Tax insurance has emerged as a cornerstone of corporate tax risk management. Whether companies use it to protect the outcome of a complex M&A transaction, to backstop the eligibility of a tax credit transfer, or to mitigate the risks of an uncertain deduction, tax insurance plays an increasingly vital role in how tax directors structure transactions and manage downside exposure.
But as the use of tax insurance grows, so does the need to address a foundational question: Are the proceeds from a tax insurance policy taxable? This might seem like a narrow technical issue, but the answer has implications for financial reporting, structuring, and policy drafting. As of this writing, the Internal Revenue Service has offered no definitive guidance. In the absence of clear authority, the best approach is to rely on general tax principles, practical analogies, and careful structuring.
The Starting Point: What Do the Proceeds Replace?
The taxability of insurance proceeds under the Internal Revenue Code typically hinges on what the payment is intended to replace. If the proceeds substitute for income that would have been taxable, such as lost profits, rental income, or a disallowed deduction, they are generally includible in gross income under IRC Section 61. On the other hand, if the proceeds simply restore a loss of capital or reimburse a cost that was deductible, they are often tax-neutral, either because they are a nontaxable replacement of a lost asset or because they are offset by corresponding expense deductions.
In the case of tax insurance, the recovery is triggered by the resolution of a dispute with the tax authority whereby the taxpayer owes more tax than it had initially reported on its tax return. This situation can result from a successful IRS challenge to a purported tax-exempt or tax-deferred transaction or from a successful disallowance of a previously claimed tax benefit, such as a tax credit or deduction. What complicates things is that the loss in the form of additional tax liability is not deductible, given that income taxes are not deductible in calculating taxable income.
The IRS could take the position that the proceeds are includible in gross income, under the reasoning that the insurance payout restores an economic cost, that is, a nondeductible tax payment. Because the tax payment itself does not generate a deduction, the insurance recovery does not offset a loss that would otherwise reduce taxable income. Instead, the insurance recovery restores cash that the taxpayer had to remit to the government and, in doing so, functions as an economic benefit, an accession to wealth, which is the broad standard for gross income under Section 61.
The courts have not tested this argument directly, and no revenue ruling has addressed it. But it is widely acknowledged as the IRS’ strongest potential theory for asserting taxability.
Key Exceptions: Underpayment Interest, State and Local Taxes, and Defense Costs
For corporate taxpayers, one notable carve-out exists when the insured loss involves underpayment interest. When the IRS assesses interest on a taxpayer due to a disallowed tax position, that interest is generally deductible as a business expense under Section 163. If the policy reimburses the interest, the interest deduction offsets the inclusion from the insurance recovery. The net federal income tax impact is therefore neutral in substance, and these interest-related proceeds typically do not require further adjustment beyond the corresponding deduction.
A similar result can apply where the insured loss covers state and local tax (SALT) liabilities. For corporate taxpayers, state and local income and franchise taxes are generally deductible for federal income tax purposes (typically under Section 164, and in some cases under Section 162 for non-income-based taxes such as certain gross-receipts or franchise-measured liabilities). If a tax insurance policy reimburses a state or local tax that the taxpayer deducts federally, the federal deduction for that tax offsets the recovery. In effect, the proceeds are included in income, but the deduction for the underlying state or local tax produces a neutral net result for federal income tax purposes.
There are two practical nuances to monitor. First, timing: for accrual-method taxpayers, the deduction for SALT may arise in a different taxable year from the insurance recovery (economic performance for taxes generally occurs when paid), which can create a temporary mismatch even if the net result is neutral over time. Second, in noncorporate contexts, individuals are subject to the Section 164(b)(6) SALT cap, and pass-through owners may rely on pass-through entity tax elections to preserve a federal deduction at the entity level. In those cases, the ability to achieve net neutrality depends on the taxpayer’s facts, including whether the state tax is in fact deductible in the relevant year and at the relevant level.
