The IRS needs to fix its Net Investment Tax proposed regulations
By Robert A. Green, CPA with assistance on tax research from Mark Feldman, JD
Petition: Please sign our Petition To Fix the Investment Tax on RallyCongress.com, and ask others to sign it, too.
Forbes Blog Version (May 6): IRS Should Fix Net Investment Tax Proposed Regulations
Traders, you may have to pay thousands of dollars in new Medicare taxes on phantom unearned income in 2013. The IRS doesn’t care if you lost money on trading and investments; its new proposed regulations (REG–130507–11) will tax you anyway.
The proposed regulations are wrong in our view, and we need to work together to ask Treasury to fix them before they become final.
Affordable Care Act taxes
The Affordable Care Act created new taxes, including a Medicare 3.8% surtax on unearned income (including investments), starting in 2013, which applies to upper income taxpayers making over $250,000 (married) and $200,000 (single). Plus a 0.9% Medicare surtax on earned income is assessed over the same AGI thresholds. The 0.9% surtax brings the Medicare rate on earned income to the same 3.8% as on unearned income.
Other taxes include a Medical Device Tax, Individual Mandate Non-Compliance Tax, High Medical Bills Tax, and Flexible Spending Account Tax.
Proposed regulations for the Medicare tax on unearned income
In December 2012, Treasury released its proposed regulations, including detailed tax rules for the 3.8% Medicare surtax on unearned income. It’s also referred to as the net investment tax (NIT) on net investment income (NII).
When we first read the fairly short section covering the Medicare surtax on unearned income (see bottom of blog), we found it to be pretty straightforward. We assumed all unearned income, loss and expense would be summarized and taxed just like the self-employment tax on earned income is summarized and taxed, now. There are no separate buckets or loss limitations in SE taxation on earned income.
But that’s not what the tax attorneys from Treasury did with the Affordable Care Act’s NIT. They took the short code and turned it into a monster of proposed regulations. In my view, they made some unintentional errors.
Our biggest problem is the proposed tax regulations could cause serious damage to traders and other taxpayers by limiting various types of losses and expenses from their NII calculations. For something that significant and material, the code should specifically state that losses will be limited in this fashion, but it doesn’t.
An example of the havoc these proposed regulations can cause
Suppose a securities trader is married to an executive with a W-2 in the amount of $450,000. The trader has a trading business loss of $100,000, comprised of a Section 475 MTM ordinary trading loss of $75,000 (reported on Form 4797) and trading business expenses of $25,000 (reported on Schedule C). It doesn’t matter if the trading business is a sole proprietorship or a pass-through entity.
The couple also has an investment long-term capital gain of $90,000, and interest and dividend income of $10,000. They have no investment expenses or investment interest expenses. Their married/filing joint AGI is $450,000, which represents the wife’s W-2 income, since all unearned income activity was at breakeven.
Based on our interpretation of the code, in this example all unearned income, loss and expense is zero, and NII matches unearned income or loss calculated in gross income. Even though the couple is over the $250,000 AGI limitation by $200,000, there is no NIT since there is no NII.
The proposed regulations create three different income-type buckets, and they limit each bucket to zero, not allowing buckets with net losses to be counted in NII. Here's what those categories would look like for our example couple:
• Regulation bucket 1 for portfolio income is $10,000.
• Regulation bucket 2 is “other gross income from a trading business." A strict interpretation of the proposed regulation shows the bucket 2 total is in the hundreds of thousands of income, because individual trading losses are carved out and placed into bucket 3. This happens whether the business trader uses Section 475 MTM or the cash method.
• Regulation bucket 3 is an investment capital gain of $90,000. But, after trading losses are moved from bucket 2, the loss is in the hundreds of thousands.
Do the math with the current proposed regulations. Bucket 1 would be $10,000. Bucket 2 would be $475,000, assuming there are $500,000 of trading gains on individual trades, less $25,000 of trading business expenses. Bucket 3 would be limited to zero since the $90,000 investment capital gain is offset with the business trading losses $575,000. Total NII would be $485,000.
