True Confession
Fraud Victims Eligible For Tax Relief
By Abe Carnow, CPA

I used to work for the IRS. Yes, for 16 years, I worked in Los Angeles as a Tax Auditor, Revenue Agent, Instructor, and Appeals Officer. This makes me, I hope, one of the good guys.

As my hobby is close up card magic, and as my profession as a CPA puts me in good company with Bob Steiner, I figured I should follow his lead and join PACC, of which I have been a proud dues paying member for quite some time.

Detective Marlock and I corresponded over the years and he asked me if I would pen a few notes on how the tax law treats theft losses. As a CPA, and as a nationwide instructor for Gear Up Tax Seminars, this is a topic I teach frequently. Let me cover the basics.

A theft loss is a casualty loss. A casualty loss is a tax deduction which is deducted on Schedule A, the tax form you file if you itemize your income tax deductions. Itemized deductions consist of medical expenses, taxes (such as real estate tax), home mortgage interest, contributions, employee business expenses, and casualty losses. If the sum of the itemized deductions exceeds the standard deduction , which for a married couple in 2001 was $7,600, then the larger itemized deductions are utilized to calculate your tax liability. For example, a married couple has real estate taxes of $2,000 and home mortgage interest of $7,000. This total of $9,000 is greater than the $7,600 standard deduction, so the taxpayer will file Schedule A, itemizing their deductions.

Now, a casualty loss is only deductible to the extent it exceeds $100 PLUS 10% of the taxpayer’s adjusted gross income. The adjusted gross income is the bottom line on page 1 of the 1040. If the married couple referred to above had total earnings from work of $40,000, a casualty loss would only be deductible if it exceeded 10% of $40,000 plus $100, or $4,100. If this taxpayer had a theft loss of $6,000, the casualty loss would be $6,000 MINUS $4,100, for a casualty loss deduction of $1,900.

The Internal Revenue Code permits a deduction for casualty losses under Code Section 165. This Section states: There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise. The deduction shall include losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft.

Now, time to get technical but this part is easy for you, the law enforcement community. A theft is the taking and removing of money or property with the intent to deprive the owner of it. The taking of property must be illegal under the law of the state where it occurred and it must have been done with criminal intent. “The word ‘theft’ as used in these provisions is not ‘a technical word of art with a narrowly defined meaning but is, on the contrary, a word of general and broad connotation, intended to cover and covering any criminal appropriation of another's property to the use of the taker.’ Edwards v. Bromberg 232, F. 2d 107, 110 (C.A. 5, 1956); Robert S. Gerstell, 46 T.C. 161, 171-172 (1966).” (Cited in Cramer v. Commissioner, 55 T.C. 1125.)

Theft includes the taking of money or property by the following means:

BLACKMAIL – BURGLARY – EMBEZZLEMENT – EXTORTION – KIDNAPPING FOR RANSOM – LARCENY – ROBBERY – THEFTS
THE TAKING OF MONEY OR PROPERTY THROUGH FRAUD OR MISREPRESENTATION IS THEFT IF IT IS ILLEGAL UNDER STATE OR LOCAL LAW.

The theft loss is treated as sustained during the taxable year in which the taxpayer discovers such loss. (165(e)). The year of discovery is the year in which a "reasonable person" in similar circumstances would have discovered the fact of the theft loss. Cramer v. Commissioner, 55 T.C. 1125, 1133 (1971), acq., 1971-2 C.B. 2.

Ponzi Scheme: There is not much tax literature on Ponzi Schemes, probably because many people who lose their savings are too ashamed, embarrassed or afraid to report their victimization. In essence, a loss from a Ponzi Scheme is a theft loss; it is a casualty. An older, but still very powerful ruling, is FSA 1999-942, which is actually a 1993 field service advice. It contains excellent citations that you should review further. (The following are excerpts from an actual IRS document. To protect taxpayer privacy, all references to the company name and products manufactured have been changed using fictitious references.)

