IRS Guidance Leaves Room For Tax Preparer Judgment

A tax preparer eager to provide greater value to clients has new IRS guidance to consider regarding losses from investment scams. The issue is complex and requires careful judgment.

Basically, taxpayers receive an advantage if they can categorize losses as thefts instead of as investment loss. Only a small limitation applies to deducting a theft loss for anyone who itemizes deductions. Conversely, an investment loss is limited to merely $3,000 in a single year under the capital loss rules.

Of course, the excess loss is carried forward. Also, a tax return preparer course instructs professionals to use carryforward for offset of gains on other investments. But this can take years when a particularly large loss occurs from a Ponzi scheme. Consequently, many taxpayers have resorted to classifying these investment rip offs as theft losses.

Unfortunately, according to a report by the Tax Inspector General for Tax Administration (TIGTA), many investment losses are erroneously reported as theft loss. The report estimated that 82 percent of 2,177 returns may have incorrectly claimed theft loss deductions totaling $697 million. Unlike capital loss limitations, tax preparer jobs with theft losses subtract only $100 and then take a tax deduction for the amount that exceeds 10 percent of taxpayer adjusted gross income.

Nevertheless, the IRS provides some guidance for Ponzi scheme victims following losses by thousands of taxpayers in the Bernard Madoff investment scandal. Investors may treat a loss from such investments as a theft loss deduction if certain conditions are met. These IRS rules allow a theft loss instead of a capital loss when investors are deprived of money by criminal acts.

A theft loss is sustained in the year a taxpayer discovers the criminal loss. However, if, the taxpayer makes a claim for reimbursement, no deduction is allowed for any portion of the loss for which recovery is reasonably expected.

The loss is the amount invested less any recovery plus an amount of income reported in prior years that was fictitious. The safe harbor calculation for such phantom income is important for tax preparer work. This process determines fictitious income from multiplication of the stolen investment funds by 95 percent if no potential third-party recovery is sought or 75 percent if pursuing a third-party recovery. Any actual recovery is subtracted from the result.

Although most tax preparers are unlikely to encounter Ponzi scheme victims, knowledge of the difficulty with such matters is desirable. Taxpayers in these cases should probably obtain a high level of tax advice. An enrolled agent training course is worth considering for tax practitioners to obtain a clear understanding of the intricate considerations in this matter.

IRS Circular 230 Disclosure

Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

Fast Forward Academy is a leading publisher of education for tax preparer and tax professionals. Access to free questions for the tax return preparer course is available on their website.