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.

• Author: Zwick, Gary A.

EXECUTIVE SUMMARY

* Investment 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.

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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) property's adjusted basis or (2) difference between the property's 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 I's 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 I's 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 property's 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 account still had $25,000 of I's 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 I's 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 loss's 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...