Tax benefits of IRC Sec. 165.

The deduction for theft losses related to nonbusiness, for-profit transactions is one of the best-kept Internal Revenue Code secrets--and a tool that tax professionals can use to provide significant tax relief for their injured investor or taxpayer clients.

SEC. 165: THE MISUNDERSTOOD DEDUCTION

Numerous technical requirements must be met before a taxpayer's loss qualifies for Sec. 165 treatment. And in most instances, tax preparation software does not adequately address this deduction.

Sec. 165 permits advantageous tax treatment as compared to the familiar Sec. 1211 capital loss treatments, which could result in your client paying more taxes than required.

Audit-sensitive tax preparers and taxpayers may be apprehensive about taking this deduction. A loss that qualifies for tax treatment under Sec. 165 frequently qualifies for a large deduction. This may result in a large refund or eliminate taxable income for years to come. Claiming a large deduction or eliminating taxable income sometimes triggers IRS over-sight. For this reason alone, you may be reluctant to use this tax treatment.

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Because clients may not realize that their investment loss was the result of fraud, you should ask about the nature of large investment losses. If you review the client's portfolio and see indications of fraudulent investments or unethical sales practices, advise your client to discuss it with a lawyer. If the lawyer feels there was malfeasance, the client's unrecoverable loss probably qualifies for tax treatment under Sec. 165.

Other losses that may qualify for Sec. 165 treatment include embezzlement, blackmail, kidnapping for ransom, burglary, larceny, extortion and threats.

THEFT LOSS VS. CAPITAL LOSS

A Sec. 165 theft-loss deduction can be more advantageous than a mere capital loss:

* A theft-loss deduction is an ordinary deduction that is not subject to the limitations imposed by Sec. 1211.

* A theft-loss deduction is not a miscellaneous itemized deduction subject to the 2 percent floor imposed by secs. 67(a) and 67(b)3.

* A theft loss is excluded from the phase-out of itemized deductions required by Sec. 68(b).

* A theft loss that exceeds a taxpayer's gross income gives rise to a net operating loss that is not subject to the limitation imposed on nonbusiness deductions of individual taxpayers [Sec. 172(d)(4)(C)]. A net operating loss resulting from a theft loss may be carried back three years or carried forward for 20 years [Sec. 172(b)(1)(A) and 172(b)(1)(F)].

* A theft loss can be used to reduce a taxpayer's tax liability to zero without resulting in any liability for alternative minimum tax [Sec. 56(b)(1)(A)(i) and 67(b)(3)].

Basically, capital losses are used first to offset capital gains. If there are no capital gains, or if the capital losses are larger than the capital gains, the capital loss can be deducted against other income, limited to $3,000 in one year. If the capital loss exceeds the capital gains and the $3,000 deduction against income, the excess capital loss carries over to the next year.

The opportunities available under Sec. 165 may far exceed those available under Sec. 1211. Why would a higher tax-bracketed taxpayer want to match a capital loss against a capital gain, which is taxed at a maximum of 15 percent, instead of reducing their ordinary income, which may be taxed at a much higher rate?

A taxpayer who claims a theft-loss deduction must first establish that the loss resulted from theft. The definition of "theft" for federal income tax purposes is found in Edwards v. Bromberg, 232 F. 2d 107 (5th Cir. 1956), where the court defined it as a word of general and broad connotation, intended to cover any criminal appropriation of another's property to the use of the taker, particularly including theft by swindling, false pretenses and any other form of guile.

The court also stated that whether or not a loss from theft occurred depends upon the law of the jurisdiction where it was sustained and the exact nature of the crime. As long as it amounts to theft in the state where the loss is sustained, Sec. 165 is applicable. It is of little importance whether it was larceny, embezzlement, obtaining money under false pretenses, swindling or other wrongful deprivations of the property of another.

RECOGNIZING FRAUD

What constitutes theft and what evidence supports criminal intent under Sec. 165 is an extensive and complicated topic.

For Sec. 165 to be applicable, there must be a specific intent to defraud. The taxpayer needs to have purchased the investment from the person or agent of the seller, or entity who made the misrepresentations or committed the malfeasance. If the client simply engages in a standard open-market transaction, such as purchasing a publicly traded security, and there was no criminal intent, it probably does not qualify for the theft-loss deduction.

In the case of a standard open-market transaction, where a loss is a result of an illegal act by management, the seller would have to have been privy to the fraudulent nature of the investment for the transaction to be executed with criminal intent. If a broker makes reckless statements, circulates half-truths, false opinions or predictions, then the transaction may qualify for this treatment.

If a broker recommends the purchase, sale or exchange of any security, that broker generally is required to have reasonable grounds for believing that the recommendation is appropriate for that client. If a broker makes an unsuitable recommendation and the client suffers a loss, that loss also may qualify for Sec. 165, depending on the laws in the jurisdiction.

