The Up Side to Investment Fraud: IRC Section 165

Investors have had very little to cheer about the last few years, and the bad news continues for many. Just over a month age, MF Global filed for bankruptcy protection, and that investigators have subsequently discovered that approximately $1.2 billion of assets in customers' accounts have disappeared. No one at the firm has confirmed what happened to the money, news reports have suggested that the money may have been used to cover bad trades and debts to other financial institutions. The New York Times, however, recently reported that investigators believe MF Global, in a frantic attempt to remain solvent, may have paid at least $200 million in customer funds to JPMorgan Chase. Also, late yesterday afternoon on Capitol Hill, after the firm's top executives repeatedly denied knowing where the money went, allegations arose that the executives knew that the firm was loaning customer money to related-parties.

It remains to be seen whether MF Global's clients will receive a return of their accounts, if any at all. Although only a full recovery of the missing $1.2 billion would make the customers whole, careful tax planning may help alleviate some of their financial losses. Section 165 of the Internal Revenue Code provides taxpayers relief to deduct casualty or theft losses that are not compensated by insurance. The IRS issued Revenue Ruling 2009-9 to clarify section 165 issues related to the Bernie Madoff Ponzi scheme, and offers useful guidance regarding the timing and character of deductions for losses that are due to theft or fraudulent investments, assuming MF Global's actions turn out to meet either of those conditions. The Ruling, however, reflects a trap for the unwary buried in section 165: in which year does can the taxpayer take the deduction?

This in an important issue because taking the deduction in the wrong tax year could come back to haunt a taxpayer. For example, suppose a taxpayer claimed a deduction under section 165 on its 2011 tax return, for the loss it sustained in its MF Global account. If IRS subsequently challenged the timing of that deduction and successfully sustained that challenge several years later, by the time the invalidity of the 2011 deduction were determined, it may very well be too late for the taxpayer to amend its return to claim the deduction in the proper year.

To analyze whether a deduction for a loss may be claimed in a given year, Treasury regulations use the "reasonable prospect of recovery" test. If a reasonable prospect of recovery exists for any portion of a taxpayer's casualty or theft loss, that portion is not currently deductible. Thus, because it remains possible that the judge overseeing the MF Global bankruptcy proceedings could allocate assets in the bankruptcy estate to make the customers whole, they would not yet be permitted a deduction for losses due to the firm's misappropriation of their money.

The IRS recognizes that the ambiguity inherent in the reasonable prospect of recovery standard can lead to inequitable results. Addressing this ambiguity in the aftermath of the Bernie Madoff Ponzi scheme, the IRS issued guidance to establish bright line rules. The guidance allows qualified taxpayers to deduct seventy-five percent of their uninsured losses, even if they continue to pursue recovery of their losses against third parties. Taxpayers who choose not to pursue recovery of their losses against third parties may deduct ninety-five percent of their uninsured losses. The guidance only allows for this deduction, however, for the tax year in which a government agency issues an indictment, information, or (in some cases) criminal or civil complaint alleging theft against one of the perpetrators. In the case of MF Global, this simply has not occurred - at least not yet - so the guidance does not yet provide relief.

Finally, subject to some limitations for individuals, casualty or theft losses constitute ordinary deductions. We understand that the equity in some MF Global customers' accounts consisted of open commodity contracts. If such a contract was the subject of a casualty or theft loss, then the customer could deduct his basis in the contract against ordinary income, even though disposition of the contract right could otherwise trigger capital gain or loss.

If you have any questions regarding losses due to theft or fraudulent investment contact one of our experienced attorneys at (916)488-8501.

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