Tax consequences to investors of broker fraud and theft: there are a number of ways tax advisers can help clients who are victims of investment fraud or theft. This article discusses the tax issues faced when trying to recoup some of the loss.

EXECUTIVE SUMMARY

* Investment may deduct as a theft loss stolen investment funds in the year the theft is discovered, to the extent there is no reasonable prospect of recovery.

* If a broker has falsely reported gains on stolen investments, the taxpayer should file protective refund claims before the SOL runs.

* Legal fees incurred to recover investment theft losses are deductible theft losses or ordinary business or production-of-income expenses.

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Fraud or theft by an investment adviser or broker is relatively uncommon. However, if it occurs, it can have a devastating effect on a client. Tax advisers can assist their aggrieved clients by making the most of the tax rules and acting quickly to preserve available refund opportunities. Practitioners also have professional obligations under such circumstances. This article addresses issues faced by investors and their tax advisers, including:

1. Applicable theft loss rules.

2. Refund claims for phantom gains and the statute of limitations (SOL).

3. Deductibility and inclusion in income of legal fees incurred to recoup theft losses.

4. Standards governing the provision of tax advice.

Casualty Theft Losses

Sec. 165(c)(2) allows a deduction for a casualty loss incurred by a noncorporate taxpayer engaged in an income-producing activity. Investment fund theft would qualify as a loss for this purpose. (1) To be deductible under Sec. 165(c)(2), the loss must be "ascertained by reference to a closed and completed transaction, and fixed by an identifiable event." (2) A taxpayer must also prove that the loss resulted from a taking of property that is illegal under the laws of the state where it occurred, and that the taking was done with criminal intent. The deductible loss is limited to the lesser of the (1) property's adjusted basis or (2) difference between the property's fair market value (FMV) immediately before and after the theft. (3) Any loss deduction must be further reduced by any insurance reimbursement or other compensation received by the taxpayer for the theft loss.

Example 1: I gave $100,000 to broker B to invest in January 2000. In December 2000, B embezzled the funds from I's account. For the next five years, B provided quarterly investment statements to I outlining fictitious transactions and reporting $20,000 in capital gains on which I paid tax. In 2006, B is arrested and convicted for these financial crimes. However, B is insolvent; there is no prospect for recovery from the brokerage house and I's money is gone.

I can claim a theft loss deduction. The loss is the lesser of his adjusted basis in the investment ($100,000) or the difference in the property's FMV immediately before and after the theft. Before the theft, the FMV was $100,000; after the theft, it is zero. Thus, the deduction is limited to $100,000. However, if the brokerage account still had $25,000 of I's money in it, he would be entitled to deduct $75,000 ($100,000 adjusted basis--$25,000 restitution payment).

Under Sec. 165(e), a theft loss must be claimed in the year of discovery, regardless of the year sustained, to the extent there is no reasonable prospect of recovery. (4) The existence of a reasonable prospect of recovery postpones the deduction until the prospect no longer exists. Reasonableness is to be judged at the time of the loss (i.e., discovery), not later on the basis of hindsight. Pursuing litigation against the wrongdoer may indicate the existence of a prospect of recovery, but it will not bar the deduction in the year of discovery if the likelihood of recovery is remote. (5) Further, if the theft loss exceeds the claim for recovery, the excess is currently deductible. (6)

Example 2: I gave $100,000 to broker B to invest in 1999. In 2000, B embezzled the funds from I's account. I learned of the loss in 2005. There is no hope of recovery; B has fled the country, and the brokerage house is not liable. The loss is deductible in 2005. If, on the other hand, B was arrested and I filed suit against both B and his employer in 2005, the loss would not be deductible in that year. Rather, I would have to wait to deduct the loss until the amount of potential recovery is ascertained. If, in 2006 and during the course of litigation, it becomes evident that B spent the money and is insolvent and the brokerage house is not liable, I may deduct his loss in that year.

Once the loss's timing is ascertained, the taxpayer has to determine whether to deduct the loss above or below the line. An investment loss is deductible in computing adjusted gross income only if the (1) taxpayer is in the business of trading or dealing in securities, (2) loss results from a sale or exchange, (3) loss is attributable to rent- or royalty-producing property, (4) loss results from a penalty for premature withdrawal of certain types of financial institution deposits or (5) loss results from a mandated repayment of certain types of supplemental unemployment compensation benefits. (7) If the loss does not meet one of these criteria, it is deductible as a miscellaneous itemized deduction. Although it will not be limited by the 2% floor, it will be limited by Sec. 68 (the overall limitation on itemized deductions; i.e., the 3% phaseout).

For the average investor, a theft by a stockbroker or investment adviser will not fall within one of the categories permitting an above-the-line deduction. Thus, the investor will likely be required to take the loss as a miscellaneous itemized deduction. Under Sec. 172(d)(4)(c), the deduction for theft losses is fully allowed in computing a net operating loss carryover or carry-back. Theft losses are reported on Form 1040, Schedule A, line 27, and also on Form 4684, Casualties and Thefts.

