Internal Revenue Code §165
The Light at the End of the Tunnel
By: Bill E. Branscum
Copyright 2004


PLEASE NOTE: This article has an update (April 2011) at the end regarding the government's case against Tobias H. Elsass, who provides "services" to fraud victims related to this particular provision of the tax code. Interestingly, a Google search reveals that someone(s) has gone to a lot of trouble to make anyone interested believe that the Tobias H. Elsass operating the Fraud Recovery Group is the not same Tobias H. Elsass whose license to practice law is suspended. They are one and the same.

While I go to great lengths in this article to make it clear that there are some very questionable activities going on with respect to this tax code provision, and caution readers accordingly, this update and the related attachments make it possible for you to read the government's pleadings and get their wonderfully cogent explanation as to how this code section is intended to be applied, as compared to the fraudulent activities that they allege.


Internal Revenue Code §165, as codified in Title 26 USC §165, is a door through which those who have suffered certain uncompensated casualty losses may recover as much as 35% of their losses, and you, as that person's investigator are the key to the door. Even assuming that the investor has a competent attorney and a knowledgeable CPA, they are highly unlikely to get through that door without you.

Although this has been referred to as one of the "best kept IRC secrets," it would be equally apt to refer to it as one of the "IRC's highest hurdles." Although the IRS' position in some of these cases may initially appear to be unreasonable, once you understand the nature of this IRC provision, I believe that you will agree that those who would apply for this tax relief should have a high burden to meet.

Before delving into the nuts and bolts of this thing, a simple introduction to basic tax issues, and terminology, may be in order. I beg the forbearance of any tax professionals among us as I try to make this as simple as possible.

First, consider the word "loss." There is nothing particularly unique about the way that this term is used in the tax code; I suppose that a loss could be generally characterized as any event that has a negative impact on net worth. Rather than become bogged down in semantics, let's just accept that if your stock portfolio takes a dive, your car burns up, your ship sinks, your home is burglarized, or you become the victim of fraud, you suffer some sort of loss.

The tax code treats these losses in different ways, according to the attendant facts and circumstances, and certain losses are treated far more advantageously than others. For example (looking strictly at the issue of loss) if your Client entrusted a broker with a million dollars with which to buy a certain stock, it wouldn't make much difference whether the broker stole their funds outright, or the stock value plummeted to zero, but the tax code would treat those events dramatically differently.

Next, consider the word, "casualty." While the term is used a bit differently in the tax code than most of us use it in daily life, there is a connection to common usage. Car wrecks, train wrecks, and bombs cause casualties - not old age. The dead are just as dead either way, but casualties are the consequence of sudden, and unusual events generally (but not exclusively) described in the tax code as fire, storm, shipwreck, and theft.

Consequently, the million dollars your Client lost when their broker stole their investment capital is a "casualty loss," whereas the loss due to plummeting stock value is not. Assuming that they hire a competent investigator who recognizes the implications, that thieving mutt may have done your Client a real favor!

Since tax treatment as a casualty loss is typically more than twice as favorable as a capital loss, IRC §165 could be compared to a "double indemnity" life insurance clause that provides for a double payment in the event of accidental death, where the deceased was the "casualty" of some sudden, unforeseen, event.

REVIEW: The main points thus far are:

  • A "loss" according to the tax code is pretty much as we define it in common usage; and
  • A "casualty loss" according to the tax code is a loss due to certain specific events; and
  • A casualty loss can be worth much more to the tax payer than an ordinary loss.

Obvious differences notwithstanding, I believe that the investigator is well served by continuing to think in terms of the familiar insurance company double indemnity clause; as we proceed, it may be helpful to visualize, and/or rationalize:

  • Mom and the kids throwing Dad in front of a train after his heart attack kills him
  • Why insurance companies require investigation and proof to support casualty claims
  • Why legal representatives loathe to open that can of worms might prefer to file for the standard death benefit instead

Internal Revenue Code §165

Now, let's look at the tax code. Bearing in mind that the term "loss" refers exclusively to "casualty" losses in this particular section of the Internal Revenue Code, the relevant statutory provisions are as follows:

IRC §165(a) says, "There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise."

