Frost Law
In recent years, online scams known as “pig butchering” have proliferated, with estimates of over $75 million stolen from unsuspecting victims. The scams are so named because the scammers “fatten up” their targets over time, before the final kill. These scams come in many flavors, but the three most common are romance scams, elder scams, and investment scams.
The scams tend to follow a familiar pattern. First, the scammer makes initial contact with the victim. This might be through a dating app, social media, LinkedIn, or even a job posting.
Once initial contact is made, the scammer works to build the trust of the victim. This might involve building a friendship or even a romantic relationship. The scammer may try to convince the victim that he is someone trying to help the victim; the scammer may pose as a government employee or a technology support representative. In an investment scam, the perpetrator will introduce the concept of investing, usually in cryptocurrency, to the victim and will oftentimes speak about their own investment success and offer to teach the victim how to trade in cryptocurrency contracts and other derivative investments.
Through the trust building process, the scammer is also working to identify the victim’s assets. The romance scammer will begin talking about their own financial problems and inquire about the victim’s ability to help. The investment scammer will discuss the victim’s other investments and whether they are interested in the more lucrative investment experience that cryptocurrency can offer.
At some point, the victim will transfer funds to the scammer. For example, a romance scam victim may think that he is sending money to pay for medical care for a sick child. Likewise, an elderly victim may be convinced that she is transferring funds to a federally secured account, out of the reach of hackers and others trying to steal her retirement funds.
An investment scam victim will generally begin by investing a small amount, maybe $1,000, through a cryptocurrency trading platform. This victim generally uses cash to buy Bitcoin or Ethereum, and then will transfer this legitimate cryptocurrency to the fabricated investment platform. The investment may initially appear to perform well, and the victim may have the opportunity to withdraw some of the “earnings.” However, the victim will soon begin to invest additional funds on the promise of similar, favorable returns. After earning satisfactory investment gains, the victim will try to withdraw their earnings from the investment platform. At that point, they are usually faced with an obstacle preventing withdrawal; sometimes, the scammer will tell the victim that to withdraw funds, they must pre-pay the “capital gain” tax on the investment gains. The scammer will tell the victim that this amount must be paid in from additional funds and cannot be taken from the account earnings.
The victim may also be told that to make a withdrawal, she must first make a “security deposit” payment to verify the authenticity of her cryptocurrency wallet.
Eventually, the victim will run out of money, and at that point, the scammer disappears.
After the scammer disappears, the victim is left with no money and, usually, no hope for recovery. Although federal law enforcement agencies have had some luck recovering funds on behalf of scam victims, in the majority of cases the stolen funds are not ever returned to the victims.
To make matters worse, the victim may be left with a hefty tax bill on top of the loss of their life savings. If the victim withdrew funds from a retirement or other tax-qualified account or sold appreciated assets to raise funds to invest in the fraudulent scheme, the victim is still responsible for paying tax on the amounts received.
Victims of so-called pig butchering scams must suffer the double shot of losing their life savings and also paying tax on the income lost to the scammers. However, there may be some limited relief available for the victims of investment scams. In certain cases, the lost funds may generate a theft loss deduction.
There are two categories of theft loss deduction under section 165(c) of the Internal Revenue Code (the “Code”) that apply in the case of an individual taxpayer.
First, generic theft and casualty losses, which are each included in the definition of “personal casualty losses,” are normally deductible under section 165(c)(3). These losses are subject to various limitations on deductibility, but most importantly, the deduction for these losses is suspended for tax years 2018 through 2025 due to the Tax Cuts and Jobs Act of 2017 (“TCJA”). Specifically, TCJA added section 165(h)(5) to the Code, under which personal casualty losses are only deductible if the loss is attributable to a Federally declared disaster. As a result, this deduction will not be available to the victim of a scam.
The second category of losses available outside of a trade or business is a loss related to a “transaction entered into for profit,” as described in section 165(c)(2) of the Code. This deduction has several key differences from the deduction under section 165(c)(3). The section 165(c)(2) deduction is not subject to limitations on the amount of the deduction and is not subject to the TCJA suspension for tax years 2018 through 2025. Further, the deduction under section 165(c)(2) is deductible in the year that the loss is discovered.
How do taxpayers differentiate between losses covered under section 165(c)(2) and section 165(c)(3)? Or, to put it another way, what is a transaction entered into for profit?
The IRS answered a similar question in Revenue Ruling 2009-9. That ruling, which dealt with losses incurred by a taxpayer who unwittingly invested in a “Ponzi Scheme,” noted that the purported financial advisor in the case stole funds from the taxpayer (and other affected victims) for his own use and perpetrated the scheme by reporting investment activities that “were partially or wholly fictitious.” The IRS concluded that the purported investment advisor committed “criminal fraud or embezzlement under the law of the jurisdiction in which the transactions occurred.”
