Archive for Casualty Losses

When Investments Go Wrong: IRS Safe Harbors for Ponzi Scheme Losses

It’s been several years since Bernie Madoff confessed to taking billions of dollars from investors in his fake asset management division. But, Ponzi schemes existed well before Madoff pulled off his extravagant plot, and you will always come across people who think they can skirt the law (and ethics in general). Sometimes, these “opportunities” seem like legitimate investments until you start looking at the statements. So, what do you do if you’ve been caught in a Ponzi scheme?

First, know that you do have some protection. You “invested” your money, so you can’t just get it all back unfortunately. You live and you learn. However, you are eligible to claim tax-deductible losses on that money. The problem is that you’ll have a heck of a time proving your Ponzi scheme losses in the year of the loss, which could really hurt your finances.[1] Luckily, the safe harbor laws grant additional protection. Legislation passed in 2009 allows losses from a Ponzi scheme to be carried back 5 years on your taxes, as long as you are eligible[2].

So, what do you do when you find yourself victim to investment fraud?

Using Tax Law Safe Harbors

First, you should know that you are not required to use the Ponzi scheme tax relief safe harbor. But, you’d be silly not to. If you don’t invoke the safe harbor rules, your losses will be deducted using the general rules for theft loss, which means jumping through more hoops and possibly being audited. Yes, you read that correctly. Regarding taxpayers who choose not to use the safe harbor, the IRS has stated:

Returns claiming theft-loss deductions from fraudulent investment arrangements are subject to examination by the [IRS].[3]

That means being audited.

When the IRS actually threatens you with an audit, you should probably take it seriously. And, what about those general theft rules? If you forego the safe harbors, you’ll be required to prove:[4]

  • The loss actually was theft;
  • You claimed this loss on your taxes the year you found out about it (which can be difficult to prove);
  • You have the exact dollar amounts lost, with documentation; and
  • You cannot reasonably expect to recover the loss through reimbursements in the year you found out about the theft and claimed the deductions.

All in all, it’s just easier to follow the safe harbor rules. In fact, you’ll have a much nicer time of it with the IRS if you do.[5] Here’s how it will work when you use the Ponzi scheme tax relief safe harbor laws:

  • You will be able to deduct the fraudulent scheme as a theft loss.
  • You will be able to deduct the loss the year the scheme was found out (i.e. when the perpetrator was indicted, or when the perpetrator either admits guilt or has their assets frozen following a federal or state criminal complaint).
  • Your losses will be calculated with the safe-harbor formula.

Using the safe harbor rules, you have less evidence to provide, and the deduction process is simpler for you to complete. You should know that the IRS often disagrees with deductions for theft loss. Safe harbor rules prevent that.

How Safe Harbor Amounts are Calculated

Before you can take advantage of the safe harbor, you’ll need to show that you are in compliance with its requirements by providing statements of the following (under penalty of perjury):[6]

  • The name of the Ponzi scheme perpetrator;
  • Confirmation that you have written documentation to back up your deduction amounts;
  • Your declaration of status as a Ponzi scheme victim and qualified defrauded investor; and
  • Confirmation that you will abide by all terms of declaration.

This information will need to be attached to your tax return.[7] Also, in this statement, you will show your loss deduction calculations for the discovery year, as follows:[8]

  1. The starting number is your original investment.
  2. Add all of your subsequent investment amounts.
  3. Add any money that was supposedly reinvested on your behalf and that you claimed on your tax returns as income (but for which you received no cash payments from the perpetrator).
  4. Subtract any withdrawals you made from the investment fund. The resultant number is your qualified investment.
  5. Next, determine whether you are a Ponzi victim with possible third-party recovery.
  6. Determine your net qualified investment. If you do have possible third-party recovery, you will multiple the qualified investment amount from step 4 by 75 percent. If you do not have possible third-party recovery, multiply the qualified investment amount by 95 percent.
  7. List any money you actually recovered from the Ponzi scheme (through any source) in the year you are making a deduction.
  8. List the totals for any agreements that protect you from the loss, including insurance policies, contracts, and amounts you are entitled to by the Securities Investor Protection Corporation (SIPC).
  9. Add together your total recoveries from step 7 and step 8.
  10. Finally, you will subtract the answer in step 9 from the answer in step 6 in order to get your gross theft-loss deduction.

It’s all pretty straightforward. As long as you kept all of your statements, and financial and insurance documents, you’ll have everything you need. In subsequent years, you’ll make adjustments for an additional recovery income or for increased losses in the case that your reasonably estimated recovery claims were too low.[9]

Typically, personal theft is subject to certain reductions before it can be claimed as a tax deduction.[10] First, the amount is reduced by a flat $100. Then, you reduce the remaining amount by 10 percent of your AGI. Fortunately, Ponzi scheme victims are not subject to these reductions; individuals can claim the full deductible amount, and businesses can claim the full business casualty loss amount.