These casualty losses are categorized in IRC §165(c) as follows:

IRC §165(c)(1) provides for, "Losses incurred in a trade or business;"

IRC §165(c)(2) provides for, "Losses incurred in any transaction entered into for profit, though not connected with a trade or business; and"

IRC§165(c)(3) provides for, "except as provided in subsection (h), 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.

Note that §165(c)(3) losses are handled, "as provided in subsection (h)" It isn't all that significant for our purposes, but subsection (h) provides that (c)(3) losses are subject to a deductible formula that does not apply to losses under (c)(1) and (c)(2) - that deduction ($100 plus 10% of adjusted gross income) applies only to losses not connected with business, or for-profit transactions.


Let me address a common misconception. (common beyond belief!)

No matter what anyone tells you, the words, " if such losses arise from fire, storm, shipwreck, or other casualty, or from theft" apply to the losses identified in (c)(1), (c)(2), and (c)(3). In other words, §165 casualty losses are categorized as; business losses, personal investment losses, and other property losses to the extent that [ANY OF] these losses are due to the specified, "casualty" related events.

You cannot imagine how many Accountants, Lawyers, and even Administrative Law Judges, read this section as if (c)(1), (c)(2) and (c)(3) were separate sentences delimited by periods, instead of semicolons, and conclude that theft losses fall exclusively within the purview of §165(c)(3).

Rather than ask you to take my word for it, I want to make this point perfectly clear because you will find yourself arguing this point with people who should know better over, and over again.

First, note that IF this were not the case, IF §165 (c)(1) and §165(c)(2) applied to ordinary, non-casualty losses, they would encompass the very same losses properly filed under IRC §1211 as "capital losses" rather than "deductions."

Logic, common sense, and statutory sentence construction issues aside, the issue is dispositively resolved by the form used to file these claims.

I direct your attention to IRS Form 4684, entitled, "Casualties and Thefts." In looking at Form 4684, you will note that Section A, on the front page of this form is entitled, "Personal Use Property (Use this section to report casualties and thefts of property not used in a trade or business or for income-producing purposes.)" In other words, Section A is properly used for declaring casualty losses cognizable under IRC §165(c)(3).

Note that if that were not the case, the instructions would say, "(Use this section to report casualties and thefts of property [PERIOD]) Instead, the instructions make it clear that you are supposed to use the other section to report casualties and thefts of property used in a trade or business, or for income-producing purposes.

It says so in the other section too, but first notice that Section A, Line 11, provides for a $100 offset against the loss, and Section A, Line 17 provides for another offset of 10% of the taxpayer's adjusted gross income as per §165(h) which only applies to §165(c)(3) losses.

In other words, if you claim a loss under (c)(3), that loss is properly reduced by $100 and ten percent of the taxpayer's adjusted gross income.

Now look at Section B of this form entitled, "Business and Income-Producing Property Casualty or Theft Loss." As you can see, this is the section of the form that applies to casualty and theft losses, when those losses are related to business cognizable under (c)(1), or when those casualty and theft losses are related to non-business, for-profit, transactions cognizable under (c)(2).

Consistent with this explanation, you will note that this section contains no provision for the above referenced offsets as specified in subsection (h) that apply to losses properly categorized as §165(c)(3), but do not apply to losses cognizable under §165(c)(1) or §165(c)(2).

Fair warning - if you completely understand this, you are going to find yourself explaining it to lawyers, accountants, IRS representatives, and Administrative Law Judges in Tax Court who oftentimes have no clue. If you read many of the tax court decisions marked, "Unsuitable for Publication," you will see what I mean.


For those of you who do not investigate financial scams, please note that your time has not been wasted. While I am most interested in the application of §165(c)(2), you will find that §165(c)(3) has a wide range of applications. KEEP IN MIND that §165(c)(3) tax treatment is not nearly as favorable as the tax deduction provided for losses properly categorized as deductible pursuant to §165(c)(1) or §165(c)(2) due to that previously referenced offsets per subsection (h).

