Chief Counsel's Office Advises on Deductibility of Losses from Scams

(Parker Tax Publishing March 2025)

The Chief Counsel's Office provided advice regarding the allowance of theft losses under Code Sec. 165 for victims of certain scams. The advice addresses the year of the loss, the amount of allowable loss under Code Sec. 165(b), and the applicability of the Ponzi loss safe harbor set forth in Rev. Proc. 2009-20. CCA 202511015.

Background

The Chief Counsel's Office was asked to provide non-taxpayer specific advice regarding the allowance of theft losses under Code Sec. 165 for victims of certain scams. The Chief Counsel's Office responded by addressing the following scenarios in which taxpayers have suffered losses from various scams perpetrated by unknown individuals operating domestically and internationally.

Taxpayer 1 - Compromised Account Scam

Taxpayer 1 was the victim of a compromised account scam involving an impersonator. Scammer A contacted Taxpayer 1 claiming to be a "fraud specialist" at Taxpayer 1's financial institution. Scammer A stated that Taxpayer 1's computer and bank accounts had been compromised and attempts were made to withdraw funds. Having gained Taxpayer 1's trust and created a sense of urgency, Scammer A fraudulently induced Taxpayer 1 to authorize distributions from IRA and non-IRA accounts and to transfer all the funds into new investment accounts created by Scammer A. Scammer A created and had access to the new investment accounts and immediately transferred the funds to an overseas account. At this point in 2024, Taxpayer 1 discovered that the accounts were empty, and Scammer A had stolen the funds. Taxpayer 1 contacted their financial institution and law enforcement and was informed that the distribution to an unknown person with an overseas account could not be undone and there was little to no prospect of recovery.

Taxpayer 2 - Pig Butchering Investment Scam

Taxpayer 2 is an individual who in 2024 was the victim of a pig butchering investment scam. Taxpayer 2 received an unsolicited email from Scammer A advertising an investment opportunity in cryptocurrency and promising large profits. The email directed Taxpayer 2 to the website of a new platform that would ostensibly invest in cryptocurrencies using proprietary methods to generate large profits.

Taxpayer 2 visited the advertised website, which appeared to be legitimate, and deposited a small amount of cash to invest. Within a few days, the account balance increased in value, and Taxpayer 2 decided to withdraw the money from the website. Taxpayer 2 received the payout, reinforcing the belief that the website was legitimate, and then deposited a larger amount of cash to invest. The investment increased in size and Taxpayer 2 once again successfully withdrew the funds.

After the success of these investments, Taxpayer 2 invested significantly more money in the scheme with funds taken from IRA and non-IRA accounts that were transferred to the website. After the account balance increased significantly in value, Taxpayer 2 decided to liquidate the investment and withdraw cash from the website. Taxpayer 2 attempted to withdraw the funds but received an error message, and customer support did not respond. Taxpayer 2 began searching online to see whether other investors had similar problems and discovered claims from several people saying they had been defrauded by the website and Scammer A.

At this point in 2024, Taxpayer 2 contacted law enforcement and the financial institution from which the original funds were withdrawn and was informed that the transfer to the website's overseas account could not be undone and there was little to no prospect of recovery. Scammer A was never identified or charged with any state or federal crime.

Taxpayer 3 - Phishing Scam

Taxpayer 3 is an individual who in 2024 was the victim of a phishing scam involving an impersonator. Taxpayer 3 received an unsolicited email from Scammer A claiming that Taxpayer 3's accounts had been compromised. The email contained official looking letterhead and was digitally signed by a "fraud protection analyst." The email contained a link, phone number, and directions to call the analyst to ensure Taxpayer 3's funds would be protected.

Taxpayer 3 immediately called the number in the email and communicated with Scammer A, who claimed to be the fraud analyst handling the case. Scammer A directed Taxpayer 3 to click on the link in the email, and then log into Taxpayer 3's tax-deferred retirement account so Scammer A could inspect the account for any issues. By clicking the link in the email, Taxpayer 3 gave Scammer A access to Taxpayer 3's computer. Scammer A was able to identify Taxpayer 3's account username and password as it was entered into the login screen. Scammer A also convinced Taxpayer 3 to do the same with Taxpayer 3's non-IRA account. The next day, Taxpayer 3 logged into the retirement account and the investment account to find that all funds had been distributed to an overseas account. Taxpayer 3 did not authorize the distributions of the funds from the accounts. Taxpayer 3 contacted law enforcement and the financial institutions and was informed that the distribution to the overseas account could not be undone and there was little to no prospect of recovery.

Taxpayer 4 - Romance Scam

Taxpayer 4 is an individual who in 2024 was the victim of a romance scam involving an impersonator. Taxpayer 4 received an unsolicited text message from Scammer A and proceeded to develop a virtual romantic relationship. Scammer A convinced Taxpayer 4 that a close relative was in dire need of medical assistance, but Scammer A could not afford the expensive medical bills. Taxpayer 4 authorized distributions from an IRA account and a non-IRA account to a personal bank account, and then transferred the money to Scammer A's overseas account to cover the purported medical expenses. After Taxpayer 4 transferred the money, Scammer A stopped responding to messages. At this time, in late 2024, Taxpayer 4 realized that the romantic relationship with Scammer A was not real, and that Scammer A had stolen Taxpayer 4's funds. Taxpayer 4 contacted their financial institution and law enforcement and was informed that the distribution to the overseas account could not be undone and there was little to no prospect of recovery.