The IRS ultimately concluded that the taxpayer’s loss was a theft loss, and not a capital loss, because the intent of the purported financial advisor was to deprive the taxpayer of money by criminal acts, which constituted a theft. The IRS further concluded that the loss would not be subject to the limitations of section 165(h), because the taxpayer’s action of opening an investment account with the purported advisor was a transaction entered into for profit, and thus deductible under section 165(c)(2), not section 165(c)(3).
The analysis and conclusions that the IRS reached in Revenue Ruling 2009-9 fits the analogous situation of a taxpayer who is the victim of an investment scam. Although the IRS has not directly ruled on that issue, a taxpayer may feel comfortable claiming a deductible loss under section 165(c)(2) based on the amount of funds invested in the scam that was entered into for profit.
The deduction available for losses related to a transaction entered into for profit can provide some help to victims of investment scams. But two limitations arising out of the TCJA continue to make the deduction an incomplete, and sometimes unavailable, solution.
First, normal theft loss deductions are still not allowed for tax years 2018 through 2025. So, for victims of romance and elder scams, the theft loss deduction is not available.
Second, the TCJA changed the rules for carrying unused losses forward and backward; under the TCJA, unused losses can be carried forward to future tax years but cannot be carried back to prior years. This can be a problem for a victim who takes a distribution from a retirement account in December of Year 1 but doesn’t discover that the scheme is fraudulent until January of Year 2. For that victim, the loss that may be deductible in Year 2 will nonetheless provide no offset to the income taxable in Year 1.
Online scams of all kinds can have devastating effects on the victims and their families. For many victims, the perpetrators have taken their life savings, leaving them with little to nothing left. For those who were unfortunate enough to have taken distributions from a retirement account, or who sold appreciated property to raise funds for investing in the scam transaction, the income tax on those transactions must still be paid.
There is a growing chorus calling for the IRS and Congress to address this issue, but so far there has been no change to current law. While the deduction under section 165(c)(2), if available, can offset the income generated from a retirement account distribution or appreciated asset sale, those individuals who lost money in a romance scam or elder scam cannot even find that small solace. Without some change in the law, these individuals are left without a place at the table. If you have any questions or concerns about these scams then please reach out to our team at (410) 497-5947 or schedule a confidential consultation
In recent years, online scams known as “pig butchering” have proliferated, with estimates of over $75 million stolen from unsuspecting victims. The scams are so named because the scammers “fatten up” their targets over time, before the final kill. These scams come in many flavors, but the three most common are romance scams, elder scams, and investment scams.
The scams tend to follow a familiar pattern. First, the scammer makes initial contact with the victim. This might be through a dating app, social media, LinkedIn, or even a job posting.
Once initial contact is made, the scammer works to build the trust of the victim. This might involve building a friendship or even a romantic relationship. The scammer may try to convince the victim that he is someone trying to help the victim; the scammer may pose as a government employee or a technology support representative. In an investment scam, the perpetrator will introduce the concept of investing, usually in cryptocurrency, to the victim and will oftentimes speak about their own investment success and offer to teach the victim how to trade in cryptocurrency contracts and other derivative investments.
Through the trust building process, the scammer is also working to identify the victim’s assets. The romance scammer will begin talking about their own financial problems and inquire about the victim’s ability to help. The investment scammer will discuss the victim’s other investments and whether they are interested in the more lucrative investment experience that cryptocurrency can offer.
At some point, the victim will transfer funds to the scammer. For example, a romance scam victim may think that he is sending money to pay for medical care for a sick child. Likewise, an elderly victim may be convinced that she is transferring funds to a federally secured account, out of the reach of hackers and others trying to steal her retirement funds.
An investment scam victim will generally begin by investing a small amount, maybe $1,000, through a cryptocurrency trading platform. This victim generally uses cash to buy Bitcoin or Ethereum, and then will transfer this legitimate cryptocurrency to the fabricated investment platform. The investment may initially appear to perform well, and the victim may have the opportunity to withdraw some of the “earnings.” However, the victim will soon begin to invest additional funds on the promise of similar, favorable returns. After earning satisfactory investment gains, the victim will try to withdraw their earnings from the investment platform. At that point, they are usually faced with an obstacle preventing withdrawal; sometimes, the scammer will tell the victim that to withdraw funds, they must pre-pay the “capital gain” tax on the investment gains. The scammer will tell the victim that this amount must be paid in from additional funds and cannot be taken from the account earnings.
The victim may also be told that to make a withdrawal, she must first make a “security deposit” payment to verify the authenticity of her cryptocurrency wallet.
Eventually, the victim will run out of money, and at that point, the scammer disappears.