The facts of this case may be summarized as follows: X was a corporation. It represented itself to be in the business of selling product. In reality, X was an elaborate ponzi scheme which began operation as early as several years earlier. It is estimated that the operation defrauded many investors out of lots of money.

X filed for Chapter 7 bankruptcy and thereafter converted the filing to Chapter 11. When X filed bankruptcy it left investors with bad loans and interest checks which the investors could not cash. According to the indictment filed in the Criminal Case involving the principals of X the extent of the fraud was still not known as the bankruptcy trustee was warned not to open any of the merchandise boxes as to do so would void the warranties. When the boxes were finally opened, sometime in early spring they were found to contain nothing but foam covered bricks and dirt. (This type of scam is reminiscent of the gold brick scam, where real bricks were painted gold and passed off as gold bullion. This was written about decades ago and fully exposed by Walter Gibson, creator of The Shadow.)

Is the loss a casualty/theft loss or a bad debt? The provisions of law which deal with deduction of losses and the section which deals with deduction of bad debts are mutually exclusive. Thus, an amount properly deductible under one section may not be deductible under the other. Spring City Foundry Co. v. Commissioner, 292 U.S. 182 (1934).

Section 165(a) and (c)(3) provide that any theft losses suffered by a taxpayer and which are uncompensated for by insurance or otherwise are deductible. Theft is a broad term and includes theft by swindling, false pretenses, and any other form of guile. Edwards v. Bromberg, 232 F.2d 107, 110 (5th Cir. 1956). Whether a loss from theft has occurred depends upon the law of the jurisdiction where it was sustained. Bromberg.

In contrast to cases where a taxpayer's loss was an indirect result of theft, a taxpayer was deemed to have suffered a theft loss, where he purchased fictitious notes and mortgages that had been endorsed and guaranteed by the seller in a scheme intended to defraud the taxpayer. Morris Plan Co. of St. Joseph v. Commissioner, 42 B.T.A. 1190 (1940), acq., 1941-1 C.B. 8. A similar result followed where the taxpayer, as security for a loan, received a forged stock certificate and a postdated bad check, the debtor being convicted under state law for theft. McKinley v. Commissioner, 34 T.C. 59 (1960).

Larceny, stealing, embezzlement, false pretenses, confidence games or shoplifting are included under the term "theft." The law defines theft as knowingly obtaining or exercising control over anything of value of another by, inter alia, deception, intending to deprive the other person permanently of the use of benefit of the thing of value. In operating a pyramid or Ponzi scheme and in obtaining funds from taxpayers by misrepresenting itself as being engaged in the business of selling it would appear, in our view, that the actions constitute theft under state law. See Berardo v. Commissioner, T.C. Memo. 1987-433 (court found that taxpayer, an investor, who was swindled in a real estate pyramid scheme was entitled to a claimed theft loss deduction to the extent he could substantiate the amount of the loss). Therefore, because taxpayers' losses resulted from the direct theft of their property rather than the indirect theft of their property or bad debts, we believe that the losses of taxpayers are governed by I.R.C. section 165(c) and not I.R.C. section 166.

It is not unusual for taxpayers, especially seniors, not to discuss their losing life savings to a bank examiner scam or a pigeon drop. In my personal experience, these crimes are less frequently reported to the accountant than to the police. If they have been ripped off, if a theft has occurred, they are entitled to a tax deduction. In speaking on this topic nationwide, I have helped many accountants help their clients in this area. I have even had to personally help family members who have been victims of fraud.

I want you to know that I will be on the road teaching this topic again this year and much of the above information is found in the manual I will be teaching from. In addition to covering this material, I have listed PACC as a reference.

As a CPA, I would be interested in hearing from you about other concerns you have so I can provide you with further information.

I’ve learned a lot from PACC, and I’ve purchased many of their books. I hope that this introduction to taxation will help the victims get the relief that Congress has provided for them in the Internal Revenue Code.