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Home Financial Planning

IRS signals leeway for tax deductions for fraud victims

by TheAdviserMagazine
5 months ago
in Financial Planning
Reading Time: 6 mins read
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IRS signals leeway for tax deductions for fraud victims
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Fraud victims wondering whether they can deduct a portion of their financial losses tied to scams on their taxes just got some clarification from the IRS. 

In a memo released last month, the IRS Office of Chief Counsel stated that victims seeking to protect their assets when they fell for a fraudster’s scam usually may deduct the tax basis of their losses for the year they discovered the theft. Previously, some financial advisors and tax pros had questioned whether that motive for moving assets qualified for the definition of “a transaction entered into for profit,” rather than a “personal casualty loss” — a type of deduction that the Tax Cuts and Jobs Act limited solely to disaster areas.

The five examples of scam losses covered in the memo reflect what experts say is a growing risk to consumers as fraudsters become more sophisticated at stealing their money. The memo held that the victims of compromised accounts, so-called pig butchering and phishing scams could receive the deduction for their tax basis. 

On the other hand, it generally ruled out tax deductions for victims of romance and kidnapping schemes. And it also noted that anyone withdrawing money early from an individual retirement account for a transaction that turns out to be fraudulent would still face normal penalties for those transactions. Furthermore, none of the five examples fit the definition of a Ponzi scheme that would qualify for additional deductions.  

Complexity and controversy

Critics have called for reform of tax rules that are complex and harmful to fraud victims. The IRS’ ruling is welcome, then, for allowing advisors and tax experts room to stem damages from efforts to safeguard assets for future investments.

Since fraud losses represent an unfortunate “part of our shared reality at this point,” the guidance can aid advisors assisting victims in the wake of a scam, said James Creech, a director with law firm Baker Tilly’s tax advocacy and controversy practice.

“The mechanisms that the fraudsters use are so polished and organized. They know the right psychological levers to pull at the right times,” Creech said. “When these happen, it’s incredibly isolating, and I find that there are a lot of people who just don’t know where to turn, and they don’t know what to do.”

In that context, some victims may be further surprised to learn that the deductible losses add up to their original basis (i.e. the initial $10,000 in an IRA that has appreciated to $100,000) instead of including any of the unrealized gains. Also, they first must verify that their money is not recoverable, said Miklos Ringbauer, the founder of Los Angeles-based tax firm MiklosCPA.

“Until we know that we are a victim, there’s no deduction,” Ringbauer said. “Once we are aware of it, we make the appropriate police reports and everything else when it becomes apparent that it’s nonrecoverable.”

READ MORE: Rising scam risk calls for coordinated prevention strategy, study says

The memo’s findings

The IRS memo acknowledged some of the confusion. For example, it noted the fact that there is “no statutory definition of ‘a transaction entered into for profit'” beyond some court-case analysis describing it as “a primary profit motive.” In addition, it cited some further IRS guidance from 16 years ago laying out the circumstances that investors can obtain a “safe harbor” from taxes on their losses from a Ponzi scheme. 

One important aspect of the qualification criteria for Ponzi losses requires a “lead figure” who is charged or otherwise named as a defendant in a criminal complaint alleging theft after they secured victims’ money, claimed to generate income, paid other investors through the earlier customers’ outlays and misappropriated those assets. None of the five circumstances discussed in the memo fit that definition. But three of them qualified for a separate deduction tied to the tax basis of their losses at the hands of “Scammer A.”

“For taxpayers who authorized distributions and transfers to new accounts or directly to Scammer A, we look to their motive in doing so to determine the character of the transactions. Taxpayers who establish that their motive was to transfer their investment funds from existing investment accounts to new investment accounts, i.e., to safeguard existing investments or to engage in new investments, had a profit motive when authorizing the distributions and transfers,” the memo said. “For taxpayers who were motivated to transfer funds to Scammer A as part of a non-investment scam, i.e., the romance scam and kidnapping scam, there is no profit motive for the transaction, and the loss is a disallowed personal casualty loss. For taxpayers who did not authorize any distribution or transfer, the loss does not result from the actions of the taxpayer, so that the relevant transaction for determining the character of the loss is the original investment and the motive of the taxpayer at that time.”

Regardless of that distinction, each of the victims must pay any penalties for early IRA withdrawals or outlays from other accounts subject to them. The lack of any deduction for the latter two cases would likely arrive as bitter news for an investor tricked into believing a new online romantic partner had a close family member “in dire need of medical assistance” or someone fooled by an artificial intelligence-generated recording into thinking a grandson had been kidnapped and needed a ransom payment.

READ MORE: Financial professionals have slowed the growth of elder fraud cases

Room for improvement to the rules

The memo “shows that more victims than perhaps previously thought might qualify for the theft loss deduction, but it also illustrates how much work remains to help all taxpayers who find themselves victims of fraud,” according to a blog post on it last week by National Taxpayer Advocate Erin Collins, head of an independent IRS unit that evaluates the agency’s operations and reports recommendations to Congress and the rest of the government. Last year, Collins listed tax-related scams as among the agency’s “most serious problems” and called for letting the limitation on deductions for theft losses expire at the end of the year.

“The memo offers important clarification on when and how taxpayers may claim a theft loss deduction,” Collins wrote. “It also exposes gaps in the current law that leave many taxpayers without meaningful relief.”

Besides asking lawmakers to eliminate the restriction on deductions for theft, Collins called on them to extend the three-year statute of limitations on refund claims to the IRS, waive the penalty on early IRA withdrawals for scam victims and enable taxpayers to amend prior returns to report income differently for the years that they sustained the losses. It’s not clear that such policy ideas will gain any traction as the current Congress considers the sunsetting provisions of the 2017 law this year, since they would increase the cost of the legislation.

READ MORE: Tax Cuts and Jobs Act expiration: A guide for financial advisors

How advisors can help

Despite the complexity, advisors “really play such a critical role” through empathy for the victims combined with the technical expertise to point them to the next step, according to Creech of Baker Tilly. They often feel the sense that they “worked so hard to build this legacy, and now it’s gone and I have nothing to show for it,” and Creech has spoken with many who have gone from expecting “a very comfortable retirement to having Social Security income only,” he said. Asset allocations or interest rates often seem much easier to discuss.

“It’s more of an art than a science. No one gets financial certifications to be a grief counselor,” Creech said. “Those are important conversations and I think, sometimes, they keep people alive.”

With AI and other technology bringing new types of risk, advisors and tax pros should guide clients on prevention strategies to avoid the scams in the first place, Ringbauer said. For instance, if they hear from someone claiming to be from their financial institution, they should either hang up from the call or refrain from answering the text message, according to Ringbauer. Then they can take the time to call into the corporate headquarters separately on their own to see whether there is any legitimacy.

“The problem is, we live in a digital world and, in that process, we don’t do due diligence. We don’t think very quickly because we are faced with a catastrophic or emergency situation. In that process, our natural instinct is to protect,” Ringbauer said. “Today you don’t know if you are talking with me. For you as a taxpayer or an individual, the only protection you have is, you go back to the original source.”



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