If Treasury fixes the proposed regulations, bucket 1 would be $10,000, bucket 2 would be a revised loss of $100,000 and bucket 3 would be a revised gain of $90,000 from the investment capital gain. Revised NII would be $100,000 since only bucket 1 and 3 are positive and can be counted in NII.
Because NII is $485,000, we would use the lower amount of AGI over the AGI threshold: $200,000 times the 3.8% rate equals a NIT of $7,600. But if Treasury makes the bucket 2 loss-carve-out fix, revised NII will be $100,000 and it’s less than the excess of AGI over the threshold. NII of $100,000 times 3.8% equals $3,800 of NIT.
The spouse already paid Medicare tax on her earned income of $450,000. The proposed regulations would cause them to pay Medicare tax on phantom unearned income.
Do away with all loss limitations and buckets
While Treasury seems to have unofficially conceded the fix to stop carving out bucket 2 losing business trades and placing them into bucket 3 investments, we don’t think that goes far enough for traders. We want to do away with all buckets, and we don’t want buckets or items limited to zero. Losses should be allowed in full.
The Managed Futures Association (MFA) sent a letter to Treasury with its suggested fixes to these proposed regulations. It pointed out some of the same problems we have, and asked for the fix of losses carved out of bucket 2, along with other fixes, too. The goal is to combine all trading and capital gains and losses between buckets 2 and 3, so you don’t have a trader business loss isolated and lost in case you have investment capital gains - which happens in the above example. The MFA made a good point about this with hedge funds. It also asked for bucket losses not included in NII to be carried over to the subsequent year’s NII calculations.
We go a big step further. We want all items summed up as we read the code. We agree all losses not used in the current year’s NII calculations should be carried over to the subsequent year’s NII calculation, on par with capital losses. Capital loss limitations exist to pay for lower long-term capital gains rates. How can anyone justify loss limitations with NII and NIT?
Special concerns for business traders using Section 475 MTM
We’re concerned Treasury will only make the bucket 2 loss carve out fix, which means we will still be left with disenfranchisement from using many unearned losses. In the big picture, that causes the most damage. That potential outcome is unacceptable for business traders using Section 475 MTM ordinary gain or loss treatment, because they likely won’t get a chance to deduct their potentially very large net trading losses from NII.
An investor or business trader using the cash method may not be as concerned over capital losses because the capital loss limitation already limits current year losses to $3,000 against ordinary income. All a taxpayer loses in NII is deducting a net $3,000 capital loss limitation, as no net losses are allowed in buckets 2 and 3. Capital loss carryovers move to the subsequent years for both regular tax and NII purposes. While there are many confusing inconsistencies between regular tax and NIT, there isn’t much for capital losses.
But, there are significant and hurtful inconsistencies between regular tax and NII in the case of Section 475 MTM losses. The proposed regulations won’t count Form 4797 ordinary losses in NII, unless you find other passive-activity income items to soak them up.
Plus, one of the best tax features of Section 475 MTM losses is they are counted in net operating losses (NOLs), which generate huge refunds for business traders by deducting the losses for regular tax purposes in the prior two and/or subsequent 20 years. The problem is that NOLs are not counted in NII calculations, and NOL carryforwards don’t reduce NII.
Nevertheless, NOLs reduce AGI and that can prevent NIT in the first place!
Should business traders continue to use Section 475 MTM?
The clear answer is yes. The income tax savings from using Section 475 MTM ordinary business loss treatment far exceeds potential NIT cost, plus NIT is only triggered if you are over the AGI threshold of $250,000 (married) and $200,000 (single).
It’s important to remember the power of Section 475 MTM losses. They will probably lower your AGI to well under the AGI threshold, so you won’t owe NIT. Section 475 MTM trading gains will provide income that your trading business expenses can be offset against in bucket 2.