Why the IRS Wants You to Follow Safe Harbor Rules

Do you really benefit from using the safe harbor calculations for your deductions? Let’s look at what you agree to give the IRS:

  • You will only deduct the amounts calculated in their formula (in the year the scheme was discovered);
  • For taxable years that precede the year of discovery, you will not amend or file tax returns that re-characterize or exclude income;
  • You will not claim Section 1341 benefits for your Ponzi scheme loss (restoration of an amount under the claim of right doctrine); and
  • You will not use the mitigation provisions of Sections 1311–1314 or the doctrine of equitable recoupment.

The IRS has made a strong statement against claiming the rights and provisions in that last bullet point.[11] It’s always a gamble going against the IRS in a situation that will likely end up in court. You could win the case, but will it be worth the time, money, and effort to challenge it?


By being educated in financial matters and paying attention to your personal and business finances, you can avoid Ponzi schemes. For one thing, you should never, ever give someone else complete control of your money. The best advice is to always know exactly what you are investing in and not making financial decisions that you don’t understand—even if everyone else is doing it. The government also has some guarantees set up to help people avoid losses: Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protection Corporation (SIPC).

Aside from avoiding fraudulent investments and being aware of government protections, you have a couple of other options for reducing your risk. One way is to have insurance on your investments. Making the investments yourself (rather than having someone else handle it) is the another way to avoid investment fraud losses. If you feel nervous about making these decisions on your own, know that you have resources from the Internet, news publications, financial magazines, and television, and just because someone says they are a financial expert doesn’t necessarily mean they know more than you do.

Even if you do hire an investment advisor to help you make decisions, you should always maintain control of your funds yourself. Never let an advisor have direct access to your money. You can reduce your chances of needing these safe harbor rules in the future if you ask questions about your portfolio and always know what is happening with your money.

  1. Rev. Proc. 2009-20, Section 2.03
  2. IRC Section 172(b)(1)(H)
  3. Rev. Proc. 2009-20, Section 8.03
  4. Rev. Proc. 2009-20, Section 8.01
  5. Rev. Proc. 2009-20, Section 5.01
  6. Rev. Proc. 2009-20, Appendix A, Part III
  7. Rev. Proc. 2009-20, Section 6.01
  8. Rev. Proc. 2009-20, Appendix A, Part II
  9. Rev. Proc. 2009-20, Section 5.03; Rev. Rul. 2009-9, Law and Analysis, Issue 3, Year of Deduction
  11. Rev. Rul. 2009-9

You Totaled Your Vehicle? Tax Benefits You Can Use

Let’s face it; wrecking your vehicle is a bummer. But, don’t let moping about something that’s done and over with keep you from being smart about the situation moving forward. There’s no need for having a totaled vehicle and missing out on tax benefits.

Understanding Tax Law

Your particular business situation will determine exactly how the tax law views your totaled vehicle, also called an involuntary conversion. Both individuals and corporations, however, have to work with the same rules as far as the business part of the vehicle. The difference lies in the personal use part. For an individual, there is a personal casualty loss. For corporations, there is no personal part; it’s all business.

If you’re confused about which situation applies to you, look at the check made out by the insurance company. When you total your vehicle, they will keep the vehicle and give you a check for its pre-accident value. If the check is made out to you (because you are a Schedule C taxpayer and you own the vehicle), you will divide the money between business and personal use based on mileage for each. A check made out to the corporation is not divided. On the books, the vehicle belongs to the business.

For a Proprietorship

Let’s do an example to see how you would divide the insurance money between personal and business use. In this example, you owned the vehicle for three years. During those three years, you drove it 20,000 miles for business and 5,000 miles for other uses. So, you have 80 percent business use from the time of purchase to the totaling of the vehicle.

You can now use that percentage to determine gain or loss on both a business and personal basis. Since a proprietorship is a Schedule C taxpayer, here’s what you need to know. 1) The business part will have either a taxable gain or a deductible loss. 2) For the personal part, you will pay taxes on any gain, but you cannot deduct a loss.

To clarify the personal casualty loss, you probably will not have a personal deduction if you had insurance. You see, by IRS rules you can deduct whichever is lower of your cost or the fair market value, minus the insurance proceeds. Since insurance will likely reimburse at fair market value minus your deductible, there will not be a personal casualty loss deduction.

Even if you have an insurance deductible, it is unlikely you will come out with a personal loss deduction. That’s because tax law includes these two additional rules regarding personal loss:

  1. The amount of each casualty loss is reduced by $100[1], and then
  2. Casualty losses are only allowed to the extent that they exceed ten percent of adjusted gross income[2].

