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IRS Warns Stock Losses Can't Be Taken As Theft

"Dirty Dozen" Top Tax Frauds Revisited

April 13, 2004
Feel like you were robbed in the stock market? Fine but don't try telling that to the Internal Revenue Service.

The IRS is warning taxpayers that stock market losses -- even those as drastic as Enron and Worldcom -- cannot be deducted as thefts on your tax return. Losses on stocks purchased in the public stock exchanges cannot be taken as a straight loss but must be used to offset any capital gains in the same year.

If the taxpayer has more losses than gains, the extra losses can only be used up at a rate of $3,000 a year to offset ordinary income taxes. If it takes years to use up the extra amount, tough, the IRS said.

What if you lost big bucks to a South Florida boiler-room operation -- one of the many pyramid or Ponzi schemes currently making the rounds? The answer is not as clear-cut. You might be able to write off your losses as theft but if you do, you're likely to wind up in tax court.

A tax consulting firm, J.K. Harris, is promoting the idea that these losses can be treated as theft under Section 165 of the tax code. The firm takes a fee, based on the amount of the loss, for its services, which include gathering background material for the taxpayer and agreeing to represent the taxpayer in case of an IRS audit.

The company claims it has helped 500 injured taxpayers seek $25 million to $30 million in such deductions in the last 2½ years.

Generally speaking, tax experts said, taxpayers are on thin ice unless they can prove that the money they paid for an investment was embezzled by the middleman -- their financial advisor or broker, for example. If the funds actually made it into the supposed investment, the case falls into a gray area and expert tax advice is needed.

The Big 12

The IRS is also watching for any of the following tax frauds on its Dirty Dozen:

• Misuse of Trusts Promoters of abusive tax transactions are increasingly urging taxpayers to transfer assets into trusts. Taxpayers should be aware that abusive trust arrangements will not produce the tax benefits advertised by their promoters and that the IRS is actively examining these types of trust arrangements.
• "Claim of Right" Doctrine In this emerging scheme, people file returns and attempt to take a deduction equal to the entire amount of their wages. The promoters advise them to label the deduction as “a necessary expense for the production of income” or “compensation for personal services actually rendered”. The deduction has no basis in law.
• Corporation Sole Would-be participants are mistakenly told that Corporation Sole laws, primarily intended for the clergy, provide a “legal” way to escape paying federal income taxes, child support and other personal debts.
• Offshore Transactions Use of an offshore bank account, brokerage account, credit card, wire transfer, trust, offshore employee leasing or other arrangement to hide or underreport income or to claim false deductions on a federal tax return is illegal. A taxpayer involved in these schemes could be subject to payment of taxes, interest, penalties and potential criminal prosecution.
• Employment Tax Evasion The IRS has seen a number of illegal schemes that instruct employers not to withhold federal income tax or other employment taxes from wages paid to their employees. These schemes are based on an incorrect interpretation of “Section 861.” Employer participants could be held responsible for back payments of employment taxes, plus penalties and interest. Employees who have no withholdings are still responsible for payment of their personal taxes.
• Return Preparer Fraud Unscrupulous return preparers can cause a lot of problems for taxpayers who use their services. Abusive return preparers derive financial gain by diverting a portion of the taxpayer’s refund for their own benefit, charging inflated fees for the return preparation services, and increasing their clientele by advertising guaranteed larger refunds. Taxpayers should choose carefully when hiring a tax preparer — no matter who prepares the return, the taxpayer is ultimately responsible for all of the information on that return.
• Americans with Disabilities Act This involves the purchase of equipment and services that the promoter alleges meet the strict criteria of the Disabled Access Credit. A minimal payment is made and a non-recourse note signed. The investor then provides insignificant services to complete the purchase agreement. This scheme is based on an incorrect interpretation of law and an over-inflated value of the services rendered.
• African-American "Reparations" Refund Thousands of African-Americans have been misled by people offering to file for tax credits or refunds related to reparations for slavery. There is no such provision in the tax law. Taxpayers could face a $500 penalty for filing such claims.
• Improper Home-Based Business This scheme purports to offer tax “relief” but in reality is illegal tax avoidance. The promoters of this scheme claim that individual taxpayers can deduct most, or all, of their personal expenses as business expenses by setting up a bogus home-based business. But the tax code firmly establishes that a clear business purpose and profit motive must exist in order to generate and claim allowable business expenses.
• Frivolous Arguments Frivolous arguments are false arguments that are unsupported by law. When a scheme promoter says “I don’t pay taxes – why should you” or urges you to “untax yourself for $49.95,” beware. The ads may claim that the promoter knows the “secret” for never paying taxes again, but that’s just plain wrong. The U.S. courts have continuously rejected this and other frivolous arguments.
• Identity Theft The IRS is aware of several identity theft scams involving taxes or the IRS. In one example, fraudsters sent bank customers fictitious bank correspondence and IRS forms in an attempt to trick them into disclosing their personal and banking data. In another, abusive tax preparers have used clients’ Social Security numbers and other information to file false tax returns without the clients’ knowledge. For taxpayers, it pays to be choosy about disclosing personal and financial information. And the IRS encourages taxpayers to carefully select a reputable tax professional.
• Share/Borrow EITC Dependents Unscrupulous tax preparers "share" one client's qualifying children with another client in order to allow both clients to claim the Earned Income Tax Credit. For example, one client may have four children but only needs to list two to get the maximum EITC. The preparer will list two children on the first client’s return and the other two on another client’s tax return. The preparer and the client "selling" the dependents split a fee.

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