Another instance of tax neutrality involves coverage for an insured’s external costs (for example, legal fees) incurred in defending the dispute. Unlike insurance proceeds relating to the underlying taxes, interest, and penalties, which are generally paid only upon the resolution of a tax dispute, insurance payments for defense costs are made periodically (say, monthly or quarterly) as the costs are incurred. These costs are generally covered regardless of the outcome of the related tax dispute. Insurance payments in relation to defense costs (similar to payments for interest and SALT) are effectively tax-neutral since they reimburse for a business expense for which a deduction was or will be claimed.
The Transferable Credit Market: Applying the Theory
Nowhere is the question of taxability more practically significant than in the context of tax credit transfers under Section 6418. In these transactions, credits are often sold at a discount—a $10 million credit is purchased for $9 million—and the buyer takes the position that it may use the full $10 million to offset its tax liability. If the IRS later disallows the credit or finds that the buyer was ineligible to claim it, the tax liability increases, and the buyer turns to its insurance policy for reimbursement. The taxability of the insurance proceeds in this scenario depends heavily on how the transaction was initially structured and what the insurance recovery is deemed to represent.
If the insurance proceeds merely reimburse for the $9 million purchase price, that is, the out-of-pocket cost the buyer incurred to acquire the credit, many practitioners argue the recovery should be nontaxable. The taxpayer has effectively suffered a loss and is being made whole for that loss. The tax insurance payment should therefore be viewed as a tax-free return of capital. On the other hand, if the insurance proceeds exceed the original investment, such as where the buyer is reimbursed for the full $10 million of credit value, the IRS could argue that the excess $1 million constitutes a taxable gain, since it restores a lost benefit that was never paid for.
Similarly, in situations involving credit recapture, such as those triggered under Section 50(b)(3) for investment tax credits (ITCs), the proceeds may be treated differently depending on the nature of the risk being covered. If the recovery replaces a tax benefit that was previously realized and then clawed back, and if that clawback leads to a nondeductible tax payment, then the recovery might be viewed as taxable. However, if the proceeds are structured as indemnification for a contractual obligation to a buyer, or if they restore a lost basis or investment value, they may be excluded from income. Ultimately, the distinction comes down to whether the recovery relates to a deductible cost, a restoration of capital, or a nondeductible tax obligation.
Consider, for example, a corporate buyer that acquires $100 million of transferable credits for $90 million and obtains a tax insurance policy covering credit disallowance, underpayment interest, and related defense costs with a policy limit of 120 percent of the credits, or $120 million. Two years later, the IRS disallows the credits. The buyer pays $100 million in additional tax, $2 million in underpayment interest, and $1 million in covered defense costs, and the insurer accepts the claim.
The recovery is paid in multiple parts:
- The $90 million that reimburses the purchase price restores a capital outlay that was deducted as a loss when the credits were disallowed and is generally viewed as nontaxable;
- The $10 million “spread” recovery compensates the buyer for a nondeductible tax liability and is typically treated as taxable income under Section 61;
- The $2 million for underpayment interest is offset by a corresponding Section 163 interest deduction, making it tax-neutral; and
- The taxability of the $1 million reimbursement for professional fees expended to defend the IRS challenge depends on whether those underlying fees would have been deductible under the ordinary and necessary expense standard—if the fees would be deductible, the insurance proceeds are taxable.
REITs and the Income Test Challenge
Taxability questions become even more sensitive in the context of real estate investment trusts (REITs). REITs must satisfy two key income tests: at least seventy-five percent of their gross income must come from real estate sources such as rents from real property, and at least ninety-five percent must come from passive sources, including rents, interest, and dividends. If insurance proceeds are treated as falling outside of these categories, they could threaten the REIT’s qualification status.
Because the IRS has not formally opined on whether tax insurance proceeds qualify as “good” income under these tests, REITs have had to rely on analogies to other forms of recovery. Notably, in two recent private letter rulings, PLRs 202335004 and 202335005, the IRS exercised its discretion to exclude certain insurance proceeds, such as those from directors and officers (D&O) coverage, from disqualified income for purposes of the REIT income tests. Although those rulings are helpful, they are not binding precedent and do not expressly address tax insurance.
