Gains & Losses

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.

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

For more information about this article, contact Mr. Zwick at gzwick@walterhav.com or Mrs. Montgomery at montgog@ccf.org.

Executive Summary

Investors 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.

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) propertys adjusted basis or (2) difference between the propertys 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 Is 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 Is 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 propertys 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 ac-count still had $25,000 of Is 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 Is 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 losss 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 carryback. 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 investors 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 clear that the claimant has made a tax overpayment. However, the Code contains some SOL relief in its mitigation provisions.

Mitigation

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 trusts or estates; correlative deductions for certain related corporations; and adjustments to the basis of property after erroneous treatment of a prior transaction.

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 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

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

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 Circuit¹⁷ 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 investors 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 investors 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 investors property) and deduct the legal fees in the same manner described in the paragraph above.

Alternately, the investors 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 IRSs 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 Services 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 230²¹ and the AICPAs Statements on Standards for Tax Services provide rules 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-years 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.

Conclusion

An investor will be able to take a deduction for losses if it is determined that they stem from a brokers criminal conduct. Investors should amend their returns if capital gains and losses were erroneously reported on prior-years 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.