file for bankruptcy.

Forgiveness of debt can be a taxable event.

If you’re writing off debt as part of your business shutdown, it could trigger a taxable event. Like PPP loans, any reduction in debt you negotiate as part of your closing may be subject to tax. Let’s say you owe $100,000 to a creditor and they forgive you that debt: That $100,000 is treated as taxable income, according to John Smallwood, president of Smallwood Wealth Management.

Keep the IRS in the loop.

To avoid tax penalties, you have to make your business closure official. To do that, you must file your final tax return with the IRS. Whether you operate a partnershipC corporationS corporation or sole proprietorship, the IRS needs to know your business is closed.

“The final tax return is due within three to four months after the business date it closed,” said Slack said. “People get in trouble with that. Late filings are subject to penalties.”  

When filing your final taxes, Slack said, be mindful of how you account for proceeds from the sale of business assets. “When you sell assets, you are still supposed to report them as a disposition on your tax return. There’s a lot of nuances to it.”

“A lot of nuances” is particularly true during the COVID-19 pandemic, as business owners navigate forced closures and social distancing rules. Some run into tax trouble, despite states’ assurances.

That was the case with Heather Manto, owner and operator of Independence Barber Co. in Austin, Texas. To help businesses forced to shut down by the pandemic, Texas announced that it would extend the sales tax due dates and waive late fees. That was a relief to Manto, who had no income as her shop remained shuttered. But when she paid her sales tax a week late, she got hit with a penalty.

“Getting a human on the phone at that time was impossible, so I just paid and lived with it,” said Manto, who has since reopened her business. “It’s just a small example, but for a small business like mine, even those minor things hurt an already-pained business.”

Sweat the small stuff.

Paying sales tax late isn’t the only thing that can get you in trouble with the IRS or local tax collectors. You can face penalties for myriad reasons. The two big ones in dissolving a small business are neglecting to notify the state and failing to pay payroll taxes.

1. Notify the state.

Unless you file dissolution documents with the state where you operated, your business is not closed in the state’s eyes.

“As far as the state is concerned, they think you are still running your business and may hit you with state taxes for that year,” said Lisa Lewis, CPA and editor of the TurboTax Blog.

Make sure to cancel your employer identification number (EIN) and close your IRS business account. That requires you to send the IRS a letter that includes the business name, EIN, address and the reason you’re closing the account. The business remains open until you’ve filed all the required returns and paid all the taxes you owe.

2. Don’t forget payroll taxes.

If you have any employees, you must not only pay them their final wages, but also make good on any payroll taxes and report employment taxes. Failure to withhold or deposit employee income, Social Security and Medicare taxes could subject you to the trust fund recovery penalty.

Taxes are an unavoidable headache of starting, running and closing a business. But they shouldn’t be ignored; the last thing you want to do is simply walk away.

“You really have to be deliberate and thoughtful when winding up your business,” Smallwood said. “You have to make sure there are no personal problems and consequences that come as a result of your failed business.” 

Credit given to: Donna Fuscaldo. She is a business.com Writer. This article was published on Nov 10, 2020.

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.

This Week’s Author, Mark Bradstreet, CPA

–until next week.
.

Choice of Business Entity March 10, 2021

Posted by bradstreetblogger in : Business consulting, Depreciation options, General, Tax Planning Tips, Tax Preparation, Tax Rules, Tax Tip, Taxes , add a comment

Entity choice is one of my favorite topics. It reminds me of a chess game. The choice of your business entity is the cornerstone of your tax and legal foundations. Not all entities are taxed in the same fashion, others treat the taxation of a sale of its assets differently, and still others will have varying types of owner’s compensation just to mention a few of the different entity attributes. Other entity choices make switching from one entity to another very expensive. For example, switching a C corporation to an LLC may be a very expensive proposition. But, going the other direction by switching an LLC to a C corporation is usually painless. Nellie Akalp in the following article does an excellent job of discussing more of the pros and cons of entity choice.
                                                                    -Mark Bradstreet

A lot is riding on the business entity type you choose. The business structure you decide on affects your legal liability as an owner, tax obligations, growth potential, and compliance requirements you’ll need to satisfy on an ongoing basis. To make matters more complex, the entity type that’s right at the beginning of a business’s existence may not continue to be the ideal choice as the company grows and evolves.