For example, suppose you are approached to assist in recovering valuables stolen during the course of a "home invasion" strong arm robbery, or hired to track down an expensive antique automobile that disappeared while undergoing repairs. In these cases, it is important that you conduct your investigation mindful of the potential IRC§165(c)(3) tax implications.

Alternatively, consider a kidnapping case where the Client pays out a million dollar ransom. It would behoove your Client to know that, although extortion is not "theft," the loss would be properly deductible as a §165(c)(3) casualty loss.

Rev. Rul. 112-72, published January 1972, addressed this specific issue and, while a ransom case may be far afield of investment related theft loss issues, this ruling serves to illustrate how broad the applicable definition of theft can be.

This ruling specifically states that:

Considering the broad general meaning of theft, it must be presumed that Congress used the term "theft" so as to cover any theft, or felonious taking of money or property by which a taxpayer sustains a loss, whether defined and punishable under the penal codes of the states as larceny, robbery, burglary, embezzlement, extortion, kidnapping for ransom, threats, or blackmail.

The seminal case on this issue is Edwards v. Bromberg, which was decided in 1956 (and therefore quotes a different code section); quoted in many §165 "theft" related cases, it stands for the proposition that:

[The] word "theft" is not like "larceny," 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, particularly including theft by swindling, false pretenses, and any other form of guile.

To qualify as a "theft" within the meaning of IRC §165, the taxpayer needs only to prove that his loss resulted from an act that is illegal under the law of the state where it occurred, and that the taking was done with criminal intent.

REVIEW: The main points thus far are:

  • A "loss" according to the tax code is pretty much as we define it in common usage; and
  • A "casualty loss" according to the tax code is a loss due to certain specific events; and
  • A casualty loss can be worth much more to the tax payer than an ordinary loss; and
  • Internal Revenue Code §165 provides that casualty losses are deductible; and
  • IRC §165 categorizes casualty losses as: (c)(1) business losses; (c)(2) personal investment losses, and (c)(3)other property losses; and
  • IRC §165 requires that that these losses must be due to "casualty" to be deductible; and
  • IRC §165 recognizes theft as a specifically enumerated casualty, and case law provides that the word "theft" encompasses virtually any unlawful taking; and
  • IRC §165(c)(3) claims are subject to the subsection (h) offset, so they are less advantageous to the taxpayer than they would be if properly categorized as (c)(1) or (c)(2).

Practical Applications

In some cases, especially those where the recovery outlook is most dismal, it is entirely possible that the victim of an investment scam could retain a Private Investigator, incur significant investigative fees and expenses, recover absolutely nothing, and yet find it to be cost effective, and money well spent. If recovery efforts prove to be fruitless, and all reasonable avenues of recovery are exhausted, there may still be some light at the end of the tunnel in the form of this tax deduction.

This is not your ordinary tax deduction. To perfect a viable §165 filing, the Tax Payer must prove that his situation meets the applicable criteria, and be able to answer questions that you, as an investigator, are best equipped to respond to. Time spent dotting "I's," crossing "T's" and diligently researching the tax code can pay big dividends.


Real World Example #1:

Suppose Joe Client reads various press releases propounded by Charlie Crook, President, and Chief Janitor of XYZ Corporation, which persuade him to believe various and sundry fraudulent misrepresentations. "XYZ Corporation, with millions in assets, and virtually no liabilities, has discovered the cure for AIDS," or so the story goes.

Acting upon this information, which was knowingly and deliberately disseminated with the criminal intent to defraud, Joe Client contacts his broker and invests $1M in XYZ Corporation, fully intending to derive a profit.

Within the month, the scam is revealed, Charlie Crook is arrested and convicted for violating numerous provisions of the Securities Act of 1934, XYZ Corporation is forced into bankruptcy, and Joe Client stands to recover $20K of his $1M investment, rather than the $3M he was led to expect.

How would you break this down?

