Theft Loss – Section 165(c)(2)

This is from a very reputable accountant:

Section 165(c)(2) theft loss deductions can be more advantageous than capital loss ones for the following reasons: As ordinary deductions, they’re not subject to limitations imposed by IRC section 1211. They’re not miscellaneous itemized deductions subject to the 2% floor imposed under section 67(a). They’re excluded from the phaseout of itemized deductions required by section 68(b).

Theft losses that exceed a taxpayer’s gross income give rise to net operating losses that can be carried back three years or forward for 20 years. They can be used to reduce a taxpayer’s tax liability to zero without resulting in any liability for alternative minimum tax (AMT).

In Edwards v. Bromberg, 232 F2d 107 (5th Cir. 1956), the court defined theft as a word of general and broad connotation, covering any criminal appropriation of another’s property by swindling, false pretenses or any other form of guile. The court also stated that whether a loss from theft occurred depended on the law of the jurisdiction where it was sustained and the exact nature of the crime. If a transaction did not amount to theft in the state where the loss was sustained, then section 165(c)(2) is not applicable.

For section 165(c)(2) to be applicable, there must be scienter, that is, requisite knowledge of the wrongness or illegality of an act. In Ottmann v. Hanger Orthopedic Group, the Fourth Circuit Court of Appeals determined that scienter could be established by pleading not only intentional misconduct, but also severe recklessness. The court further found a plaintiff must meet the “strong inference” requirement of the Private Securities Litigation Reform Act of 1995. Congress did not specify what would or would not show a strong inference of scienter, so a case-specific analysis is appropriate to determine it.
In general, the taxpayer needs to have purchased the investment from the person, or an agent of the seller, or entity that made the misrepresentation or committed the malfeasance.
In a standard open-market transaction where a loss results from an illegal act by management, the seller must have been aware of the fraudulent nature of the investment for there to be criminal intent. The transaction may qualify for this treatment if a broker makes reckless statements or circulates half-truths, false opinions or predictions. If a broker recommends the purchase, sale or exchange of any security, he or she generally is required to have reasonable grounds for believing that recommendation is appropriate for that client.
If money was invested for a specified use but used for another or unauthorized use, that loss also may qualify for section 165(c)(2) tax treatment.

The theft loss deduction is limited to the tax basis of the investment. This generally is the amount of investment in a property minus previous write-offs, depreciation, amortization or depletion, plus any commissions or transaction costs. In certain cases it is the loss in value of the account that qualifies for the section 165 deduction.
According to several authorities, a taxpayer does not have any tax basis in qualified retirement plan assets such as IRAs or 401(k)s because the Employee Retirement Income Security Act of 1974 established a taxpayer has zero basis in a traditional IRA because no taxes were paid on either the contributions or earnings.

A theft loss is deductible in the year it is discovered by the taxpayer. This may result in an extension of the statute of limitations for a taxpayer who discovers a loss several years after the actual theft. This exception prevents the statute of limitations from voiding the taxpayer’s ability to take this deduction. Section 165(a) requires that a loss must be evidenced by closed and completed transactions, fixed by identifiable events and, with certain exceptions, actually sustained during the taxable year.

If, in the year of discovery, there exists a claim for reimbursement with a reasonable prospect of recovery, that portion of the loss is not deductible under section 165(c)(2). The 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, the taxpayer must wait for the year in which it can be ascertained with reasonable certainty whether such reimbursement will be received.
If the client claimed a loss under section 165(c)(2) and the reimbursement exceeded what was estimated, the portion of the reimbursement that was previously deducted using section 165 treatment would be treated as ordinary income for tax purposes.
There often are significant benefits to using section 165(c)(2) vs. section 1211 treatment for investment theft losses related to nonbusiness, for-profit transactions. Although it can be burdensome, section 165(c)(2) treatment is worth consideration.

  1. I suggest victims read the following Law Journal article by Stephen M. Breitstone. It’s not so simple and is tied up with phantom income and can be seen by the IRS as an alternative to amended returns. Also,A blog comment seemed rational that clawback must be executed uniformly or not at all. In Madoff case it is highly unlikely this can be done due to different investment channels, different staes/countries, and different record keeping.

    ps. Jackie, I can sent you a the reference as an attachment to an email. Let me know if you want it.

  2. I believe that this article may have originally been written by a CPA with whom I co authored an article back in 2006. You can find that article on my firm’s website, http://www.ifrn165.com. I would be glad to answer any questions about this somewhat thorny issue. We are presently authoring an article for the Florida Bar Journal which I would be glad to share when it is finished.

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