Never Better!

By Kevin G. Diamond, Esq.

What do Ponzi schemes, Nigerian investments, pyramid schemes, misrepresentations, omissions, high-yield in­vestments, misappropriation, stockbrokerage churning, pump and dump schemes, failed hedge funds, subprime mortgages, and maybe even auction-rate securities, all have in common with your tax practice? Opportunity!

The rampant financial fraud now prevalent on Wall Street has led to multiple corporate failures, along with the auction-rate securities and subprime mortgage fiasco. While the government has approved a bailout to avoid a financial Armageddon, the government still provides a unique opportunity for recovery of taxes paid if money was lost as investment theft loss.

So be aware of a benefit for your client who has lost money in such a scheme or any other type of financial fraud! The "theft loss" provisions of the IRC section 165(c)(2) may help provide the only relief to be found.

All financial frauds start with a story that appears to be too good to be true. In the end, it usually is. Most frauds leave your client with no money and no alternative sources of recovery.

The variations of financial fraud are too numerous to summarize in this article. One thing is clear, the next fraud is right around the corner.

Financial fraud is not new; the infamous Charles Ponzi began his operation on School Street in Boston in 1920. He duped 17,000 people out of tens of millions of dollars before pleading guilty to mail fraud and being sentenced to five years in federal prison.

While the names have changed, the financial fraud game has stayed the same. In the 1980s, it was the S&L crisis. In the 1990s, it was the dotcom bust. Today, you can pick between failed hedge funds, the auction-rate securities scandal and the subprime mortgage mess.

The fraud from Wall Street is coming so fast that Congress has ap­proved a $700 billion bailout of the financial markets. Even the role of the SEC is now being challenged with the Federal Reserve assert­ing its leadership in the wake of the collapse of Bear Stearns and others.

In June 2008, the Wall Street Journal reported that Samuel Israel, head of the Bayou Group hedge fund, allegedly jumped to his death from the Bear Mountain Bridge rather than serve the 20-year jail sentence for his role in a $450 million fraud. As part of the fraud, Israel went so far as to create a sham accounting firm to issue fake audits attesting to the phony results. Israel finally surrendered to federal authorities on July 2, 2008 after living in a trailer canal) in Massachusetts.

The recent indictment of two Bear Stearns managers for fraud re­lated to the subprime mortgage market makes the possibility of your clients' having theft losses quite possible.

Every CPA and tax practitioner should be aware of how to help their client with such losses. With few or no viable sources of re­covery, the best method may be to have the government help your client in the form of a tax refund and/or a reduction or elimination of future tax obligations. This is best accomplished by maximizing tax benefits under IRC Section 165(c)(2).

Technical Requirements

Certain investment losses may qualify for advantageous tax treat­ment. The "theft loss" provision of the Internal Revenue Code (IRC) may allow for a reduction of ordinary income, recoup of previously paid taxes and minimize future tax obligations by using IRC section 165(c)(2).

That section has numerous technical requirements and certain "legal" determinations that may make the CPA reluctant to take or defend the IRS response to this type of claim. Further, most tax software does not properly handle this situation and is usually is geared toward preparing the more common IRC Section 1211 deduction with its $3,000 limitation.

The best course of action is for the CPA to take this to his tax attorney. An experienced attorney can help determine if the legal re­quirement of a "theft" has occurred. Whether a loss constitutes a "theft loss" is determined by examining the law of the state where the alleged theft occurred. Ed­wards v. Bromberg, 232 F.2d 107, 111 (5th Cir. 1956).

Further, the attorney can help determine whether there was actual fraud with the necessary element of "scienter" which is a criminal intent. Thus, to claim a theft loss, the taxpayer must prove that the "loss re­sulted from a taking of property that is ille­gal under the law of the state where it occurred and that the taking was done with criminal intent" Rev. Rul. 72-112, 1972-1 C.B. 60.

The investor must have bought the invest­ment directly from a seller that committed fraud under a local law. This leads to a re­quirement of "reliance" that the investor re­lied on the fraudulent information when parting with their property. This means that the investor dealt directly with the person committing the fraud, as opposed to pur­chasing the stock through their broker on the open market. The courts have consis­tently disallowed theft loss deductions relat­ing to a decline in the value of the stock that was attributable to corporate officers misrepresenting the financial condition of the corporation, even when the officers were indicted for securities fraud or other criminal violations. Paine v. Commissioner, 63 T.C. 736, 523 E2d 1053 (5th Cir. 1975).

The IRS in Notice 2004-27, 2004-1 C.B. 782 advised taxpayers that the IRS will disallow (and may impose penalties) for theft losses claimed by taxpayers for the decline in mar­ket value of their stock caused by disclosure of accounting fraud or other illegal miscon­duct of the officers or directors of the corporation that committed the fraud. Think WorldCom!

These legal elements often deter the CPA from advising the client to use the "theft loss" and its added benefits to the safer and less imposing IRC 1211, which is limited to $3,000 a year. Help your clients by dealing with a tax professional, who will fight for your clients' best interests and the benefit that Congress intended for them.

The tax attorney can help the CPA and the client by using the IRC to possibly elimi­nate this year's tax but also by going hack 20 years. This type of deduction can be used without triggering the Alternative Minimum Tax and is not subject to the two percent floor by IRC; Section 67.

If there are no viable options for recovery, as there often aren't in financial fraud mat­ters, then IRC Section 165 may be the best alternative for the client. Other issues that will confront the client and require the CPA's input is what is the "tax basis" in the investment being claimed in the theft and the "year of the discovery of the loss" Generally speaking, IRC section 165(e) provides that a loss arising from a theft shall be treated as sustained during the taxable year in which the taxpayer discovers the loss. While this may sound like a hard and fast rule which could eliminate claims for "theft losses;' a recent case, Johnson and Johnson v. The United States, US-CL-CT, 2008 -1 USTC 50, 142 (January 24, 2008), will show how the court showed some flexibility in its application to the Johnsons.

The Johnsons lost $78,160,409 in a fraud scheme. This case and issue will he further discussed in Part II of this article.

Conclusion

The educated use of this IRC section and the relevant case law may lead to your client recovering up to 35 percent of the investment that was a theft loss!

Part II of the this article will be published in the Winter I issue of SumNews.