Taxpayer 5 - Kidnapping Scam

Taxpayer 5 is an individual who in 2024 was the victim of a kidnapping scam involving an impersonator. Scammer A contacted Taxpayer 5 by text and phone and claimed to have kidnapped Taxpayer 5's grandson for ransom. Taxpayer 5 demanded to speak to Taxpayer 5's grandson and heard his voice over the phone begging for help. Scammer A directed Taxpayer 5 to transfer money to an overseas account and not to contact law enforcement. Taxpayer 5 did not know that Scammer A had used artificial intelligence to clone the grandson's voice and that no kidnapping had taken place.

Under immense duress, Taxpayer 5 authorized distributions from an IRA account and a non-IRA account, then directed those funds to be deposited in the overseas account Scammer A provided, hoping to ensure the safety of Taxpayer 5's grandson. Later the next day, Taxpayer 5 was able to contact other family members and Taxpayer 5's grandson and learned that no kidnapping had taken place. Taxpayer 5 immediately contacted law enforcement and their financial institution but was informed that the distribution to the overseas account could not be undone and there was little to no prospect of recovery.

Law

Code Sec. 165(a) provides a deduction for losses actually sustained during the tax year and not compensated for by insurance or otherwise. Under Reg. Sec. 1.165-1(d)(1), a loss is treated as sustained during the tax year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such tax year. In the case of an individual, Code Sec. 165(c) limits the deduction to (1) losses incurred in a trade or business; (2) losses incurred in a transaction entered into for profit, though unconnected to a trade or business; and (3) losses not connected with a trade or business, or a transaction entered into for profit, if such losses arise from a casualty or theft (personal casualty losses). To claim a theft loss, a taxpayer must establish that the loss resulted from an illegal taking of property done with criminal intent that is considered theft under applicable state law.

Code Sec. 165(e) provides that any loss arising from theft is treated as sustained during the tax year in which the taxpayer discovers the loss. A loss has not been sustained, and no portion of the loss is deductible, if at the end of the year there is a reasonable prospect of recovery. Under Code Sec. 165(b), the amount of a loss that is allowed as a deduction is generally limited to the taxpayer's adjusted basis in the property (generally the amount paid) and not the fair market value of the property at the time of the loss.

For tax years 2018 through 2025, Code Sec. 165(h)(5) disallows Code Sec. 165(c)(3) personal casualty losses except to the extent of personal casualty gains or unless attributable to a federally declared disaster. Personal casualty losses include losses from theft that are not connected with a trade or business, or a transaction entered into for profit.

Rev. Proc. 2009-20 provides an optional safe harbor that allows taxpayers to claim a Code Sec. 165 theft loss in limited circumstances even if the loss would otherwise not be allowed due to the taxpayer having a reasonable prospect of recovery. Specifically, the safe harbor applies to losses from a criminally fraudulent investment arrangement, commonly known as a "Ponzi scheme," if specific requirements set forth in the revenue procedure are satisfied. Taxpayers are eligible for the Ponzi safe harbor if they establish that they are (1) a "qualified investor" who (2) incurred a "qualified loss" from (3) a "qualified investment" in (4) a "specified fraudulent arrangement," as those terms are defined in Rev. Proc. 2009-20. The safe harbor election must be made in the discovery year, defined as the tax year the "lead figure" was charged by indictment or information under state or federal law that, if proven, would meet the definition of theft under Code Sec. 165.

Analysis

The Chief Counsel's Office advised that Taxpayers 1 through 5 sustained a theft loss under Code Sec. 165 due to an illegal taking of property that is considered criminal theft under applicable state law. The tax consequences under the Code are as follows:

1. The year of the loss is 2024 because that is the year Taxpayers 1 through 5 discovered the theft and determined that there was no reasonable prospect of recovery.

2. The amount of the theft loss allowable under Code Sec. 165(b) is the victims' basis in the stolen funds.

3. The theft loss is deductible in 2024 for Taxpayers 1, 2, and 3 because they incurred the loss in a transaction entered into for profit under Code Sec. 165(c)(2).

4. The theft loss is not deductible for Taxpayers 4 and 5 because they did not incur the loss in a transaction entered into for profit. Their losses are personal casualty losses that are disallowed by the Tax Cuts and Jobs Act of 2017 (TCJA) amendment to Code Sec. 165(h)(5) that disallows most personal casualty losses for tax years 2018 through 2025.

5. Taxpayers 1 through 5 are not eligible to use the Ponzi loss safe harbor set forth in Rev. Proc. 2009-20 because the conduct of Scammer A does not satisfy the requirements that the theft loss result from a specified fraudulent arrangement that is operated by a lead figure who is indicted or the subject of a criminal complaint under state or federal law. Additionally, Taxpayers 4 and 5 are not eligible to use the safe harbor because their losses are not deductible under Code Sec. 165.

For a discussion of casualty and theft losses, see Parker Tax ¶98,100. For a discussion of losses from Ponzi schemes, see Parker Tax ¶84,515.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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