Victims of securities fraud and tax deductions

After being the victim of securities fraud, the last thing someone wants to worry about is whether and when to claim a tax deduction for the loss.  And yet, the issues can be extremely complicated.  A decision of the Federal Court of Claims, Adkins v. United States (Dec. 11, 2013), illustrates some of the important issues to keep in mind.

What difference does it make if a loss is due to fraud?  A loss on the sale of a security is typically a capital loss, which individuals may only deduct to the extent of capital gains, plus $3,000 per year.  IRC §§ 165(f), 1211(b).  In contrast, a theft loss – which includes losses due to fraud — can be deducted against ordinary income, to the extent not compensated for by insurance or otherwise.  IRC § 165(e).

When is the loss deductible?  The loss is generally allowable in the year in which it is discovered. However, if there is a reasonable prospect of recovery at the time the theft is discovered, the deduction is suspended until it can be ascertained whether the recovery will be received.  Regulations § 165-8(a)(2).  So, to claim an ordinary tax deduction you must prove not only that you were the subject of a crime, but also that you had no reasonable expectation that you would be compensated for your loss.

Charles and Jane Adkins were the victims of a scheme in which a brokerage firm manipulated the price of over-the-counter securities. Some of the securities were purchased from the broker, while others were purchased from other brokers at its recommendation.  In 2002, the Adkins submitted a demand for arbitration against their broker, and it ceased operations due to insufficient capital before the end of 2002.  During 2003, the plaintiffs learned that criminal indictments were forthcoming.  In 2004, several of the principals of the firm were indicted on various fraud-related charges, and agreed to plead guilty.  As part of the guilty plea, the defendants agreed to make restitution payments to victims, although no such payments were ever made.

The Adkins filed refund claims for tax years 2001 through 2004, asserting that the losses were attributable to theft, and that there was no reasonable likelihood of recovery at that time.  After initially contesting the claim, the IRS conceded that the losses on securities purchased directly were theft losses.  However, with respect to the securities purchased through other brokers, the IRS disputed that characterization, despite the fact that the market price for those securities had been the subject of market manipulation.  It claimed that in order for a loss to meet the definition of “theft” for tax purposes, there must be privity between the victim and the perpetrator of the fraud. On the facts of the case, the court held that the necessary relationship of privity existed for some, but not all, of the Adkins’ losses incurred.

On the issue of a reasonable prospect of recovery, the court reviewed all of the facts relevant to the question of the likelihood of recovery as of the end of 2004. It noted that there was a legal right to restitution, and that the likelihood of such recovery had not been established.  The court concluded that the issue was one of fact rather than law, and accordingly dismissed both parties’ motions for summary judgment.  The proceedings continued for all open years, addressing the issue of whether there were reasonable prospects for recovery as of the end of 2004.

This case illustrates a few interesting points.  First, the details of the relationship between the victim and the perpetrator of the fraud can have significant tax ramifications, which should be kept in mind during the course of the litigation.  Second, there is a tension between the financial objective of preserving potential rights to recovery and the tax objective of demonstrating that the victim does not have a reasonable likelihood of success in that effort.  In some circumstances, a client may be better off abandoning claims with a low likelihood of success, and strengthening the case for a tax deduction.    Finally, watch the statute of limitations for tax returns.  The worst result is a tax loss pushed into a year for which the statute of limitations has expired, potentially barring the refund claim.