Tax benefits of IRC Sec. 165

California CPA, Sept, 2004 by Bart H. Siegel

The deduction for theft losses related to nonbusiness, for-profit transactions is one of the best-kept Internal Revenue Code secrets--and a tool that tax professionals can use to provide significant tax relief for their injured investor or taxpayer clients.

SEC. 165: THE MISUNDERSTOOD DEDUCTION

Numerous technical requirements must be met before a taxpayer's loss qualifies for Sec. 165 treatment. And in most instances, tax preparation software does not adequately address this deduction.

Sec. 165 permits advantageous tax treatment as compared to the familiar Sec. 1211 capital loss treatments, which could result in your client paying more taxes than required.

Audit-sensitive tax preparers and taxpayers may be apprehensive about taking this deduction. A loss that qualifies for tax treatment under Sec. 165 frequently qualifies for a large deduction. This may result in a large refund or eliminate taxable income for years to come. Claiming a large deduction or eliminating taxable income sometimes triggers IRS over-sight. For this reason alone, you may be reluctant to use this tax treatment.

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Because clients may not realize that their investment loss was the result of fraud, you should ask about the nature of large investment losses. If you review the client's portfolio and see indications of fraudulent investments or unethical sales practices, advise your client to discuss it with a lawyer. If the lawyer feels there was malfeasance, the client's unrecoverable loss probably qualifies for tax treatment under Sec. 165.

Other losses that may qualify for Sec. 165 treatment include embezzlement, blackmail, kidnapping for ransom, burglary, larceny, extortion and threats.

THEFT LOSS VS. CAPITAL LOSS

A Sec. 165 theft-loss deduction can be more advantageous than a mere capital loss:

* A theft-loss deduction is an ordinary deduction that is not subject to the limitations imposed by Sec. 1211.

* A theft-loss deduction is not a miscellaneous itemized deduction subject to the 2 percent floor imposed by secs. 67(a) and 67(b)3.

* A theft loss is excluded from the phase-out of itemized deductions required by Sec. 68(b).

* A theft loss that exceeds a taxpayer's gross income gives rise to a net operating loss that is not subject to the limitation imposed on nonbusiness deductions of individual taxpayers [Sec. 172(d)(4)(C)]. A net operating loss resulting from a theft loss may be carried back three years or carried forward for 20 years [Sec. 172(b)(1)(A) and 172(b)(1)(F)].

* A theft loss can be used to reduce a taxpayer's tax liability to zero without resulting in any liability for alternative minimum tax [Sec. 56(b)(1)(A)(i) and 67(b)(3)].

Basically, capital losses are used first to offset capital gains. If there are no capital gains, or if the capital losses are larger than the capital gains, the capital loss can be deducted against other income, limited to $3,000 in one year. If the capital loss exceeds the capital gains and the $3,000 deduction against income, the excess capital loss carries over to the next year.

The opportunities available under Sec. 165 may far exceed those available under Sec. 1211. Why would a higher tax-bracketed taxpayer want to match a capital loss against a capital gain, which is taxed at a maximum of 15 percent, instead of reducing their ordinary income, which may be taxed at a much higher rate?

A taxpayer who claims a theft-loss deduction must first establish that the loss resulted from theft. 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 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.

The court also stated that whether or not a loss from theft occurred depends upon the law of the jurisdiction where it was sustained and the exact nature of the crime. As long as it amounts to theft in the state where the loss is sustained, Sec. 165 is applicable. It is of little importance whether it was larceny, embezzlement, obtaining money under false pretenses, swindling or other wrongful deprivations of the property of another.

RECOGNIZING FRAUD

What constitutes theft and what evidence supports criminal intent under Sec. 165 is an extensive and complicated topic.

For Sec. 165 to be applicable, there must be a 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. If the client simply engages in a standard open-market transaction, such as purchasing a publicly traded security, and there was no criminal intent, it probably does not qualify for the theft-loss deduction.

In the case of a standard open-market transaction, where a loss is a result of an illegal act by management, the seller would have to have been privy to the fraudulent nature of the investment for the transaction to be executed with criminal intent. If a broker makes reckless statements, circulates half-truths, false opinions or predictions, then the transaction may qualify for this treatment.