So, what’s an entrepreneur to do? First and foremost, I encourage business owners to consult with a licensed attorney and accountant or tax advisor to get professional guidance. Every situation is unique, so it’s critical to have expert advice before making the crucial decisions of choosing a business entity and assessing when it’s time for a change.

To help you prepare for your all-important discussions with your legal and financial advisors, the following is food for thought about some of the most popular business entity types.

Business entity basics

1. Sole proprietorship and general partnership

Many small businesses start as either a sole proprietorship (one owner or a married couple) or general partnership (multiple owners). When business owners don’t formally register their companies with the state, they are, by default, considered either a sole proprietorship or general partnership. There is no legal or financial separation between the business and its owners.

Pros of sole proprietorships and general partnerships:

Cons of sole proprietorships and general partnerships:

2. Limited liability company (LLC)

The LLC business structure may be described as a bit of a cross between a sole proprietorship or partnership and a corporation. By default, an LLC is considered the same tax-paying entity as its owners (“members”). However, the LLC is regarded as a separate legal entity from its members. Articles of Organization must be filed with the state to form an LLC. 

Pros of limited liability companies

Cons of LLCs

3. C Corporation

A C Corporation is regarded as a separate taxpayer and legal entity from its owners. Business income and expenses are tied to the business, and the corporate entity reports and pays taxes. Ownership of a C Corp is through purchasing shares of stock.

Incorporating as a C Corp involves filing Articles of Incorporation (sometimes called Certificate of Incorporation) with the state. Other state requirements must also be met to start a corporation.

Pros of C Corporations

Most legal protection for owners—The C Corp structure provides the highest degree of liability protection for business owners. Under most circumstances, shareholders, directors, and employees have protection from lawsuits and debts of the corporation. 

Growth potential—C Corporations can have an unlimited number of shareholders and may issue multiple classes of stock. Typically, investors will be more interested in funding companies organized as corporations rather than those operating as other entity types.  

Tax flexibility—Eligible corporations may choose to be taxed as an S Corporation (see more about that in the next section). Often, corporations are eligible for more tax deductions than businesses operating as other business structures. 

Perpetual life—Ownership interests in a corporation may be transferred to others. Shareholders can sell, gift, or bequeath their shares of company stock, and the corporation continues to exist. Only when a C Corp is formally dissolved is its life ended. 

Cons of C Corporations

More compliance complexity and costs—In most states, it costs more to incorporate a business than to form an LLC. There are more internal and external rules to start and operate a C Corp, such as appointing a board of directors, drafting bylaws, filing an initial report, filing annual reports, etc.

Double taxation—A C Corporation’s profits get taxed at the federal corporate income tax rate. Then they are again taxed to shareholders when the corporation distributes those profits as dividends. This creates a double tax because the dividends paid do not qualify as tax deductions for the corporation. Another potential disadvantage from a shareholder’s individual tax perspective, is that they may not deduct any loss of the corporation on their personal tax returns.  

Overview of the S Corporation election for LLCs and corporations

The S Corporation is a tax election that qualifying LLCs and corporations can choose.

The benefit for LLCs is that S Corp election can reduce the amount of self-employment tax business owners must pay. An LLC taxed as an S Corp still gets pass-through tax treatment (tax obligations pass-through to the owners’ returns), but only the wages and salaries of business owners on the company’s payroll are subject to Social Security and Medicare taxes. Any profit distributions paid to owners do not have those taxes levied on them.

To request S Corporation election, an LLC must file IRS Form 8832 (to be taxed as a corporation) and IRS Form 2553 (to choose S Corporation election).

S Corp tax treatment allows corporations to avoid the sting of double taxation. As an S Corporation, a corporation’s profits and losses flow through to shareholders’ personal tax returns. The corporate entity does not pay income tax. Shareholders who are employed by the corporation pay Social Security and Medicare taxes on their wages or salaries from the company, but the dividend income paid to shareholders is not subject to those taxes.

Note that S Corporations may not exceed 100 shareholders. Therefore, corporations with more than that are not eligible for S Corp election.

Is your business entity type still the right one for you?

Business owners operating as a sole proprietor, general partnership, or LLC may find that their business is outgrowing the limitations of their entity type. A few things that might drive entrepreneurs to consider changing their business structure include:

The process to switch from one business entity type to another will vary by business structure and in which state the business is operating. An attorney and accountant can help determine whether a change may be beneficial. Also, a lawyer can advise on the correct steps to take to change business entities. Details are often available on states’ Secretary of State websites, as well. 