As a result, many REITs have taken a conservative approach: rather than housing the insurance policy at the REIT level, they purchase coverage through a taxable REIT subsidiary (TRS). The TRS can receive the proceeds without triggering any risk under the seventy-five percent or ninety-five percent income tests. This approach, however, comes with its own limitation: no more than twenty percent of the REIT’s total assets can be held in TRS entities. A large insurance recovery could inflate the balance sheet of the TRS, inadvertently pushing the REIT over the asset cap. Nonetheless, this structure is widely viewed as the most reliable way to avoid an income-test failure.
For example, consider a REIT that holds a diversified portfolio of commercial real estate and wants to hedge against the risk of state-level property tax reassessments. Even if the policy covers a real estate–related cost, the REIT may choose to place the policy in a TRS. That way, if a large insurance payout occurs, the REIT won’t have to argue that the proceeds are passive or real estate income. It will simply report the recovery through the TRS and avoid jeopardizing its qualification tests. This “belt-and-suspenders” strategy has become the default among REIT sponsors.
Practical Observations From the Field
In real-world transactions, managing the potential tax consequences of insurance proceeds requires both thoughtful structuring and careful policy negotiation. When a risk exists that proceeds may be treated as taxable, such as when they reimburse a nondeductible tax payment, it is important to negotiate after-tax protection. This step typically involves defining the covered loss to include any taxes imposed on the recovery, along with related interest and penalties, so that the insured is made whole on a net after-tax basis.
Where gross-up protection is unfeasible or limited, structural techniques can reduce the risk of inclusion or other negative consequences. These might include placing the policy in a blocker entity, a taxable subsidiary of a REIT, or in the seller entity in a credit transfer transaction. In some situations, it may also be appropriate to include the taxability of the proceeds themselves as a covered tax position under the policy. Doing so allows any resulting tax burden to be addressed as part of the insured loss rather than as leakage to the insured.
A Side Note on Premium Deductibility
Although this article focuses on the taxability of proceeds, taxpayers often ask whether premiums for tax insurance are deductible. In a 2020 Chief Counsel memorandum (CCM 202050015), the IRS concluded that premiums a partnership pays for a policy to protect partners against a potential reduction in a partnership charitable contribution deduction are not deductible under Section 162 or Section 212 because the policy relates to protecting a charitable deduction (a partner pass-through item) that lacks a sufficient nexus to a trade or business and bears no proximate relation to producing or collecting income or to managing income-producing property. This could be interpreted favorably in that if the policy relates to protection of a partnership deductible item, the premiums would be deductible. However, the memorandum also noted, in passing, that the policy effectively backstopped federal income tax, a nondeductible outlay under Section 275. This last argument for nondeductibility, which is based on the nondeductible nature of the underlying taxes being insured, could be viewed as reinforcing the rationale discussed above for treating tax insurance proceeds as taxable.
Final Thoughts
The tax treatment of insurance proceeds ultimately comes down to the following question: Does the insurance recovery compensate for either the loss of an asset or an expense that would be deductible? If the answer is yes, the proceeds are generally excluded from income. If the answer is no, especially in cases where the recovery restores a nondeductible tax liability, the IRS has an argument that the proceeds are taxable under Section 61.
Although there is no bright-line rule and little in the way of direct IRS guidance, the legal principles are well established. For business tax directors, the key lies in careful planning, clear structuring, and well-supported reporting positions. In a world where tax insurance continues to evolve and where audits of transferable credits are likely to increase, the importance of understanding and defending the taxability of recoveries is only growing.
Barry Sklar is a partner at Birch Risk Advisors, where he leads the firm’s efforts in tax insurance placement and complex transactional structuring. Bill Kellogg is managing director and head of US tax insurance at Birch Risk Advisors, responsible for driving the firm’s tax insurance strategy, underwriting relationships, and client execution.