We have an individual, a transaction entered into for profit, and a loss due to fraud that might qualify as a deduction cognizable under §165(c)(2). What do you, as the Client's Investigator, need to do to support this claim? Do you feel like it has the potential to be viable?

As with any case, you need to completely document the facts and circumstances, and explore all avenues of potential recovery. Assuming that Charlie Crook and XYZ Corporation are dead ends, do you see any other recovery potential?

How about your Client's Broker? Was your Client a sophisticated investor? Was this an appropriate trade strategy in light of his personal circumstances? What you have here is an arbitration claim - and perhaps an extraordinarily good one.

What you do not have is any viable §165(c) claim - unless you manage to make the case against the Broker.

To qualify as a "theft" within the meaning of IRC §165, the taxpayer must prove that his loss resulted from an act that is illegal under the law of the state where it occurred, and that the taking was done with criminal intent.

Ask yourself, "Who took the Client's money?" To support a §165 deduction, you must prove that the person who took your Client's money did so with criminal intent. The issue is called "privity," which relates to the connection, or relationship between parties.

A million dollar tax deduction is a big deal. Unless your Client makes his arbitration case against Barry Broker, the fact that your Client had no direct dealings with Charlie Crook could conceivably cost him something in excess of $300K.

See: Crowell v. Commissioner


Real World Example #2:

Suppose Joe Client met with Robert Cash who had designed a machine that would convert $1 bills to $100 bills via a three stage process - the $1 are bleached, the inks are separated into their constituent parts allowing them to be reclaimed/reused and then the $1 bills are reprinted using laser technology and the reclaimed ink. Robert Cash has a functional prototype that Joe Client carefully examined, and used.

In inviting Joe Client to their meeting, Robert Cash suggested that he first stop by the bank and obtain some crisp, new $1 bills. At the meeting, Joe Client was permitted to feed these crisp, new $1 bills into Robert Cash's machine which produced, damp, but otherwise apparently perfect $100 bills with an average turn around time of five minutes per bill. Joe Client was allowed to keep the money, and encouraged to have it examined by his bank. The head teller examined the bills and reported that they were, by all appearances, genuine.

After consulting with representatives of three other banks (each of whom concurred that the bills appeared to be genuine), Joe Client invested $250,000 in Robert Cash's money making machine. Apparently, it did not occur to Joe Client that a man who could make his own money would not need an investor. Robert Cash promptly evaporated along with Joe Client's investment.

How would you break this down?

We have an individual, a transaction entered into for profit, and a loss due to fraud that might qualify as a deduction cognizable under §165(c)(2). What do you, as the Client's Investigator, need to do to support this claim? Do you feel like it has the potential to be viable?

This fundamentally identical fact situation was considered by the Court in the 1959 case, Richey v. Commissioner where they held that theft-loss deduction would be disallowed to avoid a frustration of sharply defined public policy. While holding that the taxpayer had brought himself within the literal requirements of §165(c), the Court concluded that to allow the loss deduction would constitute a severe and immediate frustration of the clearly defined policy against counterfeiting obligations of the United States.


Real World Example #3:

Suppose Joe Client, a successful neurosurgeon, attended a seminar in the Cayman Islands where Larry Lawyer and Albert Accountant promoted Agris, a program they developed calculated to minimize tax liabilities by funneling income and assets thru a series of corporate entities and a complex constellation of trusts.

As a direct consequence of the representations made during that seminar, and a series of personal, one-on-one encounters that followed, Joe Client was persuaded to retain Larry and Albert to manage his finances. After paying a $25,000 set up cost to buy into the program, many of his assets were liquidated and the funds were transferred to offshore accounts. Most of his remaining assets were titled in the name of various trusts that Larry and Albert controlled.

During the years that followed, Joe Client's income was paid directly to a business management corporation that paid him a nominal salary which he declared as income. The remaining funds were passed around thru offshore entities and charitable trusts, and Joe Client was provided monthly statements demonstrating the program's effectiveness and justifying the management fees that he paid Larry and Albert, which usually averaged approximately $1000 per month.