Continue to use trader tax status and Section 475 MTM. GreenTraderTax strategies will stand up to these new taxes and we will make tweaks as needed.
Affordable Care Act advocates have good intentions, and the code may be true to those intentions. But these proposed regulations don’t match the goals. We're respectfully asking Treasury to fix all inadvertent errors. We think its interpretations stray too far from the code.
We're assuming that Treasury won’t provide all this necessary relief, so we plan to publish a Petition on RallyCongress.com for traders to send to their congressmen and women and President Obama. Hopefully these groups can also speak with Treasury about these important problems.
Excerpt of the Affordable Care Act tax code
(1) In general.
The term “net investment income” means the excess (if any) of—
(A) the sum of—
(i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2),
(ii) other gross income derived from a trade or business described in paragraph (2), and
(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2), over
(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.
When you read this excerpt of the tax code, what do you conclude? Do you see a provision for buckets and loss limitations? March 31, 2013
PFG investors can deduct theft losses on 2012 tax returns with Rev. Proc. 2009-20 safe harbor relief. That’s great news!
By Robert A. Green, CPA @GreenTraderTax with Darren L. Neuschwander, CPA @neuschwandercpa
April 1, 2013 postscript: In our 2013 GTT Guide: 2012 Tax Return Examples for Section 1256 Contracts, Futures & Forex Traders, we added an example 2012 tax return example showing a PFG theft loss deduction in accordance with IRS Rev. Ruling 2009-09 and Rev. Proc. 2009-20. Notice the Schedule A (line 28) deduction without any limitation, coming from Form 4684 with worksheet, the footnotes and signature block. This example tax return reflects a $100,000 deposit loss, 95% loss calculation ($95,000), and after adding back the 30% recovery in 2012 ($30,000), the Form 4684 and Schedule A line 28 theft loss deduction is $65,000.
Good news: The CCC was successful in winning IRS Rev. Proc. 2009-20 tax relief for PFGBest customers. Read the important update on the CCC site. The IRS letter to the CCC states “…the PFGBest scheme qualifies as a ‘specified fraudulent arrangement’ within the meaning of Revenue Procedure 2009-20. Thus, investors who otherwise meet the requirements of Revenue Procedure 2009-20 may use the safe harbor, following the procedures as set forth in that revenue procedure.”
As the CCC points out, “It is not required that PFGBest victims use this procedure. It may not provide the best solution for your particular tax situation. Claimants in the PFGBest case are urged to consult their tax professionals as soon as practicable to determine if it is appropriate and wise to seek relief under the safe harbor deduction for theft losses.”
In this blog, I refer to IRS Rev. Ruling 2009-09 and Rev. Proc. 2009-20, and they are related to each other. Generally, a revenue ruling states the IRS position, whereas a revenue procedure provides return filing or other instructions concerning the IRS position.
PFG investors should use Rev. Proc. 2009-20 relief in 2012
In most cases, taxpayers are better off using this IRS Rev. Proc. 2009-20 “safe harbor” relief to deduct 95% of their net PFG theft losses in 2012 — the year of loss — with what effectively is like business ordinary loss treatment. Technically, it’s an unrestricted itemized deduction reducing taxable income dollar-for-dollar and that’s what counts most. Normally theft or casualty itemized deductions face lots of restrictions and limitations, including AMT, and state income tax limitations, too.
Many states limit itemized deductions and some (New Jersey) don’t allow them at all. Check to see if your state honors Rev. Proc. 2009-20 theft loss relief. But, that may not be enough. For example, New York State confirmed it accepts Rev. Ruling 2000-20 losses, but there are many state limitations that may apply (see below).
When it comes to deducting tax losses, consider the following. Limitations, AMT preferences, unutilized loss amounts, capital loss carryovers, wasted negative taxable income, and using the loss mostly at the lowest marginal tax brackets are inefficient ways of dealing with the loss. To get the most bang for your buck, you want to use the tax loss in full against income of any kind, as soon as possible, at the higher tax brackets on both federal and state tax returns.