SOLs and Protective Refunds

In recent publicized cases, brokers have engaged in elaborate embezzlement schemes. (8) After the investor's funds are taken, the broker disguises the crime by giving false investment statements to clients that report transactions and include gains and losses. As a result, the investor reports gains and losses that did not occur. Courts have held that if income and losses are reported on returns, and the purported transactions generating the gains and losses did not occur, the reported gains and losses need to be eliminated through adjustments on amended returns. (9) Thus, affected investors should file amended returns seeking refunds for taxes paid on fictitious gains erroneously reported; returns would also need to be amended for reported fictitious losses.

The theft-loss reporting problem is compounded by the SOL. For example, according to Sec. 6511, a refund claim due to a tax overpayment must be filed within three years from the time the return was required to be filed, or two years from the time the tax was paid, whichever is later. Under some elaborate embezzlement schemes, investors may have received false investment statements for many years and filed returns reporting fictitious gains and losses more than three years ago. For them, refund claims are time-barred by the SOL.

The IRS strictly adheres to the SOL; there are only narrow opportunities to extend the time to file for a refund, regardless of fraud. If a case qualifies for the mitigation provisions, then an exception is made. In Brockamp, (10) the Supreme Court held that the Sec. 6511 SOL is not subject to equitable tolling, even if the circumstances are sympathetic and it seems dear that the claimant has made a tax overpayment. However, the Code contains some SOL relief in its mitigation provisions.

Mitigation

Under Sec. 1311, to be entitled to relief under the mitigation provisions, taxpayers must show that:

1. There has been a determination of tax liability;

2. The determination falls within one of the "circumstances of adjustment" described in Sec. 1312; and

3. Depending on the circumstance of the claimed adjustment, either an inconsistent position must have been maintained by the party against whom mitigation will operate, or the occurrence of the error must not have been barred at the time the party seeking mitigation first maintained its position.

For an investor just discovering a theft loss at the hands of an investment broker, chances are no "determination has yet been made." If not, relief under the mitigation provisions is not available. (11) Even if there is a determination, it must fall within one of the Sec. 1312 "circumstances of adjustment," which include a double inclusion of an item of gross income; double allowance of a deduction or credit; double exclusion of an item of gross income; double disallowance of a deduction or credit; correlative deductions and inclusions for masts or estates; correlative deductions for certain related corporations; and adjustments to the basis of property after erroneous treatment of a prior transaction.

Ordinarily, theft or embezzlement by a broker will not result in a circumstance of adjustment. Usually, there will not be a double inclusion or deduction. More often, a transaction will be reported in a time-barred year; opening that year to recoup taxes erroneously paid may be difficult. The mitigation provisions are a vehicle to do so, but may have only limited application.

Refund Procedures

Protective refund claims: It may be prudent to file protective refund claims or incomplete claims with the IRS for tax years for which an SOL is about to expire. A protective refund claim is one filed with the IRS requesting a refund before the statute closes, which may occur if an item is in controversy for a different year or a different item is later resolved. In many brokerage fraud cases, however, the SOL may close before a taxpayer is able to determine the proper income for that year, because such information is not available from the broker. In this case, a protective refund claim is not appropriate; however, an incomplete claim (discussed below) may be helpful.

The Eleventh Circuit has articulated standards governing protective claims. In Mills, (12) it recognized that "there are no rigid guidelines except that an informal claim must have a written component and should adequately notify the IRS that a refund is sought for certain years."

The investor can file a protective refund claim with the best facts currently available on how to properly adjust capital gains and losses previously reported. However, protective claims can be risky. According to the Internal Revenue Manual, a protective claim should be based on an expected change in tax law, other legislation, regulations or case law, contingencies that prevent a full refund claim from being filed. (13) Further, the Service does not have to accept a claim as "protective" just because the taxpayer labels it as such. If an investor files a protective claim, the IRS could argue that it is not proper, as the claim is not contingent on a legislative or case law change. As a result, an incomplete claim may be a safer mechanism to preserve a refund claim.

Incomplete claims: In an incomplete claim, a taxpayer files a timely refund claim for "one dollar or any amounts legally allowable." (14) The taxpayer specifically states the legal grounds and factual basis for filing the refund claim. After the SOL expires, the taxpayer files a supplemental claim for the appropriate refund amount. As long as the supplemental claim (1) is filed before the Service takes final action on the original claim and (2) does not require an investigation of new matters not disclosed during the investigation of the original claim, it will be deemed a timely amendment to the original claim. "Final action" generally occurs when the IRS denies or allows the original claim. (15) However, disallowance of the original claim is not "final action" for these purposes if the IRS did not fully consider all the grounds for the refund. (16)

The supplemental claim must not introduce new matters that would require investigation by the Service. If new matters must be investigated, the supplemental claim will be deemed a new claim and will not be timely filed.