Instead of paying annual income tax in excess of $150K, Joe Client paid a few hundred, plus approximately $12K a year in management fees; on balance, it was a wonderful deal.

After five years, one of the Agris program's clients was audited. Once the giggling stopped, the IRS initiated a legal action to enjoin Larry Lawyer and Albert Accountant from engaging in any more of this nonsense, and force them to turn over their client list.

Within months, Joe Client was audited and advised that moving all this money around was a useless exercise - from the standpoint of the IRS, it was nothing more than razzle dazzle voodoo utterly devoid of economic substance. Federal authorities investigating the matter determined that Larry Lawyer and Albert Accountant had masterminded this abusive trust tax scheme, and neglected to file tax returns for many years. They were subsequently indicted, buried in federal tax liens, and they remain federal fugitives.

Their fraud scheme cost Joe Client the $25,000 set up fee and approximately $60,000 which they collected as management fees.

Of course, that is no shade of what this really "Cost" Joe Client - I am just talking about what his involvement in the program put together by these characters cost him out-of-pocket. In reality, that $85K is a mere "drop in the bucket" compared to what the IRS is going to do to him. Assuming that Joe Client is afflicted with the remarkable hubris that it would take to try and characterize the money he paid to these knuckleheads as some kind of investment loss, how would you break this down?

We have an individual, who relied on the representations of an accountant, and an attorney in engaging in a series of transactions that would appear to be cognizable under §165(c)(2) as they were entered into in an effort to make a profit . . . or maybe not.

Perhaps the government would hold that Joe Client did not enter into these transactions intending to generate profit, but rather in an effort to minimize tax liability. Would that mean that Joe Client incurred losses related to trade or business cognizable under §165(c)(1)?

Perhaps this series of transactions could be correctly classified as a loss that was neither business related, nor entered into for profit, thereby cognizable under §165(c)(3)?

In any event, what do you, as the Client's Investigator, need to do to support this claim? Do you feel like it has the potential to be viable?

The IRS representatives you deal with are going to make references to snowballs and furnaces, and conjure up images of a guy with a pointed tail and pitchfork wearing ice skates. That pretty much sums things up.

Succinctly put, taxpayers are estopped from claiming a deduction for losses that would otherwise be cognizable under IRC §165 if their investment was intended to reduce or postpone taxes rather than to earn profits.

Once upon a time, a Court saw things differently; in Perry A. Nichols v. Commissioner, 43 T.C. 842 (1965), the Court ruled that it didn't matter and permitted Nichols to take the disputed deduction. Anyone thinking they can "hang their hat" on that case would do well to revue Rev. Rul. 70-33.

Similarly, in the case Omerza v. Commissioner, the United States Court of Appeals for the Third Circuit stated that:

" . . . if a transaction is devoid of economic substance . . . it simply is not recognized for federal taxation purposes, for better or for worse. This denial of recognition means that a sham transaction . . . cannot be the basis for a deductible "loss."

In essence, the court holds that taxpayers are estopped from claiming a deduction for losses procured by fraud, where the objective evidence demonstrates that the purpose of their investment was to reduce or postpone taxes rather than to earn profits. Having stipulated that the underlying transaction was a sham, the purported expectation of a profit is irrelevant and their claimed deductible loss must be denied."

Sometimes, Judges can be remarkably eloquent in their expression of position; I particularly enjoyed the way in which the Court characterized this case.

"In this case, the parties have asked us to preside over the ceremony in which we nail down the coffin to which we consign the lost hopes of Mr. Graham's gullible investors to salvage some residual tax benefit from their participation in the spurious tax shelters that he promoted. We have invariably held that these tax shelters lacked economic substance and that the participants were not entitled to deduct their out-of-pocket expenditures under section 165(c)(2)."

The proper test for whether a transaction is a sham is whether the transaction has any practicable economic effects other than the creation of income tax losses.

