PIABA LAW JOURNAL

It seems these days that we security litigators are faced with an increasingly bleak case selection.  Prospective clients come in to discuss trading losses that they incurred in the market crash over six years ago.  We might even see new cases, but the damages are not that big.  Nevertheless, there are always new horizons, whether they be hedge funds, annuity abuse, or other broker-dealer malfeasance.  This article focuses on another category of cases.  It seeks to illustrate how the Internal Revenue Code may be helpful in obtaining some relief for our previously “unhelpable” clients.

 Being judgment proof, uncollectibility, the high cost of litigation, or multiple other extenuating circumstances, may no longer prevent you from providing relief.  It may also mean additional revenues for your firm.  If your practice includes assisting clients that suffer investment losses resulting from a malfeasance, you need to be aware of the tremendous tax benefits available to them under Internal Revenue Code (IRC) §165. Your client may qualify for a very large refund under IRC §165 that they would not have qualified for utilizing the more familiar, and more commonly utilized, IRC §1211 capital loss treatment.

Scenario:  

Perhaps you have a file on your desk that fits this description:

Wealthy, high earning investor invests $200,000 in a Ponzi, or promissory note scheme.  He did not use a traditional broker dealer (rather he dealt with the issuer’s principals) and it appears that the issuer is in bankruptcy, or receivership.  In addition there are pending SEC, or criminal proceedings, against the principals for theft, or securities fraud, etc..

As a securities litigator, what can you do?  (1) Do you take this case on a contingency fee basis?  (Probably not if you want to keep your bills paid.)  (2) Do you let this sit on your desk until it stinks up the room?  (Not if you don’t want an upset potential client.)

The answer?  You may want to give consideration to utilizing IRC §165, if the situation qualifies.

Rev. Rule 112-72

Considering the broad general meaning of theft, it must be presumed that Congress used the term “theft” so as to cover any theft, or felonious taking of money or property by which a taxpayer sustains a loss, whether defined and punishable under the penal codes of the states as larceny, robbery, burglary, embezzlement, extortion, kidnapping for ransom, threats, or blackmail.

Investment fraud, broker misconduct, breach of fiduciary duties, unsuitable investment recommendations, market manipulation, lack of diversification, unethical behavior, unauthorized use, misrepresentation, omission of fact, margin abuse, and misappropriation, are a few of the extenuating circumstances that may permit your client to qualify for this very special tax benefit.  Fraud as defined by the IRS is deception by misrepresentation of material facts, or silence when good faith requires expression, resulting in material damage to one who relies on it and has the right to rely on it.

Berardo v. Commissioner, TC Memo 1987-433

In this case, the court determined that a defrauded investor duped in a real estate pyramid, or ponzi, scheme was entitled to claim a theft loss deduction in the full amount of the substantiated investment.

Introduction to 26 USC IRC §165(c)(2)

This sub-section may be used to essentially allow a taxpayer to “recover” as much as 35%, or slightly more depending on the tax year, of their losses.  The best part is that the source of the recovery is readily collectable- The United States Treasury.

One thing the IRS has made fairly clear is that, in most cases, losses generated from stocks purchased on the open market generally are not going qualify.  This treatment is reserved for losses where the perpetrator not only targeted their victim, but was directly involved in the transaction.  In other words if the victim relied on material misrepresentations of management, but then went to a broker to purchase the securities, in an unsolicited trade, it has been held that the client will be limited to the less favorable capital loss treatment permitted under IRC §1211.  For example if your client relied on Ken Lay’s, Enron’s founder, misrepresentations, and then purchased Enron stock through a discount broker, the client would be limited to a capital loss for tax purposes, despite the fact that they were entitled to recovery in a class action suit.  The reason is that the transaction was between an unknowing seller, and buyer, and therefore it lacks the prerequisite intent.  Nevertheless, there may be certain limited situations where the stock was purchased on the open market, but the brokerage house where the stock was purchased, had violated their fiduciary duty.  For instance, Eliot Spitzer, Attorney General of New York, in April of 2003, concluded an  investigation of Citigroup's Salomon Smith Barney, now called Citigroup Global Markets (SSB). Key findings of this investigation were as follows:

The principal distinction to be drawn in the analysis of the above case centers around whether, or not, the client was targeted, and there was sufficient privity for the transaction to qualify under IRC §165.

Internal Revenue Service Memorandum 200305028 (issued Dec. 27, 2002)

The Office of Chief Counsel reviewed a situation where taxpayers who invested in a ponzi scheme operated by a title loan company.  The funds obtained from investors were generally not lent to the title company, but were instead used to pay the promoter’s commissions and fund interest payments to prior investors.  Under these facts, the Office of Chief Counsel opined that the “investors would generally be entitled to a theft loss, providing a theft occurred under local law.”  (Note: The IRS counsel did not require a criminal conviction for such treatment to be valid.)

