Insurance Proceeds

Insurance proceeds are benefit proceeds paid out by any type of insurance policy as a result of a claim. Insurance proceeds are paid out once a claim has been verified, and financially indemnify the insured for a loss that is covered under the policy. Insurance proceeds are sometimes paid directly to a care provider (as with health insurance), but usually, it is sent to the insured in the form of a check.

Insurance proceeds require some specific accounting procedures.

For example, if an insurance company pays for the loss, an accountant should record the full amount of the insurance proceeds and the full amount of the loss. Here's how it works...consider a fire that destroys $15,000 of inventory that belongs to Company X. Since the insurance company covers the entire loss, the first entry is a $15,000 debit to fire damage, and a $15,000 credit to inventory to remove the inventory from your accounting books. The second entry is a $15,000 debit to cash-fire damage reimbursement, and a $15,000 credit to fire damage. This procedure zeroes out the amount of the fire damage loss on Company X's books.

Based on the amount of the insurance proceeds, a person may have a gain or loss. For example, if $10,000 of inventory is damaged in a fire and the proceeds are $7,000, the transaction should be recorded as a $7,000 debit to cash-fire damage reimbursement, a $3,000 debit to loss on insurance proceeds, and a $10,000 credit to inventory. If the proceeds check is larger than the loss, the surplus is recorded as a gain. If $10,000 of inventory is damaged, and the insurance proceeds are $12,000, record the transaction as a $12,000 debit to cash-fire damage reimbursement, a $10,000 credit to inventory and a $2,000 credit to gain on insurance proceeds.

Insurance proceeds are tax-free in most cases, regardless of the type of insurance or policy. One exception is disability insurance, which is taxable to the insured as income if the insured used pretax income to pay premiums. Another is when a homeowner receives insurance proceeds for a damaged or destroyed home that exceed the property's adjusted basis. In this case, the profit is taxed as a capital gain unless a replacement property is purchased within the specified period of time.

Usually, when a person receives insurance proceeds from a life insurance policy due to the death of the insured person, the payout isn't taxable, and you aren't required to report it as income. However, interest income is taxable and reportable as interest received. 

If a life insurance policy was transferred to you for cash or other valuable consideration, the insurance proceeds exclusion is limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts. Some exceptions apply to this rule, but generally, you report the taxable amount based on the type of income document you receive.