REVIEW: The main points thus far are:

  • A "loss" according to the tax code is pretty much as we define it in common usage; and
  • A "casualty loss" according to the tax code is a loss due to certain specific events; and
  • A casualty loss can be worth much more to the tax payer than an ordinary loss; and
  • Internal Revenue Code §165 provides that casualty losses are deductible; and
  • IRC §165 categorizes casualty losses as: (c)(1) business losses; (c)(2) personal investment losses, and (c)(3)other property losses; and
  • IRC §165 requires that that these losses must be due to "casualty" to be deductible; and
  • IRC §165 recognizes theft as a specifically enumerated casualty, and case law provides that the word "theft" encompasses virtually any unlawful taking.
  • IRC §165 claims are subject to some serious pitfalls established via case law, particularly, privity, public policy, and tax sham transactions

Closing Comments:

I chose to cite examples in which there were unforeseen perils in order to best profile the most common areas of concern. I do not wish to leave you with the impression that availing oneself of relief that Congress unquestionably intended is fraught with insurmountable obstacles - it isn't.

In Schneider v. Commissioner, the Court held that Schneider was entitled to an IRC §165 deduction under circumstances where Schneider entrusted investment capital to a con artist who outright stole it, notwithstanding the fact that Schneider made no real effort to recover his loss. I particularly like this case as it was the Petitioner's "extensive investigation" that saved the day. The Court found the fact that the IRS was unable to collect from the perpetrator to be persuasive evidence that any effort Schneider might have made would have been a waste of time and effort.

Ahem, kick the podium, slap the pointer on the desk . . . "The Court found the fact that the IRS was unable to collect from the perpetrator to be persuasive evidence that any effort Schneider might have made would have been a waste of time and effort." If you are involved in a §165 case, you will check for unsettled IRS tax liens won't you!

In Ander v. Commissioner, the Court held that Ander was entitled to include attorney's fees as part of her theft loss deduction, after her husband stole, forged and cashed checks related to the sale of their jointly owned residence, using the money for his own use. The Court declined to accept the IRS' position, contending instead that the attorney's fees were analogous to the costs of recovery or salvage which were so closely identified and connected with the theft loss itself as to be further or additional or collateral theft losses. Noting that the attorney's fee was paid solely in connection with the taxpayer's action against her husband and that this action was based entirely on the husband's conversion by forgery, the court made an analogy between a necessary recovery cost of stolen property and a necessary repair cost to damaged property. The court said that it would be anomalous in the extreme if expenses paid to reduce the amount of a loss were not themselves deductible in full.

In the wonderfully bizarre case of Bennett v. Commissioner, the Court held that the taxpayer was entitled to a §165 deduction related to an armed robbery. The taxpayer, a professional bookmaker, satisfied the Court that a police report was filed along with a report to the Federal Bureau of Investigation. The case was investigated, suspects were identified and apprehended, but no money was ever recovered.


Clients who have been defrauded in an investment scam often stand to receive little to no "bottom line" benefit under IRC §1211, but a properly supported IRC §165 filing can result in a recovery dramatically exceeding what they would have received consequent to a successful lawsuit - even assuming that the crook paid the judgment.

To perfect a viable IRC 165(c)(2) filing, the Client must PROVE, inter alia, that the investment loss was due to theft, the transaction has been completed, and there is no reasonable likelihood of recovery -- that's our job. A Client who might derive no benefit from a capital loss, could stand to recover 35% (net) of their theft loss based entirely on your work.

Help your Clients deal with tax professionals reluctant to fight the battle that inevitably accompanies a §165 deduction. IRC §1211 is the easy way out for them, and you should not stand by quietly while your Client's best interests are sacrificed by a tax professional afraid to fight for the benefits that Congress intended that they have.

Once you have successfully made that case, do not let anyone undermine your hard work by categorizing your §165(c)(2) theft loss under §165(c)(3), thereby subjecting it to offsets that should not apply.

Don't look at the IRS as your enemy, think of them as protecting insurance company stockholders from those who would push a dead guy in front of a train in an effort to collect under a "double indemnity" clause. Dot your I's, cross your T's and study relevant case law.

The IRS does not make it easy, but this can be done, and the tax deduction can be worth a lot more than many of these victims actually net consequent to their law suits, and other recovery efforts.