While a criminal conviction in a state court may establish conclusively that a theft occurred, the deduction does not turn on whether the thief has been convicted or prosecuted. Vietzke v. Commissioner, 37 T.C. 504, 510 (1961); Monteleone v. Commisioner, 34 T.C. 688, 694 (1960).

If your client has sufficient capital gains that will permit their utilization of their capital loss, it will reduce income that would be taxed at the rate of 15 percent.  Under §165(c)(2) your client will be able to use their loss to reduce their ordinary taxable income, which may be taxed at rates up to 35 percent.  That is a 20% rate difference.  §165(c)(2) provides even more advantageous treatment when you consider that your client may not have any capital gains to offset, while at the same time enjoying high income.  In that event their capital losses may only be written off at $3,000 per annum if utilized to offset ordinary income.  In other words much of your clients tax loss may not be able to be utilized for many years to come, if ever.  Under §165(c)(2) your client may be able to recapture taxes paid in previous years, at even higher income tax rates, and to avoid future tax obligations.  By the way, a legal fee paid to recover stolen property has been held to be deductible as part of the theft loss.

If you have had clients who: 

1. Settled their arbitration claims for less than their realized loss,

2. Could not recover their arbitration awards, or did not pursue recovery due to a lack of recoverable assets,

3. Did not pursue recovery due to the high cost of litigation, their unrecovered balance may qualify for tax treatment under §165.  If their accountants had previously utilized §1211 capital loss treatment, sometimes their tax returns may be amended, and additional relief obtained.  Uncovering these additional benefits, previously foregone, is a great way to provide additional revenues for your firm, while at the same time maximizing your client’s satisfaction.

Some casualty losses due to theft, but are not related to a non-business, for-profit transaction, may still be deductible under §165, but they will not enjoy some of the more beneficial aspects of a §165(c)(2) loss.

Many tax practitioners are unfamiliar with the special tax privileges allowed under §165(c)(2).  Tax preparation software often does not adequately address this deduction. Audit-sensitive tax preparers may be apprehensive about taking this deduction.  Losses that qualify for tax treatment under IRC §165(c)(2) frequently trigger IRS oversight.  As a result many tax preparers defer to the more familiar IRC §1211 capital loss treatment to the detriment of their clients. 

Tax practitioners may be intimidated by the relatively high burden of proof required to demonstrate that the loss is eligible for this treatment.  If any portion of an underpayment, as defined in section 6664(a) and §1.6664-2, of any income tax imposed under subtitle A of the Internal Revenue Code that is required to be shown on a return is attributable to negligence or disregard of rules or regulations, there is added to the tax an amount equal to 20 percent of such portion.  In other words, if you are going to apply for the tremendous tax advantages available under §165(c)(2), you had better know what you are doing, because if misapplied it may result in serious penalties, and liabilities. 

Why is it extremely worthwhile to investigate whether your client qualifies for tax treatment under IRC §165(c)(2): 

Theft loss vs. capital loss:

Clearly, the opportunities available under IRC §165 may far exceed those available under IRC § 1211.

Determining Theft Loss

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, and covering, 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.  

Whether a loss from theft occurred depends upon the law of the jurisdiction where it was sustained, and the exact nature of the crime.  

Recognizing fraud 

For IRC §165 to be applicable there must be 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. 

The deduction is limited to the tax basis of the investment. This is generally the amount of the investment, minus previous write-offs, depreciation, amortization, or depletion, plus any commissions or transaction costs.  

Year of discovery 

A theft loss is deductible in the year it is discovered by the taxpayer. This may result in the extension of the statute of limitations for a taxpayer who discovers a loss a year, or more, after the transaction.  

If in the year of discovery there exists a claim for reimbursement with reasonable prospect of recovery, that portion of the loss for which there is a chance of recovery, cannot be deducted under Section 165.

If the client claimed a loss under IRC §165, and the reimbursement exceeds what was estimated, that portion of the reimbursement, which was previously deducted utilizing IRC §165 treatment, that amount will be treated as ordinary income for tax purposes.  The reimbursement that exceeds the adjusted basis will be treated as a capital gain.  

IRC §165 has many nuances.  Tax professionals, that rarely encounter investment theft losses, may find it beneficial to work with a specialized tax/legal service provider due to the technical nature of this deduction. Legal services are generally required to properly document the illegal nature of the loss, to estimate that portion of the loss for which there is, or is not, a chance of recovery, and to establish the date of discovery.