DEDUCTION LIMITED TO TAX BASIS OF INVESTMENT

The theft-loss deduction is limited to the tax basis of the investment, which is generally the amount of the investment in a property, minus previous write-offs, depreciation, amortization or depletion, plus any commissions or transaction costs. In certain cases, the loss in value of the account qualifies for the Sec. 165 deduction, and the loss amount is not predicated on the individual transactions.

Several authorities support the position that a taxpayer does not have any tax basis in qualified retirement plan assets, such as an IRA or 401(k). This is because the Employee Retirement Income Security Act of 1974 established that a taxpayer has a zero basis in a traditional IRA because no taxes were previously paid on either the contributions or earnings. It can be assumed that Congressional intent behind the Sec. 165 deduction was to return the taxes paid on the income with which the investment was purchased. If taxes were not paid on the income used to purchase the investment, then providing a deduction would not meet Congressional intent.

YEAR OF DISCOVERY

A loss attributable to theft is deductible in the year when it is discovered by the taxpayer. This may result in the extension of the statute of limitations for a taxpayer who discovers a loss and then a year or more later learns that the loss was due to theft. The reason for this exception is to prevent the statute of limitations from voiding the taxpayer's ability to take this deduction.

Many times the actual theft will occur several years prior to its discovery. Income tax regulations require that to take a deduction under Sec. 165(a), a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and with certain exceptions, actually sustained during the taxable year [Treas. Reg. 1.165-1(d)(1)].

If in the year of discovery there exists a claim for reimbursement, and there is a reasonable prospect of recovery, that portion of the loss for which there is a reasonable chance of recovery is not deductible under Sec. 165. Those 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, you must wait for the year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received [Treas. Reg. 1.165-1(d)(3)].

If it is determined that there is no reasonable prospect of recovery, then the loss is sustained under Sec. 165. If the client claimed a loss under Sec. 165 and the reimbursement exceeds what was estimated, that portion of the reimbursement, which was previously deducted using Sec. 165 treatment, will be treated as ordinary income for tax purposes. The reimbursement that exceeds the adjusted basis will be treated as a capital gain.

Sec. 165(c)(2), as it relates to for-profit, nonbusiness transactions, has many nuances that CPAs need to understand to better serve their clients.

RELATED ARTICLE: Fraud Qualifying for Sec. 165

Highly Margined, Over-Concentrated Portfolio

Mr. Worker was directed by Employer Corp. to exercise his employee stock options through Brokerage House Corp., the plan administrator for Employer Corp. Since the funds to exercise the options and pay the taxes due were provided by margining the stock in Brokerage House Corp.'s Option Financing Program, Mr. Worker was told that he would have no money out of his pocket.

Mr. Broker recommended to Mr. Worker that he use a strategy known as "exercise and hold." This created a highly margined, over-concentrated portfolio that was not suitable considering Mr. Worker's financial situation or goals. Mr. Broker failed to advise Mr. Worker of the risks of using margin and lack of diversification in his portfolio. Brokerage House Corp. had an investment banking relationship with Employee Corp., in which Employee Corp. indicated that they didn't want their employees' stock, from exercised options, flooding the market. The price of Employer Corp.'s stock fell dramatically and Mr. Worker lost his money. Mr. Worker claimed that his loss was the result of unsuitability and omission of fact.

Diverted Funds

Ms. Investor was solicited by Mr. Salesman, a salesperson with Viatical Financial Network. Viatical Financial Network supposedly was in the business of buying life-insurance policies from the terminally ill at a discount from their face value. Ms. Investor was told that she could expect a 15-percent yield. Viatical settlements provide terminally ill individuals with access to the proceeds of their life insurance policies prior to their death, while at the same time providing an attractive return for the investor. Ms. Investor was looking for safety, with little risk, when she invested in these viatical settlements. Ms. Investor was assured that there would be no risk to her principal. The owner of Viatical Financial Network diverted Ms. Investor's money to his own personal use and made other unauthorized investments.

A Ponzi Scheme 

Mr. Perpetrator, a financial adviser with Cash for Titles, solicited Mr. Victim to invest in the unregistered securities of Cash for Titles. The client's loss was stated to be the result of misappropriation. The SEC obtained temporary restraining orders and asset freezes against the various principals that operated Cash for Titles. Virtually all of the proceeds from the sale of the securities were used for improper and undisclosed purposes. The SEC has alleged that the defendants raised money in a multi-level marketing scheme that sold notes and bonds as part of a massive Ponzi scheme. Mr. Perpetrator since has pled guilty to conspiracy, securities fraud and international money laundering and has been sentenced to more than 10 years in prison for his involvement with Cash for Titles.

BY BART H. SIEGEL, CPA, CFP, CFE, CGFM 

Bart H. Siegel, CPA, CFP, CFE, CGFM is an independent investment and tax expert retained by JK Harris 165 Services, LLC, a national company specializing in substantiating investment theft losses. You can reach him at [e-mail] or by visiting www.growthportfolio.com.