UPDATE 2009: The IRS Addresses These Issues Directly

In the wake of the Madoff case, the IRS has published rulings specifically addressing IRC 165(c)(2), and its appropriate application to investment fraud, as well as providing "safe harbor" procedures for those who were affected.

These documents should make it easier for you to explain these policies and procedures to clients.


CAVEAT

If you are involved in the investigation of investment fraud, and you develop the information and evidence necessary to support an appropriate deduction cognizable under IRC 165(c)(2), you will probably, and properly, be required to submit an Affidavit in support of that deduction. It may be in the best interests of your Client to include language in your Affidavit distinguishing yourself from the cottage industry of those providing IRC 165 related services on a contingent fee basis. I have attached an example taken from a Declaration that I recently prepared.


COMMENT

If your involvement in the investigation of investment fraud cases is widely publicized, you are likely to be contacted by individuals who have horror stories to share regarding companies and individuals that solicited them to handle IRC 165(c)(2) tax deduction issues on their behalf, for a percentage of the deduction, on a "no recovery, no fee" basis.

I am not going to wade into that imbroglio, other than to say that the IRS Criminal Investigation Division is investigating some of these "165 service providers," and I believe that indictments are long overdue regarding the fraud that is pervasive within that industry.

I am not suggesting that there are no legitimate providers of services related to these deductions, nor am I alleging that a contingent fee contract implicates fraud, but when there is fraud, the fraud works like this.

Joe Investor loses a million dollars. Charles the Conniver solicits Joe and touts the potential to recover hundreds of thousands of dollars for Joe by claiming a tax deductible investment fraud casualty loss pursuant to the provisions of IRC Section 165. In soliciting this business Charlie proffers the "no recovery, no fee" aspect of his contract as an inducement. "After all," he argues, "what do you have to lose?"

Unfortunately, Joe Investor generally has no idea what he stands to lose.

What Charles the Conniver fails to explain is the fact that the entire tax system relies upon "voluntary compliance." Consequently, this deduction (as is true for a host of completely ridiculous claims for other deductions I could name) can be expected to be initially processed without issue whether it is legitimate or not. Joe Investor will almost always initially enjoy the benefit of a windfall deduction, and Charles the Conniver will collect his fee.

That the deduction will initially be processed without issue is to be expected . . . just as it is to be expected that this IRC 165 deduction will subsequently be audited when the IRS gets around to it, generally a couple of years down the road.

That the IRS will eventually audit this deduction is to be expected . . . just as it is to be expected that they will initially deny it, requiring that Joe Investor prove he is entitled to it, or pay the assessment to include the amount of the deduction, interest and penalties. Charlie Conniver knew very well that was coming, but by that time, this fraudster is long gone along with his fee.

That is how they system works, the cottage industry of Charlie Connivers out there perpetrating fraud are exploiting it, and the IRS is aware of it.

Having said that, my purpose was just to make you aware of the potentialities for fraud. I would also say that this should be of no concern to you. If you investigate a case where your client suffers a legitimate casualty loss cognizable under any of the provisions of Internal Revenue Code Section 165, no IRS agent is going to come bang on your door for attempting to deal with that accordingly; it is the charlatans out there proposing to pound square pegs into round holes for a fee that they are concerned with - as they should be.

If you encounter a victim of this sort of fraud, please let me know. I am putting together a collection of case studies.


UPDATE: April 2011

Last year, in April 2010, the government filed a Complaint for a Permanent Injunction in an effort to enjoin Tobias H. Elsass, Sensible Tax Services, Inc., and the Fraud Recovery Group, Inc., from "directly or indirectly promoting the “theft loss” scheme described herein, and from engaging in any other conduct subject to penalty under I.R.C. Sections 6694, 6695, 6700, and 6701, and from engaging in any other conduct that substantially interferes with the proper administration and enforcement of the internal revenue laws."

 

I welcome your comments, questions and suggestions.


 
 
 
© Copyright 2002 - Bill E. Branscum. All Rights Reserved.