Every business should have adequate insurance in the event of fire, flood or other catastrophe.  To this end, you may acquire “business interruption insurance” to compensate the company for lost profits while you’re closed.

Hopefully, you won’t need to collect on these policies.  But it’s far better to be safe than sorry.

Strategy: Consider the tax implications of business insurance.  You might want to adjust your policies –or obtain new ones—to ensure that you are maximizing the tax benefits.

Insurance proceeds that compensate your business for lost income are generally treated as income subject to federal income tax.  “Lost income” may include compensation for services already performed by the businesses as well as profits that were anticipated but never realized.

On the other hand, the IRS exempts certain types of insurance proceeds from tax.  Under a special section of the tax code—Section 1033—you can avoid paying tax on insurance proceeds received because of property damage by reinvesting in replacement property.  For this purpose, “property damage” includes theft, seizure and condemnation.

Pay close attention to the fine print in your policies to strengthen your tax position.  Remember that it’s better tax wise to have property characterized as “replacement property” rather than “payment attributable to profits.”

Here are a few helpful hints for obtaining the best tax results:

• The policies should specifically provide “loss of value” coverage to the extent that your business assets may lose some of their value.
• The policy should pay benefits on a flat per diem basis without any mention of profits or fixed-business charges if you insure additional potential losses. The per diem amount can be adjusted for inflation.
• The policies should not refer to historic profits or be limited by those profits in any way.

If you follow these suggestions, you may avoid having your insurance profits recast by the IRS as taxable income.  That way, you will be able to rely on the full amount of proceeds to reinvest in replacement property.