How do I get a useful theft tax loss for embezzlement and Ponzi scheme instead of useless capital loss in Scottsdale, Phoenix, and Paradise Valley

How do I get a useful theft tax loss for embezzlement and Ponzi scheme instead of useless capital loss in Scottsdale, Phoenix, and Paradise Valley

The huge losses of the Madoff embezzlement and Ponzi scheme resulted in victims inability to get tax relief.  The IRS acted to help these victims (per below).

The stock and real estate markets have created investment loss that have resulted in capital losses that exceed the $3,000 maximum capital loss that can be deducted each year.

Douglas F. Vaughan Ponzi scheme and real estate partnership schemes created large capital losses which were limited to $3K of losses per year (if Married filing jointly).

Prepared Testimony of Doug Shulman, Commissioner, Internal Revenue Service, Before the Senate Finance Committee on Tax Issues Related to Ponzi Schemes and an Update on Offshore Tax Evasion Legislation

Per IRS website:  March 17, 2009

The IRS is issuing two guidance items to assist taxpayers who are victims of losses from Ponzi-type investment schemes. While I recognize that the Committee is today focused on one specific case, the IRS guidance is not specific to this case.  The first item is a revenue ruling that clarifies the income tax law governing the treatment of losses in such schemes. The second is a revenue procedure that provides a safe-harbor method of computing and reporting the losses.

Revenue Ruling
The revenue ruling sets forth the formal legal position of the IRS and Treasury Department:

  • The investor is entitled to a theft loss (Jeff Brooks, CPA highlighted in red), which is not a capital loss.  In other words, a theft loss from a Ponzi-type investment scheme is not subject to the normal limits on losses from investments, which typically limit the loss deduction to $3,000 per year when it exceeds capital gains from investments.
  • The revenue ruling clarifies that “investment” theft losses are not subject to limitations that are applicable to “personal” casualty and theft losses.  The loss is deductible as an itemized deduction, but is not subject to the 10 percent of AGI reduction or the $100 reduction that applies to many casualty and theft loss deductions.
  • The theft loss is deductible in the year the fraud is discovered, except to the extent there is a claim with a reasonable prospect of recovery.  Determining the year of discovery and applying the “reasonable prospect of recovery” test to any particular theft is highly fact-intensive and can be the source of controversy. The revenue procedure accompanying this revenue ruling provides a safe-harbor approach that the IRS will accept for reporting Ponzi-type theft losses.
  • The amount of the theft loss includes the investor’s unrecovered investment – including income as reported in past years. The ruling concludes that the investor generally can claim a theft loss deduction not only for the net amount invested, but also for the so-called “fictitious income” that the promoter of the scheme credited to the investor’s account and on which the investor reported as income on his or her tax returns for years prior to discovery of the theft.

Some taxpayers have argued that they should be permitted to amend tax returns for years prior to the discovery of the theft to exclude the phantom income and receive a refund of tax in those years. The revenue ruling does not address this argument, and the safe-harbor revenue procedure is conditioned on taxpayers not amending prior year returns.
  • A theft loss deduction that creates a net operating loss for the taxpayer can be carried back and forward according to the timeframes prescribed by law to generate a refund of taxes paid in other taxable years.
    The revenue procedure provides two simplifying assumptions that taxpayers may use to report their losses:
  • Deemed theft loss.  Although the law does not require a criminal conviction of the promoter to establish a theft loss, it often is difficult to determine how extensive the evidence of theft must be to justify a claimed theft loss.

The revenue procedure provides that the IRS will deem the loss to be the     result of theft if: (1) the promoter was charged under state or federal law with the commission of fraud, embezzlement or a similar crime that would meet the definition of theft; or (2) the promoter was the subject of a state or federal criminal complaint alleging the commission of such a crime, and (3) either there was some evidence of an admission of guilt by the promoter or a trustee was appointed to freeze the assets of the scheme.

Of course, what if you want capital loss and not theft loss treatment?  We would need to legally find a way to take a capital loss!

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About Jeffrey Brooks

Jeffrey Brooks, CPA, CFP, MBA since 1976 has specialized in helping clients save significant taxes, help businesses increase their cash flow, revenues and profits while increasing their control and satisfaction. Jeff and his accounting firm sincerely cares about the happiness of his clients.

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JBrooks Wealth Advisors, PC.

Certified Public Accountant
Address: 4647 N 32nd Street, Suite B245
Phoenix, Arizona 85018
Phone: 602-292-2009