Ideally, when starting your business, it’s helpful to think both short-term and long-term about what structure will best serve your needs and vision. With some research, reaching out to the right resources for guidance, you will be empowered to make an informed decision. 

Credit Given to:  Nellie Akalp is a passionate entrepreneur, business expert, professional speaker, author, and mother of four. She is the Founder and CEO of CorpNet.com, a trusted resource and service provider for business incorporation, LLC filings, and corporate compliance services in all 50 states. Nellie and her team recently launched a partner program for legal, tax and business professionals to help them streamline the business incorporation and compliance process for their clients.

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.

This Week’s Author, Mark Bradstreet, CPA

–until next week.

Business Interruption Insurance Coverage March 3, 2021

Posted by bradstreetblogger in : Business consulting, COVID-19, General, Tax Tip, Uncategorized , add a comment

Question:  What is a business interruption insurance loss? 

Answer: “We will pay for the actual loss of business income you sustain due to the necessary suspension of your “operations” during the period of “restoration.” The suspension must be caused by the direct physical loss, damage, or destruction to insured property. The loss or damage must be caused by or result from a covered cause of loss.”

Several of our clients have suffered business interruptions over the years. Most of these interruptions have been the result of fire and water damage. The process of obtaining a settlement with the insurance adjusters are never fun and the process is often lengthy. The adjusters are typically difficult to work with and understandably so. Their job is to minimize the dollar amount of the claim. And, the adjusters have a lot of experience at doing just that. Our job is to maximize the insurance dollars our clients receive. Good recordkeeping is crucial to this process. Many of the formulas used to calculate the business loss are based on your financials. If your records are poor or even worse nonexistent, the adjuster will do their best to reconstruct your records but it won’t be in your favor. Every business owner believes their claim should be higher. A nonprofitable business regardless of the company size may not receive any insurance monies. The argument being that the business was losing money and during the down time, it lost just that much less. The insurance company will typically lowball their first offer. If you dig in your heels the settlement number will usually climb especially with the help of an attorney and an accountant. 


– Mark Bradstreet
                                                                                              

Eight Key Concepts to Understanding Business Interruption Coverage

The COVID-19 pandemic has resulted in unprecedented disruptions for businesses and the economy. Compounding the challenges for businesses are recent civil unrest in major cities along with the early days of what may be an active Atlantic hurricane season. These trends mean it’s vital for risk professionals to know how their property insurance policies — including business income or business interruption coverage — may respond to potential losses.

What’s in a Business Income or Business Interruption Clause or Endorsement?

Many insurers’ property policies include business interruption or business income either as a coverage within the form; others, including those insurers that use Insurance Services Office (ISO) forms for their policies’ content, add this coverage via endorsement. A business interruption clause or endorsement is designed to protect the insured for losses of business income it sustains as a result of direct physical loss, damage, or destruction to insured property by a covered peril.

While many such clauses are in use today, a typical business interruption insurance clause might read as follows:

“We will pay for the actual loss of business income you sustain due to the necessary suspension of your “operations” during the period of “restoration.” The suspension must be caused by the direct physical loss, damage, or destruction to insured property. The loss or damage must be caused by or result from a covered cause of loss.

Although the contents of individual policies and endorsements may vary slightly, many use relatively consistent language to describe business interruption coverage. To better understand this coverage and how it might respond to potential losses, it’s important for risk professionals to focus on eight key concepts.

Actual Loss Sustained

Business interruption coverage protects against an actual loss sustained by an insured as a result of direct physical loss or damage to the insured’s property by a peril not otherwise excluded from the policy. The insurer is only obligated to pay if the insured actually sustains an interruption of business leading to a business income loss. This loss, however, is subject to the policy limit or sublimit that is applicable to the specific location where the loss occurs or the type of peril that leads to the loss.

Business Income

Usually, an insurer is responsible for the reduction in net income that results from suspension of operations — whether wholly or partially — due to a physical loss at an insured’s premises. Generally, insurers consider business income to include:

Period of Restoration

Insurers are liable for the loss of business income only during the period of restoration, which is often defined as the length of time required to rebuild, repair, or replace damaged or destroyed property. The period of restoration begins when the physical loss or damage occurs; it ends when the property should, with reasonable speed, be repaired or replaced and the location is made ready for normal operations to resume.

