After Fires, What Next For Businesses?

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There's no official tally yet, but it's a safe bet that dozens -- if not hundreds -- of Southern California small businesses were lost [BusinessWeek, 10/24/07] in the recent wildfires. The owners of many suburban hair salons, sandwich shops, and dry cleaners will be dealing with their insurance companies in the coming weeks and trying to figure out when -- or if -- they can get back to business. Tim Good, a partner in Los Angeles accounting firm Windes & McClaughry, spoke recently to Smart Answers columnist Karen E. Klein about practical steps small business owners can take after a fire or any natural disaster. Edited excerpts of their conversation follow.



We've written in the past about disaster preparedness [BusinessWeek, 6/19/06], and how all businesses should take steps to prepare. But what should owners do if they are generally unprepared when informed of an immediate danger, like a wildfire, flood, or hurricane?



If I were sitting in my small business and I was informed of an evacuation, I would gather up the financial records that form the guts of my business: Pending orders, customer lists, copies of ledgers, inventory data, backup accounting records, employee and personnel records, tax returns, insurance policies, and receipts for equipment. If I had time, I'd take pictures of my business premises to document my equipment and inventory. You're entitled to reimbursement for that stuff if you're insured. If you can, take your computers and definitely your server, if it's on site.



If your company was insured for fire damage, what kind of recovery would you expect?



That all depends on what your coverage was, so you'd have to talk to your insurance carrier. Those photos you take and the other documentation you have about your building, your equipment, and other assets will be the key to obtaining the maximum insurance recovery possible. The other coverage you may have is business interruption insurance, which pays you for the weeks or months when your business is closed or your revenues reduced due to the disaster.



It's my sense that many small businesses do not have business interruption insurance, which is not inexpensive. If they don't have that coverage, their income will obviously be down for a certain period of time, and their tax payments -- if they're paying quarterly -- can be lowered accordingly. If a spouse is working outside the business, one consideration might be to have the spouse reduce his or her income tax withholding to bring more money in. This could work out because if you file a joint income tax return, it's likely that the overall household tax liability will be lower.



What are the tax implications for businesses hit by major disasters?



Tax law considers a compensated casualty to be treated the same as a sale of the assets you lost. So if I had a sandwich shop with counters, slicing machines, and refrigerators as my assets, and I get burned out and my insurance company writes me a check for the fair market value or the replacement value of those assets, the tax law regards that as a sale of the assets.



So an insurance reimbursement payment would be counted as income?



Only if you don't reinvest that money. If you use it to purchase new or used equipment to get your business running again, there's no tax due because you are rebuilding your company. But say I was tired of running that sandwich shop, and maybe this fire was just what I needed. In that case, if I got insurance money and kept it instead of using it to reopen the shop, I'd have a taxable event.



How much would be taxed?



You'd compare how much you got from the insurance company with what your cost basis for that equipment was when you lost it. It depends on what kind of depreciation deduction you've taken on the asset since you purchased it. The depreciation deduction reduces the cost basis of the asset dollar for dollar. New rules allow small businesses to deduct $100,000-plus each year for the cost of new equipment that they've purchased that year. So, back to my sandwich shop: If I had spent $100,000 for equipment and taken the deduction for that entire amount in the first year, my cost basis would be zero. If I got an $85,000 check from my insurance company as the replacement value of the equipment, that entire $85,000 would be counted as income.



But again, if I use that money to buy new equipment, there's no taxable income to report. Just make sure that you document the purchases. If you're audited, as with anything else, you'll have to produce your receipts to show how you spent that money.



Even if businesses are able to reopen reasonably soon after disasters, it's likely that many of their local customers won't be around or won't be spending as much money as they used to. What are the tax issues there?



If you've got an overall casualty loss even after your insurance pays out, you can claim that loss on your tax return. Now, there's a special rule that applies in the case of a Presidentially declared disaster, which we had here in Southern California. In that case, people will have the choice to claim that loss either on their 2007 return, or they can file an amended 2006 return and claim the casualty loss as if it occurred in the 2006 tax year. That way, they can get an immediate tax refund to build their businesses instead of waiting to file next spring.



That rule is fairly complicated, however, because you'll need to analyze your income for both years and make sure you're claiming the loss in the year that will get you the best refund. So I'd recommend that any small business owners ask their accountants to help them work out that formula. And, of course, the sad thing is that a lot of small businesses never recover from something this devastating. Even if the building isn't burned out, customers relocate temporarily or permanently, and employees scatter. They may have to take new jobs in other areas just to make ends meet. So in addition to losing your physical assets and premises, you've also typically lost many of your customers and employees. That's tough to overcome.



If they are fortunate enough to survive, what advice would you give them -- and other small business owners -- about preparing for future disasters?



Update your inventory annually and make a list of your company's assets and possessions so you can estimate their value for insurance or tax purposes. Be specific: Include model and serial numbers, and take those photos we talked about earlier. Don't forget to photograph your property's exterior, your vehicles, the contents of your office space, closets, and storage spaces. Store this inventory list in a safe place away from your business, such as a safe deposit box at a bank located away from disaster prone areas.



Definitely back up your computer data to an off-site server or to disks that you store away from your business premises. These days, the most valuable assets many of our small businesses have are not their physical property, but their business data, intellectual property, customer lists, and those other intangibles.



What additional resources would you recommend?



The disaster relief section on the IRS Web site has tons of information about tax relief in the event of disasters, including publications, FAQs, and memos. I think that would be helpful for a lot of business owners.