Pyramid Sceme Loss as a Deduction?

[Chowdahead]

I've got a client who lost over $60,000 in a pyramid marketing scheme called Wealth Pools International. The owners of the company were charged with fraud by the SEC in December 2007.

He has not seen a penny of the money back. Anyone know if he can claim some/all of this as a capital gains loss.. or perhaps a "casualty" loss? I've done tons of searching and reading on this and can't seem to find anything...

[Julie]

Question: Did your client know he was participating in an illegal pyramid scheme?

I've got a client who lost over $60,000 in a pyramid marketing scheme called Wealth Pools International. The owners of the company were charged with fraud by the SEC in December 2007.

He has not seen a penny of the money back. Anyone know if he can claim some/all of this as a capital gains loss.. or perhaps a "casualty" loss? I've done tons of searching and reading on this and can't seem to find anything...

[Chowdahead]

Question: Did your client know he was participating in an illegal pyramid scheme?

No, according to the information he gave me. The way he decribed it was that a friend of his was invested already and convinced him to invest. So he pulled the money out of his retirement account, thinking his earnings from the investment would cover the penalties and extra taxes. He is going to see lots of penalties and taxes on that early withdrawal. It's staggering....

[kcjenkins]

The best he can do is the theft loss rules, which is a shame, but not your fault. It's his fault for doing it, especially doing it without asking for competent professional advice. Isn't it amazing how people will spend that kind of money, especially when they don't really have it to spend, without asking first?

[jainen]

>>Anyone know if he can claim some/all of this as a capital gains loss.. or perhaps a "casualty" loss?<<

I put pyramid scheme into a search engine and got several dozen hits, mostly court cases. It's obvious the government is not too keen on the activity. No matter what the taxpayer's position, the rulings were always against it. If they made money, it was ordinary income not capital gain (with accuracy penalty). If they lost money, it wasn't a business deduction or theft (with accuracy penalty). One guy invested $145,000 and only got back $60,000--they said he couldn't deduct any theft, but had to pay tax on the $60,000 (with accuracy penalty). The luckiest taxpayer of the bunch WAS allowed to deduct his losses--as wagers not to exceed his gambling income! (Oh, yeah, with accuracy penalty.)

So anyway there is some material to research. Hopefully your client has excellent records. I don't know how you define it as a theft if he willingly gave the money to his friend instead of the guys being charged. He knew or should have known it was an illegal plan (the IRS calls it tax evasion), the courts have repeatedly cited various technical theories to hold it is not a capital investment, and it was certainly not a bona fide business. Just a personal fling; maybe gambling is the best comparison after all.

[Chowdahead]

>>Anyone know if he can claim some/all of this as a capital gains loss.. or perhaps a "casualty" loss?<<

I put pyramid scheme into a search engine and got several dozen hits, mostly court cases. It's obvious the government is not too keen on the activity. No matter what the taxpayer's position, the rulings were always against it. If they made money, it was ordinary income not capital gain (with accuracy penalty). If they lost money, it wasn't a business deduction or theft (with accuracy penalty). One guy invested $145,000 and only got back $60,000--they said he couldn't deduct any theft, but had to pay tax on the $60,000 (with accuracy penalty). The luckiest taxpayer of the bunch WAS allowed to deduct his losses--as wagers not to exceed his gambling income! (Oh, yeah, with accuracy penalty.)

So anyway there is some material to research. Hopefully your client has excellent records. I don't know how you define it as a theft if he willingly gave the money to his friend instead of the guys being charged. He knew or should have known it was an illegal plan (the IRS calls it tax evasion), the courts have repeatedly cited various technical theories to hold it is not a capital investment, and it was certainly not a bona fide business. Just a personal fling; maybe gambling is the best comparison after all.

He showed me 4 cancelled checks to "Wealth Pools International". They totalled just over $63,000. I did a search on the company, and apparently they swindled over $143 million from people in 2007 alone. He thought it was a legitimate "DVD Learning" product that he was investing in. He didn't give the checks to his friend, he wrote them directly to the company.

Is it really "fair" that he can get taxed on any earnings from this sort of "investment" yet can't claim any losses? He also has a 1099-R of over $58,000 issued to him for his early withdrawal of the reitement funds.

My guess is that the rules for casualty loss might still be gray enough to be worth chancing it, but he's probably guaranteed to be audited.

[JohnH]

When I see a client pull a stunt like this, it brings to mind the old WC Fields line:

"You can't cheat an honest man; never give a sucker an even break, or smarten up a chump."

[barosser]

Ironic... I met with a client last night that is also involved in investing in a pyramid scheme. He has been told by federal investigators that there was never any profit, TP has paid on investment Income since 2004 (rec'd K-1). He put in about 300K and withdrew about the same might actually have to pay the federal trustee back some that he is not entitled to. His good church friend who was running this scheme had over 1000 investors for almost 200 million invested. What a MESS. First thought is that We need to amend the previous years since he is being told that there was never any income from the investments. Or better maybe to tell him to find some else to take care of this.