If you think you might still have a personal loss to claim after these calculations, check with your tax advisor to be sure.

For a Corporation

Your corporation may own a vehicle that you use for both business and personal reasons. In that case, the corporation will assign a value to your personal use. That amount then goes on your W-2, or you will be responsible for reimbursing the corporation. Since you are a more than 5 percent shareholder, you are obligated by specific legal requirements regarding how your corporation determines this value.

Here’s how the example above plays out when the vehicle belongs to your corporation. As far as depreciation, gain, and loss purposes, the corporation owns 100 percent of the vehicle. So, all gains will be taxable, and any loss will be deductible.

Deferring Taxes

In either scenario, you can end up with some taxable gains. Usually, these gains come about because of depreciating the vehicle or expensing deductions claimed on it. When your gain comes from deductions, it’s called “recapture income”, which is taxed at the usual income tax rates. But, here’s a little secret: you can avoid those taxes!

Instead of claiming your totaled vehicle as a gain, you can replace it with other like-kind property. Tax law even allows for two years from the time of the wreck for you to make the replacement[3]. The details are covered under IRS Section 1031 on exchanges of business vehicles, which states that like-kind property for vehicles includes cars, light general-purpose trucks, and vehicles that share characteristics of the two former types (such as crossovers, SUV’s, vans, etc.).

All you have to do to defer the taxes is reinvest all of your insurance money into a new vehicle and properly document this on your tax return. That means if you wreck your SUV, you can take the $20,000 insurance money and replace your SUV with a car. If you don’t reinvest the full amount, you will have taxable income for the amount leftover[4]. So, if that new car only costs $16,000, you’ll have a taxable gain of $4,000. It works this way for both a proprietorship and a corporation.

Don’t Forget the Documentation

In order for your vehicle replacement to be accepted by the IRS (and to avoid taxes), be sure you attach a statement to your tax return (either the Form 1040 or the corporate return) that includes[5]:

  • Details of the wreck, including the date,
  • Amount of insurance reimbursement,
  • How you calculated the gain,
  • The replacement property purchased,
  • The amount of gain that is postponed,
  • The adjusted basis on the replacement vehicle (which is reduced by the deferral of gain), and
  • How much of the gain is taxable (again, if you invest the full reimbursement amount, there is no taxable gain).

So, in order to avoid those gain taxes, replace your vehicle with one of like-kind (which basically means for the same use) and document everything about your wreck, insurance reimbursement, and purchase of the new vehicle. For any business losses, deduct those immediately! Business loss deductions work the same way for a proprietorship or a corporation. You may not like knowing that you totaled your vehicle, but you can rest easy with the knowledge to set your finances straight in the aftermath.

  1. IRC Section 165(h)(1).
  2. IRC Section 165(h)(2).
  3. IRC Section 1033(a)(2).
  4. IRC Section 1033(a)(2)(A).
  5. IRS Pub. 547, Casualties, Disasters, and Thefts (2012), posted Nov. 29, 2012, p. 12.

Don’t Be a Target for the IRS

If there’s one thing the IRS is most known and feared for, it’s the audit. It’s well-known by now that the IRS has had its eye on tax-exempt conservative groups, but what you may not realize is that they’ve now expanded that extra attention to entrepreneurs, owners of small businesses, and high income earners. This is atypical of their past trends, since they had previously focused efforts on watching large corporations. However, the number of revenue agents in the IRS has risen by more than 5,000 people in the last few years.

Who’s at Risk?

This expansion in auditing-capability primarily hits the upper-middle class and affluent individuals. Without raising taxes, this move has allowed the IRS to greatly increase total tax collections because more audits are performed and more revenue officers are available to collect unpaid taxes from citizens. Grumble if you will, but the decision-makers are probably pretty happy with their investment in extra workers. Estimates show that the IRS has an 18 to 1 return rate on each dollar invested in audits and collections.

Are you feeling confident that your business is too small to come under scrutiny? Think again. The IRS conducted a study involving 46,000 taxpayers, and the results indicate a $345 billion tax gap. Guess what else the study revealed—about two-thirds of that gap came from entrepreneurs, small business owners, professionals, and investors. The IRS has grown its means to act on suspicious tax returns, and it’s looking straight at you. That’s right; it’s moving about 30 percent of its auditors away from large corporations and using that workforce to scout out smaller prey.

