New Wildfire Relief Payment Exclusion
This provision is more complex than you may think
Congress passed, and President Biden will soon sign, the Federal Disaster Tax Relief Act of 2023 (H.R. 5863). There are three provisions; they were not placed in the Internal Revenue Code text, so they exist only in the text of the law:
Sec. 2, Extension of rules for treatment of certain disaster-related personal casualty losses
Sec. 3, Exclusion from gross income for compensation for losses or damages resulting from certain wildfires
Sec. 4, East Palestine disaster relief payments
Overview of Wildfire Provision
Sec. 3(a) states that a qualified wildfire relief payment is excluded from an individual’s income. The exclusion applies to qualified wildfire relief payments received by an individual during tax years beginning after December 31, 2019, and before January 1, 2026 (i.e., calendar years 2020 through 2025).
Sec. 3(b)(1) defines a qualified wildfire relief payment as follows:
The term “qualified wildfire relief payment” means any amount received by or on behalf of an individual as compensation for losses, expenses, or damages (including compensation for additional living expenses, lost wages (other than compensation for lost wages paid by the employer which would have otherwise paid such wages), personal injury, death, or emotional distress) incurred as a result of a qualified wildfire disaster, but only to the extent the losses, expenses, or damages compensated by such payment are not compensated for by insurance or otherwise.
A qualified wildfire disaster is any federally declared disaster (as defined in §165(i)(5)(A)) declared after December 31, 2014, as a result of any forest or range fire.
The exclusion does not apply to payments received for losses, expenses, or damages already compensated from another source, such as insurance or §139 qualified disaster relief payments. In addition, the payment must be compensatory in nature for losses, expenses, or damages; therefore, payments akin to punitive damages do not qualify for the exclusion.
No Double Benefit
If an amount is excluded as a qualified wildfire relief payment, there are two restrictions on the excluded amounts:
No deduction or credit is allowed for any amount compensated for by a qualified wildfire relief payment, and
No increase in the basis or adjusted basis of property is allowed from a qualified wildfire relief payment with respect to such property.
Refund Statute Relief
For timely filed 2020 Form 1040s, the refund statute of limitations has expired unless an individual made payments on that tax period within the prior two years. In addition, for timely filed 2021 Form 1040s, the refund statute of limitations expires in 2025 unless an individual made payments on that tax period within the prior two years.
Sec. 3(e) states that the refund statute of limitations end date with respect to a refund allocable to the exclusion will not end any earlier than the date one year after the law’s enactment date (which is the date the President signs it). Thus, all refund claims allocable to this exclusion for tax years 2020 and 2021 will be timely through a date in December 2025 to be determined; some may go beyond that depending on the facts and circumstances related to that tax period.
Usually, the refund amount is limited to the amount paid in the prior two-year or three-year period (depending on what provision the claim is timely). For all refund claims allocable to this exclusion, this lookback limitation does not apply; therefore, provided a claim is timely filed, the full refund is eligible to be paid out.
Important Issues
Can estates and trusts qualify? In §7701(a)(1), the definition of a person clearly distinguishes individuals from estates and trusts:
The term “person” shall be construed to mean and include an individual, a trust, estate, partnership, association, company or corporation.
However, a qualified wildfire relief payment is “any amount received by or on behalf of an individual” (emphasis added). This likely opens the door to the exclusion of certain payments made to estates and trusts.
Can sole proprietors qualify? Sole proprietors are individuals, but partnerships and corporations are not. In Rev. Rul. 2005-46, the IRS implied that a sole proprietor could qualify for §139 qualified disaster relief payments, which are also limited to individuals.
X [a corporation] may not exclude the grant payment from gross income under §139 because that exclusion applies only to individuals. Even if X's business were a sole proprietorship or the disaster were a qualified disaster under §139, the grant payments would not qualify for exclusion from gross income under §139 because the grant payments are not made for any of the specific purposes described in §139(b)(1), (2), and (4).
What is the treatment of related legal fees? Legal fees allocable to tax-exempt income are nondeductible. See §265(a)(1). Legal fees for the production of income are 2% miscellaneous itemized deductions and are currently federally suspended through tax year 2025; however, some states allow the deduction.
Is this provision only applicable to California wildfires? No. The provision applies to any qualified wildfire disaster as defined previously.
Next Steps
If you have clients entitled to refunds due to this provision from previously filed returns or can exclude amounts received in 2024 on returns to be filed for this upcoming season, I suggest waiting to see what guidance the IRS releases regarding this new exclusion. A special procedure for amended or original returns claiming the exclusion may be announced.
If the refund would otherwise be time-barred but for the refund statutes of limitations relief provided by the provision, I recommend waiting for IRS guidance. If that guidance does not come, it will be essential to explain on the amended return why the claim is timely and not subject to the lookback limitation; the IRS is notorious for denying refund claims as untimely that are timely filed and proper.
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