Once the IRS receives an incomplete claim, it will request additional information as to the actual claim amount. If the taxpayer does not provide the information in a reasonable time, the Service can take final action on the claim after fully considering all of the stated grounds for a refund. It could also determine that the refund is not processable and disallow it on the basis that the taxpayer failed to respond to the information request, or it could insist on full compliance with the refund claim regulations.

Legal Fees

Investors may incur legal expenses in an effort to recoup their loss. Three possible tax consequences result from the payment of or reimbursement for legal fees incurred as a result of a theft loss.

The Code contains no special provision permitting a deduction for legal fees. However, they may be deductible as business expenses under Sec. 162 (if the taxpayer is a trader or a dealer) or as a production-of-income expense under Sec. 212 (an itemized deduction subject to the 2% floor). If the taxpayer is not engaged in a trade or business, or the legal fees were not generated in an income-producing activity, the taxpayer may still deduct them under other statutes, including Sec. 165(c) (theft losses). If the investor pays attorneys' fees directly, he or she can deduct them as part of the theft loss under Sec. 165. The Ninth Circuit (17) held that expenses and legal fees instant to obtaining a return of property were deductible theft losses. To determine the appropriate statute under which to deduct the legal fees, the origin-of-the-claim test is applied.

Alternatively, the opposing party may pay the investor's attorneys' fees at the resolution of the suit (either by settlement or judgment). The payment of such fees by the opposing party is a payment of the investor's obligation and income to the investor. (18) It is generally inappropriate to "net" reimbursed legal fees against a taxable recovery to arrive at a reduced taxable amount, even when the taxpayer actually receives a reduced payment because attorneys' fees are paid out of the entire award. As a result, the client will include the entire taxable portion of the recovery in income (assuming it is in excess of any applicable basis of the investor's property) and deduct the legal fees in the same manner described in the paragraph above.

Alternately, the investor's attorneys' fees may be paid under a contingent fee arrangement. Until Banks, (19) differing results, based on different circuit court decisions, had occurred in contingency fee cases. It had been the IRS's view that plaintiffs must include the entire award in gross income and then deduct the fees as a miscellaneous itemized deduction. In Banks, the Supreme Court decided that the Service's view is correct. As a consequence, attorneys' fees paid on a contingency basis out of an award will be treated as a miscellaneous itemized deduction, subject to the 2% floor, the 3% phaseout and the alternative minimum tax (AMT). The American Jobs Creation Act of 2004 addressed this issue by adding Sec. 62(a)(19), allowing legal fees in contingency cases to be deductible above the line and, thus, not subject to any of these limits, but only in cases involving claims of unlawful discrimination. (20) This is of no help in broker fraud cases.

Strategy

Unfortunately, the tax rules inadequately address broker fraud. Fictitious trades are often reported and tax paid in years closed by the SOL long before the fraud is discovered. Then, taxpayers, having an expectation that their brokerage accounts are much larger than they really are, can only deduct the actual loss. Taxpayers are often faced with having paid tax on income they never had and being able to deduct only that which was actually taken.

Absent the ability to open earlier years when tax was erroneously paid under the concepts discussed above, there may be a loss of tax dollars that cannot be recouped. By acting quickly, tax advisers may be able to stop the SOL from running. The answer is to reconstruct the transactions for the years in question, find ways to open (or keep open) affected tax years and act quickly to preserve tax years by filing amended tax returns or protective refund claims.

Professional Responsibilities

Both Circular 230 (21) and the AICPA's Statements on Standards for Tax Services provide roles that govern the conduct of a CPA rendering tax advice to clients. These pronouncements clearly provide that practitioners must advise their clients to amend previous-year's returns to correct capital gains and losses erroneously reported due to false information. Circular 230, Section 10.21, provides that a CPA, who knows that a client has not complied with the Code or has made an error in, or omission from, any return or other paper that the client is required by law to execute, must properly advise the client of such noncompliance, error or omission. Under Circular 230, Section 10.22, CPAs must exercise due diligence as to (1) preparing or assisting in the preparation of filing returns, documents or other papers relating to IRS matters; (2) determining the correctness of their oral or written representations made to Treasury; and (3) determining the correctness of oral or written representations they made to clients as to any matter administered by the IRS. Finally, Circular 230 provides standards for advising on tax return positions and for preparing or filing returns. Specifically, under Section 10.34(a), tax advisers are not permitted to sign a return if they determine that it contains a position that does not have a realistic possibility of being sustained on its merits, unless the position is not frivolous and is adequately disclosed to the IRS.