Ideally, PFG futures traders – and some electing forex traders - can report their 2012 Form 1099 trading gains with lower Section 1256 60/40 tax rates or offsetting capital gains with capital loss carryovers. They can deduct their theft loss with business ordinary loss treatment.
Unless you are a business trader qualifying for trader tax status, Rev. Ruling 2009-09 and Rev. Proc. 2009-20 relief is probably the best tax treatment you can have since there are no capital loss limitations or Schedule A limitations (10% or 2% of AGI). Plus for investors, Rev. Ruling 2009-09 includes theft losses in net operating loss (NOL) treatment and even adds one year to the normal two-year carryback (and/or 20-year carry forward). Normally, you only get NOL treatment with trader tax status (business treatment). NOL treatment helps ensure you don’t have wasted losses with negative taxable income.
If you already sold your PFG bankruptcy claim, you can’t use Rev. Ruling 2009-09 relief, and you have a realized capital loss. (We covered this in our March 7 blog.)
Some traders may want to skip Rev. Ruling 2009-09 relief in 2012
Some business traders may be better off skipping Rev. Ruling 2009-09 “safe harbor” relief and using the default Section 165 business ordinary loss treatment. One problem is the loss may not be sustained until 2013 or 2014, as the trustee expects another 20% plus recovery of funds after 2012. But a Section 165(c)(1) business theft loss can be deducted from gross income (above the line) and that may help ensure better tax treatment on all fronts like AGI limitations, credits, state taxes and more. Also, consider that your Obama-era tax rates may be much higher in 2013 and 2014 vs. lower Bush-era tax rates in 2012. States are also raising taxes this year and next. The ObamaCare 3.8% Medicare surtax on unearned income started in 2013 and a Section 165 theft loss on an investment is a deduction against unearned income for this Medicare tax calculation. The difference in tax rates may be well over 10% on a combined basis and that’s meaningful. Saving state taxes is important if your state doesn’t allow Rev. Ruling 2009-09 losses.
When it comes to choosing between Rev. Ruling 2009-09 and other Section 165 loss alternatives, it’s important to understand exactly what you qualify for, how it relates to your status, and your income and loss otherwise in the related tax years. Crunch the numbers with an accountant in the know and make the right decision for you. Every taxpayer is different. File a 2012 extension to give yourself more time to see as well. You’ll know how 2013 is shaping up before the extension deadline.
How to deduct PFG theft losses in accordance with Rev. Proc. 2009-20
In accordance with Rev. Proc. 2009-20, plan on using the 95% theft loss deduction option, as few traders are part of a third-party lawsuit which would require the 75% loss option.
The PFG trustee recovered 30% of funds for futures traders in 2012. PFG futures traders may deduct 95% of their theft loss amount, and then must add back the 30% recovery. For example, if you lost $100,000, first take 95% of the loss amount ($95,000) and then add back the 30% recovery ($30,000), for a net theft loss deduction of $65,000. Report that theft loss on a 2012 Form 4684 as an itemized deduction without limitation (see further details below).
Unfortunately, forex traders had no money protection like segregation of funds for futures traders, and the trustee did not recover any funds for them in 2012. Forex traders may deduct 95% of their entire deposit lost. For example, if you lost $100,000, you can deduct $95,000 on Form 4684 without limitation.
We understand that some PFG retail forex and spot metals traders hired their own attorneys to represent their interests in the bankruptcy proceedings, versus the interests of futures account holders. They seek “customer account” status for retail forex and spot metals accounts in the bankruptcy proceedings, rather than potential unsecured creditor status. In our view, this is not a “third-party lawsuit”, so these PFG forex and metals traders can still deduct 95% of their theft losses under Rev. Proc. 2009-20.
Reports from the CCC indicate the trustee may recover an additional 20% to 30% of funds for futures traders and forex traders in 2013 or 2014, perhaps different amounts for different types of traders. If there is recovery of funds over the 5% amount not deducted in 2012, then you have gross income to report in the year of collection as a cash method taxpayer. If there is recovery of funds under the 5% amount reserved above, then you can have an additional Form 4684 deduction without limitation for that final loss amount.