Thanks for any advise on this

[RoyDaleOne]

Well, my comment is if there is fraud in the inducement or false pretenses there is a crime and therefore a possible theft loss.

Most of the cases I researched had factors other than a "normal" swindle.

"I don't know how you define it as a theft if he willingly gave the money to his friend instead of the guys being charged." And why not? His friend was being swindle at the same time. That the way this type of fraud works.

I had one of these for about $250,000, newspaper clippings covering the fraud worked great as proof.

The SEC new release is pretty good evidence that the Government thought this activity was illegal.

You can file a normal return and amend the return for theft loss asking for a refund, making all the disclosures.

Knew or should have known is not the test for this activity, heck, if that was the test NO Ponzi would work. It is the deception that makes the scheme work (I know greed has to be there too.).

[jainen]

>>Is it really "fair" that he can get taxed on any earnings from this sort of "investment" yet can't claim any losses?<<

Of course it is. Totally fair. Nobody changed the rules on him after the fact. For spending $63,000 without investigating tax consequences, he has only himself to blame. If you don't care for the gambling comparison, think about party sales or volunteer work or any other personal activities that don't involve capital assets and aren't operated in a business-like manner. Income always goes on the tax return, losses never do.

It's fine to be uncomfortable or sorry about the client's poor judgment, but I believe tax preparers should be committed to truth and accuracy. As I said, this is not the first taxpayer to get green-eyed over such promises. Can you point to ANY authority that supports the theory that investing in an illegal scheme can generate a Schedule A deduction under Section 165 (theft loss)?

By the way, did you catch Attorney General Mukasey yesterday, saying "Not every wrong, or even every violation of the law, is a crime"?

[RoyDaleOne]

"investing in an illegal scheme", what a funny statement that is. Yes, if a person knows that the scheme is illegal before they invest then a theft loss is not allowed for tax purposes. However, does a Ponzi victim know that it is an illegal scheme up-front. That by the very nature of the theft, the answer is no. Yes, I am aware of the tax shelters, illegal transaction, etc disallowance of the theft loss deduction. However, to cast the investors in "Wealth Pools International", I don't have one fact to support that contention.

Yes, if a person knows that the scheme is illegal before they invest then a theft loss is not allowed for tax purposes. There are also over various limitations, however, the general rule is that the theft loss is allowed, and exceptions do exist.

Regs. Sec. 1.165-8. Theft losses.

--------------------------------------------------------------------------------

(a) ALLOWANCE OF DEDUCTION.

(1) Except as otherwise provided in paragraphs (B ) and (C ) of this

section, any loss arising from theft is allowable as a deduction

under section 165(a) for the taxable year in which the loss is

sustained. See section 165(C )(3).

Edwards v. Bromberg, KTC 1956-7 (5th Cir. 1956)

We reject it on reason because the word "theft" is not like "larceny", a technical word of art with a narrowly defined meaning but is, on the contrary, a word of general and broad connotation, intended to cover and covering any criminal appropriation of another's property to the use of the taker, particularly including theft by swindling, false pretenses, and any other form of guile.

[jainen]

>>what a funny statement that is<<

Why, thank you! Do you really think so? I'm always amazed that more people don't challenge some of the nonsense I post.

[zeke]

"I'm always amazed that more people don't challenge some of the nonsense I post. "

From another thread, MaMalody wrote:

>>That's one reason he shouldn't do that, at least, without some type of disclaimer or notification. <<

Jainen - offtimes methinks thou extends us credit overlymuch.

Zeke

[jainen]

>>offtimes methinks thou extends us credit overlymuch<<

I only assume that you will read my words and form your own opinions. In the other thread I described specific actions to be taken, but I put a clear disclaimer in it. I don't feel I need a disclaimer in this thread because nowhere have I stated an opinion as to how the particular return should be filed.

[RoyDaleOne]

Yes, funny in that the posed question, already, had the answer by default, or, some type of test. All your posts seemed to be about the exceptions to the general rule about theft loss, nevertheless, good job.

[jainen]

>>any loss arising from theft is allowable as a deduction<<

A new case gives some perspective on this question. In TC Memo 2008-212, the taxpayer put money in an investment that soon went bust. The SEC waded in slinging subpoenas around and charging "massive fraud," and at least one of the perps actually copped to doing the dirty. But this was a CIVIL enforcement, while theft is a CRIMINAL matter. Nobody proved criminal knowledge or intent, so it could not be called a theft and was only deductible as a capital loss.

Another factor was that the middleman was the one who misrepresented the investment, but the money was given to the principals.