Expiration of the policy does not end the period of restoration; as long as the insured’s physical loss occurs during the policy period, a business interruption endorsement will provide coverage for the duration of the period of restoration.

An endorsement published by ISO includes a 30-day extended period of restoration provision beyond the standard period of restoration, as do some insurers’ forms. This provides additional coverage after an insured business resumes operations following the date of repair or replacement of the damaged property, which can be crucial since it may take time for the business to return to pre-loss income levels. However, if an insured requires more than this 30-day limit, it may be able to increase this limit — from 30 days to any multiple of 30 days up to 720 days — by purchasing an extended period of indemnity optional endorsement.

Extra Expense

A business interruption clause in a property policy or added endorsement can provide additional coverages, including for extra expense. This extension covers necessary expense sustained by an insured during the period of restoration that would not have been incurred had there been no physical loss to real or personal property caused by a covered peril.

When a business income loss occurs, an insured is obligated to take reasonable steps to prevent or minimize it. Any expenses incurred to reduce the loss are covered as part of the business income loss, as long as they do not exceed the loss itself.

An insurer will typically not pay any part of the expense that is more than the claim itself. For example, an insurer will reimburse an insured $100 to reduce the business income loss of $200, but will not reimburse the insured $100 if the claim is only reduced by $50. Any additional expenses above this $50 amount that are incurred to continue the business may be recoverable under an extra expense provision in an insurance policy.

Business income clauses or endorsements may also include “extensions of coverage” wherein the insured’s policy will insure against business income losses resulting from certain specified events. These include service interruption, contingent business interruption, leader property, and interruption by civil or military authority. A sublimit typically applies for each additional coverage.

Service Interruption

If included within the policy, a service interruption extension typically provides business income coverage arising from direct physical loss, damage, or destruction to electrical, steam, gas, water, sewer, telephone, or any other utility service’s transmission lines and related plants, substations, and equipment supplying such services to an insured business. The owners, managers, or operators of such utilities or services are not named insureds under the policy.
A physical loss, damage, or destruction at the location of the utility or service typically must be the result of a peril similar to those covered under the insured’s policy. Some restrictions on coverage may apply, however, including:

Contingent Business Interruption (CBI)

A CBI extension is designed to cover an insured’s business income loss resulting from physical loss, damage, or destruction of property owned by others. These typically include direct “suppliers” of goods or services to an insured and direct “receivers” of goods or services manufactured or provided by the insured. The physical damage to these suppliers or receivers usually must be of a type that would be covered by the insured’s policy had the damage happened to the insured’s property.

A CBI extension typically provides coverage for the “direct” relationship between an insured’s “suppliers” or “receivers” of its goods or services. Coverage can sometimes be extended for suppliers of a direct supplier — typically known as “indirect” or “second tier” suppliers. Such coverage may require, among other things, that indirect suppliers are specifically identified.

Leader Property (Attraction Property)

A leader property endorsement provides coverage to an insured for direct physical loss, damage, or destruction — of the type insured by the insured’s property policy — to property not owned or operated by the insured, located within a stated distance to the insured’s property or business, that attracts business to the insured. Examples would include a nearby amusement park, casino, mall, or destination retail store.

Interruption by Civil or Military Authority

This extension provides coverage to an insured for the actual loss of business income it sustains during the length of time when access to its premises is prohibited by order of civil authority as a direct result of physical damage — as insured against in the policy — to property of the type insured. An interruption by civil or military authority extension is commonly found under most policies insuring business income or business interruption.

The coverage time period most commonly specified in this extension is 30 consecutive days. An insurer may also impose a waiting period — typically 48 or 72 hours — that must be reached in order for coverage to apply.

Familiarity with these critical terms and specific relevant policy language is crucial to any organization’s understanding of how business interruption coverage may or may not apply to a loss, the preparation of potential claims, and future purchasing decisions. Risk professionals — working with their advisors — should carefully review their specific policy language and other coverage options that may be appropriate given their companies’ individual needs.

For more information, contact your Marsh representative or:

Mike Rouse
US Property Practice Leader
212-345-0429

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.

This Week’s Author, Mark Bradstreet, CPA

–until next week.