After the scammer disappears, the victim is left with no money and, usually, no hope for recovery. Although federal law enforcement agencies have had some luck recovering funds on behalf of scam victims, in the majority of cases the stolen funds are not ever returned to the victims.
To make matters worse, the victim may be left with a hefty tax bill on top of the loss of their life savings. If the victim withdrew funds from a retirement or other tax-qualified account or sold appreciated assets to raise funds to invest in the fraudulent scheme, the victim is still responsible for paying tax on the amounts received.
Victims of so-called pig butchering scams must suffer the double shot of losing their life savings and also paying tax on the income lost to the scammers. However, there may be some limited relief available for the victims of investment scams. In certain cases, the lost funds may generate a theft loss deduction.
There are two categories of theft loss deduction under section 165(c) of the Internal Revenue Code (the “Code”) that apply in the case of an individual taxpayer.
First, generic theft and casualty losses, which are each included in the definition of “personal casualty losses,” are normally deductible under section 165(c)(3). These losses are subject to various limitations on deductibility, but most importantly, the deduction for these losses is suspended for tax years 2018 through 2025 due to the Tax Cuts and Jobs Act of 2017 (“TCJA”). Specifically, TCJA added section 165(h)(5) to the Code, under which personal casualty losses are only deductible if the loss is attributable to a Federally declared disaster. As a result, this deduction will not be available to the victim of a scam.
The second category of losses available outside of a trade or business is a loss related to a “transaction entered into for profit,” as described in section 165(c)(2) of the Code. This deduction has several key differences from the deduction under section 165(c)(3). The section 165(c)(2) deduction is not subject to limitations on the amount of the deduction and is not subject to the TCJA suspension for tax years 2018 through 2025. Further, the deduction under section 165(c)(2) is deductible in the year that the loss is discovered.
How do taxpayers differentiate between losses covered under section 165(c)(2) and section 165(c)(3)? Or, to put it another way, what is a transaction entered into for profit?
The IRS answered a similar question in Revenue Ruling 2009-9. That ruling, which dealt with losses incurred by a taxpayer who unwittingly invested in a “Ponzi Scheme,” noted that the purported financial advisor in the case stole funds from the taxpayer (and other affected victims) for his own use and perpetrated the scheme by reporting investment activities that “were partially or wholly fictitious.” The IRS concluded that the purported investment advisor committed “criminal fraud or embezzlement under the law of the jurisdiction in which the transactions occurred.”
The IRS ultimately concluded that the taxpayer’s loss was a theft loss, and not a capital loss, because the intent of the purported financial advisor was to deprive the taxpayer of money by criminal acts, which constituted a theft. The IRS further concluded that the loss would not be subject to the limitations of section 165(h), because the taxpayer’s action of opening an investment account with the purported advisor was a transaction entered into for profit, and thus deductible under section 165(c)(2), not section 165(c)(3).
The analysis and conclusions that the IRS reached in Revenue Ruling 2009-9 fits the analogous situation of a taxpayer who is the victim of an investment scam. Although the IRS has not directly ruled on that issue, a taxpayer may feel comfortable claiming a deductible loss under section 165(c)(2) based on the amount of funds invested in the scam that was entered into for profit.
The deduction available for losses related to a transaction entered into for profit can provide some help to victims of investment scams. But two limitations arising out of the TCJA continue to make the deduction an incomplete, and sometimes unavailable, solution.
First, normal theft loss deductions are still not allowed for tax years 2018 through 2025. So, for victims of romance and elder scams, the theft loss deduction is not available.
Second, the TCJA changed the rules for carrying unused losses forward and backward; under the TCJA, unused losses can be carried forward to future tax years but cannot be carried back to prior years. This can be a problem for a victim who takes a distribution from a retirement account in December of Year 1 but doesn’t discover that the scheme is fraudulent until January of Year 2. For that victim, the loss that may be deductible in Year 2 will nonetheless provide no offset to the income taxable in Year 1.
Online scams of all kinds can have devastating effects on the victims and their families. For many victims, the perpetrators have taken their life savings, leaving them with little to nothing left. For those who were unfortunate enough to have taken distributions from a retirement account, or who sold appreciated property to raise funds for investing in the scam transaction, the income tax on those transactions must still be paid.
There is a growing chorus calling for the IRS and Congress to address this issue, but so far there has been no change to current law. While the deduction under section 165(c)(2), if available, can offset the income generated from a retirement account distribution or appreciated asset sale, those individuals who lost money in a romance scam or elder scam cannot even find that small solace. Without some change in the law, these individuals are left without a place at the table. If you have any questions or concerns about these scams then please reach out to our team at (410) 497-5947 or schedule a confidential consultation