What IRS Expansion Means for Your Tax Return

An audit can cost you a lot of money in professional fees, back taxes, interest, and penalties, so it makes sense to audit-proof your return now. Don’t assume that you make too little for the IRS to be concerned with you. Although the top earners have the highest audit risk (those earning more than $1 million have seen a dramatic increase in audit rates recently), even individuals making $200,000 are experiencing the effects of increased tax surveillance. Your risk of audit may not be as high as the 1 in 8 chance that millionaires now face, but it is trickling down to businesspeople with more modest incomes.

In order to understand why you may be audited, it helps to understand the process used by the IRS. It has several different methods for selecting returns for audit, and one that has been in use for decades is called the discriminant index factor (DIF). Basically, a mathematical formula is used to score a return, often based on the ratio of income to deductions. The process breaks down like this:

  • You send in your tax return, and the systems at Martinsburg West Virginia National Computer Center run the numbers.
  • Your return gets a DIF score. The higher the score, the bigger the chance that additional taxes may be able to be collected from you.
  • IRS employees audit the returns with the highest score first (i.e. the returns that will bring in the most additional revenue).

The formula for DIF scores is regularly updated using an analysis of intensive audits, the Taxpayer Compliance Measurement Program (TCMP). It’s conducted every few years. For a TCMP audit, every single piece of information on the return is analyzed. For people reporting business receipts on their personal income tax return (Schedule C and Schedule F), gross business income is used to determine DIF score, not net business income. Red flags that generate a high DIF result may lead to your receiving a letter of inquiry, or even the dreaded examination of your tax return.

Avoiding the Audit

After computer DIF scores are assigned to the returns, IRS employees then select which returns will be audited. This process usually starts later than June. A computer formula may assign you a high DIF, but in the end it is up to classifiers working in the district offices to determine whether your return raises red flags. So, even if a high DIF result brings your return under scrutiny, you can follow some simple rules to keep down your chances of being selected for audit.

Take a look at some basic tips for making your return less likely to be audited:

  • Balance Your Deductions—Risk of being scrutinized increases with the more deductions you take compared to the size of your income. Time your deductible expenses right so that they are fairly even on a year to year basis.
  • Always Respond to Inquiries—If the IRS sends you a letter regarding missing schedules, send a response! Failing to answer makes you much more likely to be examined.
  • Remember Form 8283—When you make a non-cash charitable contribution, you must include this form.
  • File Your AMT—The alternative minimum tax is separate from regular taxes. You’ll need to use Form 6251 and send it in with your 1040.
  • Document Your Casualty Losses—Casualty losses are already a red flag for the IRS. You definitely deserve any deductions you are entitled to for such losses, but be sure to document all information about the date of loss, cost, and any insurance payments you received. And, include this information with the return, not when they’ve flagged you for auditing.
  • Report Any 1099 IncomeIf a client of yours reports a 1099 to the IRS, you’d better make sure you report it on your tax return. When you don’t, it’s considered a matching issue, and you will be contacted about it. In the case that you are contacted about a mismatch issue, respond to the IRS immediately to prevent an escalation of the situation.
  • Use an Entity Structure—Filing a high number of gross receipts for your small business drastically increases your return’s chance of being examined. However, when you switch from reporting these on a Schedule C to reporting them as a corporation, partnership, or LLC, you significantly reduce that risk. Not only does using an entity structure lower your chance of being audited, it also decreases your taxes. It’s an excellent option to consider if you are functioning as a proprietorship or independent contractor.
  • File On Time—This one should go without saying, but turning in your tax return by deadline (including extensions) can help you to avoid examination.
  • File a Paper Return—Filing electronically may seem easy, but there’s a reason the IRS encourages taxpayers to use this method. An electronic return can go right into their DIF scoring system and be ready for analysis immediately. Rumor has it that only about half of all paper returns even get scored in the DIF system. Most taxpayers are required to use the electronic filing system. However, you can opt out by attaching IRS Form 8948 to your paper return.
  • Watch Out for the Big Three—IRS agents are coming down hard on deductions for travel, automobiles, and entertainment expenses. The secret to having these deductions approved is documentation, documentation, documentation. Quick and dirty tip: The IRS requires 5 pieces of documented evidence, but all you really need is your receipt! It covers 1) date of the expense, 2) where the expense occurred, and 3) amount of the expense. Then, you simply write on the back of the receipt 4) the business purpose for the expense and 5) your relationship to the person or group you entertained. Simple! Just don’t forget the receipt—the IRS does not count credit card statements as receipts. For automobile deductions, you’ll also need to keep a mileage log.

Electronic filing has made auditing easier (and a bigger priority) for the IRS. Now that they need fewer employees sifting through paper files, they have allocated a larger portion of their workforce towards audits and collections. With this increased strength, they have turned their eyes toward smaller entities, but you can audit-proof your return by providing accurate documentation and following these tips. Don’t let the IRS intimidate you into forgoing deductions you have a right to!