AICPA guidelines provide that CPAs should not be associated with any return or communication for which there is reason to believe it may contain a false or misleading statement. Also, when CPAs learn of a material error or omission in a prior-year return, they have a responsibility to advise the client promptly of the error or omission and to recommend disclosure to the proper authorities. (22)

Conclusion

An investor will be able to take a deduction for losses if it is determined that they stem from a broker's criminal conduct. Investors should amend their returns if capital gains and losses were erroneously reported on prior-year's returns. If such returns were filed less than three years ago, the investor may be entitled to a refund. If they were filed more than three years ago, the SOL precludes a refund, unless mitigation provisions apply. Attorneys' fees incurred to recover the losses may also be deductible. If fees were reimbursed or paid via a contingency fee arrangement, the investor will have to include such fees in income and deduct them as itemized deductions, subject to AMT and the 3% phaseout, but not the 2% floor. Finally, the tax adviser has a duty under Circular 230 and the AICPA guidance to direct clients to amend their returns, if he or she determines that the client erroneously reported gains and losses.

(1) Sec. 165 (h) provides that a theft loss incurred by a noncorporate taxpayer on property not used in a trade or business or in a transaction entered into for profit is deductible to the extent that (1) it exceeds $100; and (2) added to other net casualty or theft losses incurred by the taxpayer for the tax year, it exceeds 10% of the tax-payer's adjusted gross income for the year.

(2) See Regs. Sec. 1.165-1(b).

(3) See Regs. Sec. 1.165-8(c) and -7(b)(1)(ii).

(4) See B.C. Cook & Sims, Inc., 59 TC 516 (l 972) (loss attributable to embezzlement was held deductible in the year discovered, even though the (1) embezzlement had been reflected in the taxpayer's prior-year returns as purchases in computing costs of goods sold and (2) deficiency assessments for those prior years were barred by the SOL).

(5) Joseph C. Mann, TC Memo 1981-684.

(6) Est. of Levi T. Scofield, 266 F2d 154 (6th Cir. 1959), aff'g in part and rcv'g in part 25 TC 774 (1955).

(7) See Temp. Regs. Sec. 1.62-1T(c)(1), (4), (5), (10) and (13).

(8) See, e.g., U.S. Dep't of Justice, "Stock Broker Indicted in Fraud Scheme" (10/5/04); and U.S. Securities and Exchange Commission Litigation Release No. 17590 (6/27/02).

(9) See Peter F. Maring, TC Memo 1988-469 (citing Barry Glass, 87 TC 1087 (1986)) (purported government securities transactions found to be fictitious and entered into for the sole purpose of generating tax losses, were not bona fide transactions; thus, the income and gains reported by clients and limited partners had to be eliminated, as well as the losses). See also, Sherman B. Harland, 312 F2d 402 (Cr. Cl. 1963) (in a refund suit, the court held that a corporation was entitled to recover a part of overpaid taxes. It found that some income items reflected in the taxpayer's books and records were fictitious or nonexistent. Thus, items of income and loss that were invalidly reported due to transactions' nonexistence were excluded).

(10) Marian Brockamp, 519 US 347 (1997).

(11) For purposes of this rule, Sec. 1313(a) defines "determination" as (1) a decision by the Tax Court, or a judgment, decree or other order by any court of competent jurisdiction, which has become final; (2) a closing agreement; (3) a final disposition by the IRS of a refund claim; or (4) under regulations prescribed by the IRS, an agreement for mitigation purposes, signed by the Service and by any person, relating to such person's tax liability.

(12) James H. Mills, 890 F2d 1133 (11th Cir. 1989).

(13) See IRM 21.5.9.3.7.4 and Service Center Advice 199941039 (10/15/99).

(14) See id.

(15) See id.

(16) See Bemis Brothers Bag Co., 56 F2d 407 (DC MO 1931).

(17) Virginia Vincent, 219 F2d 228 (9th Cir. 1955).

(18) See Cheryl Brewer, TC Memo 1997-542; Jack Baylon, 43 F2d 1451 (1995); and Louise F. Youths, 240 F3d 369 (4th Cir. 2001).

(19) John W. Banks, II, 125 S.Ct. 826 (2005); see Tax Trends, "Supreme Court Decides Contingent Fee Cases," 36 The Tax Adviser 178 (March 2005).

(20) See Nissenbaum, "Significant Individual Provisions of the AJCA," 36 The Tax Adviser 92 ( February 2005).

(21) Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries and Appraisers Before the Internal Revenue Service (June 2005).

(22) See AICPA Statement on Standards for Tax Services No. 6, Knowledge of Error: Return Preparation.

Gary A. Zwick, J.D., LL.M., CPA

Partner

Walter & Haverfield, LLP 

Cleveland, OH

Gwendolyn A. Montgomery, J.D., LL.M.

Associate Director of Gift Planning

Cleveland Clinic Foundation

Cleveland, OH