nvestment theft losses that result from nonbusiness, for-profit transactions may qualify for advantageous tax treatment. When a client is the victim of fraud or embezzlement, for example, CPAs can reduce the client’s ordinary income, recoup any previously paid taxes and minimize future tax obligations by using IRC section 165(c)(2).
Be aware that CPAs who prepare and defend an investment loss deduction under IRC section 165(c)(2) must meet numerous technical requirements and make certain determinations based on examining the circumstances. Section 165(c)(2) deductions also frequently prompt IRS oversight, and in many instances, the standard tax preparation software does not adequately address this deduction, since it’s generally geared to the more familiar section 1211 capital loss treatment. But while section 1211 is an appropriate treatment, using it may result in clients’ paying more taxes than are required.
If a client suffers an investment loss as a result of a fraudulent investment or unethical sales practice, probably the most prudent action a CPA can take, even though there is no requirement to do so, is to suggest the client first discuss it with his or her lawyer. Taxpayers are required to take reasonable action to recover a loss and not doing so disqualifies it for section 165(c)(2) treatment. If the lawyer feels there was malfeasance and it is not practical to pursue recovery due to a lack of recoverable assets, the cost of litigation or other reasons, the loss probably is deductible in the current period. Losses from embezzlement, blackmail, kidnapping for ransom, burglary, larceny, extortion and threats also may qualify for section 165 treatment.
Section 165(c)(2) theft loss deductions can be more advantageous than capital loss ones for the following reasons:
As ordinary deductions, they’re not subject to limitations imposed by IRC section 1211.
They’re not miscellaneous itemized deductions subject to the 2% floor imposed under section 67(a).
They’re excluded from the phaseout of itemized deductions required by section 68(b).
Theft losses that exceed a taxpayer’s gross income give rise to net operating losses that can be carried back three years or forward for 20 years.
They can be used to reduce a taxpayer’s tax liability to zero without resulting in any liability for alternative minimum tax (AMT).
In Edwards v. Bromberg , 232 F2d 107 (5th Cir. 1956), the court defined theft as a word of general and broad connotation, covering any criminal appropriation of another’s property by swindling, false pretenses or any other form of guile. The court also stated that whether a loss from theft occurred depended on the law of the jurisdiction where it was sustained and the exact nature of the crime. If a transaction did not amount to theft in the state where the loss was sustained, then section 165(c)(2) is not applicable.
For section 165(c)(2) to be applicable, there must be scienter , that is, requisite knowledge of the wrongness or illegality of an act. In Ottmann v. Hanger Orthopedic Group, the Fourth Circuit Court of Appeals determined that scienter could be established by pleading not only intentional misconduct, but also severe recklessness. The court further found a plaintiff must meet the “strong inference” requirement of the Private Securities Litigation Reform Act of 1995. Congress did not specify what would or would not show a strong inference of scienter , so a case-specific analysis is appropriate to determine it.
In general, the taxpayer needs to have purchased the investment from the person, or an agent of the seller, or entity that made the misrepresentation or committed the malfeasance.
In a standard open-market transaction where a loss results from an illegal act by management, the seller must have been aware of the fraudulent nature of the investment for there to be criminal intent. The transaction may qualify for this treatment if a broker makes reckless statements or circulates half-truths, false opinions or predictions. If a broker recommends the purchase, sale or exchange of any security, he or she generally is required to have reasonable grounds for believing that recommendation is appropriate for that client.
If money was invested for a specified use but used for another or unauthorized use, that loss also may qualify for section 165(c)(2) tax treatment.
The theft loss deduction is limited to the tax basis of the investment. This generally is the amount of investment in a property minus previous write-offs, depreciation, amortization or depletion, plus any commissions or transaction costs. In certain cases it is the loss in value of the account that qualifies for the section 165 deduction.
According to several authorities, a taxpayer does not have any tax basis in qualified retirement plan assets such as IRAs or 401(k)s because the Employee Retirement Income Security Act of 1974 established a taxpayer has zero basis in a traditional IRA because no taxes were paid on either the contributions or earnings.
A theft loss is deductible in the year it is discovered by the taxpayer. This may result in an extension of the statute of limitations for a taxpayer who discovers a loss several years after the actual theft. This exception prevents the statute of limitations from voiding the taxpayer’s ability to take this deduction. Section 165(a) requires that a loss must be evidenced by closed and completed transactions, fixed by identifiable events and, with certain exceptions, actually sustained during the taxable year.
If, in the year of discovery, there exists a claim for reimbursement with a reasonable prospect of recovery, that portion of the loss is not deductible under section 165(c)(2). The regulations further provide that “whether a reasonable prospect of recovery exists with respect to a claim for reimbursement of a loss is a question of fact to be determined upon an examination of all facts and circumstances.” Therefore, the taxpayer must wait for the year in which it can be ascertained with reasonable certainty whether such reimbursement will be received.
If the client claimed a loss under section 165(c)(2) and the reimbursement exceeded what was estimated, the portion of the reimbursement that was previously deducted using section 165 treatment would be treated as ordinary income for tax purposes.
There often are significant benefits to using section 165(c)(2) vs. section 1211 treatment for investment theft losses related to nonbusiness, for-profit transactions. Although it can be burdensome, section 165(c)(2) treatment is worth consideration.
BART H. SIEGEL, CPA/PFS, is an independent investment and tax consultant retained by JK Harris 165 Services LLC, which specializes in substantiating investment theft losses. His e-mail address is firstname.lastname@example.org .