Even if you have gross income in 2013 or 2014 subject to higher tax rates and perhaps Medicare tax on unearned income, it’s still a good deal for investors without trader tax status, as other Section 165 options are generally worse.
Rev. Ruling 2009-09 under the microscope
Here is a redacted and shortened version of Rev. Ruling 2009-09 with my comments as they apply to PFG losses.
Rev. Rul. 2009-9, IRC Sec(s). 165 Loss — theft loss; fraudulent investment scheme.
Cash-method taxpayer … in Ponzi-type scheme, IRS ruled that loss incurred was theft loss, not capital loss, and as it arose from transaction entered into for profit, it isn't subject to limitations under Code Sec. 165(h). Guidance was also provided on timing and amount of deduction, possible application of extended NOL carrybacks for eligible small business investors …
My comment: A Madoff Ponzi scheme was broadened under the title “Ponzi-type scheme” to include a PFG-style theft or embezzlement loss. PFG CEO Russell Wasendorf was indicted for embezzlement in 2012 and that satisfies the criminal standard which is at the heart of Rev. Ruling 2009-09. In 2011, the IRS further modified this ruling to include a crook who commits suicide before his indictment for a crime. This ruling is all about accelerating the loss for a cash method taxpayer into the year it was discovered and the crime was decreed by a court. An accrual method taxpayer could accrue losses.
(1) Is a loss from criminal fraud or embezzlement in a transaction entered into for profit a theft loss or a capital loss under 165 of the Internal Revenue Code? – Answer, theft loss with full ordinary loss-type treatment.
(2) Is such a loss subject to either the personal loss limits in 165(h) or the limits on itemized deductions in 67 and 68? – Answer, no limits on Schedule A which would otherwise be the norm.
(3) In what year is such a loss deductible? – Answer, the year theft loss is discovered and crime decreed, and both happened for PFG in 2012.
(4) How is the amount of such a loss determined? – Answer, it’s laid out in Rev. Proc. 2009-20; 95% of net loss after recovery if no third-party lawsuit, 75% with third-party lawsuit.
(5) Can such a loss create or increase a net operating loss under 172? [/i]Answer, yes and the two-year carryback is expanded to three years. The 20-year NOL carry forward remains the same. [/i]
Sections 6 and 7 deal with complex mitigation beyond the scope of this article.
My comment: Redacted all as they relate to the Bernie Madoff investment management Ponzi scheme and PFG was very different for many traders. But the PFG CEO stole their money and he was indicted for embezzlement, a theft loss. The IRS letter to CCC acknowledged that most PFG traders did self-directed trading rather than engage PFG for investment management. The IRS appreciated the CCC’s point that Wasendorf lied about and stole the underlying account collateral, using some investors’ collateral to cover other investors’ collateral, and that is a Ponzi-type scheme.
Law And Analysis
Issue 1. Theft loss.
Section 165(a) allows a deduction for losses sustained during the taxable year and not compensated by insurance or otherwise. For individuals, 165(c)(2) allows a deduction for losses incurred in a transaction entered into for profit…
For federal income tax purposes, “theft” is a word of general and broad connotation, covering any criminal appropriation of another's property to the use of the taker, including theft by swindling, false pretenses and any other form of guile … The character of an investor's loss related to fraudulent activity depends, in part, on the nature of the investment. For example, a loss that is sustained on the worthlessness or disposition of stock acquired on the open market for investment is a capital loss, even if the decline in the value of the stock is attributable to fraudulent activities of the corporation's officers or directors, because the officers or directors did not have the specific intent to deprive the shareholder of money or property … In the present situation, B specifically intended to, and did, deprive A of money by criminal acts. B's actions constituted a theft from A, as theft is defined for 165 purposes. Accordingly, A's loss is a theft loss, not a capital loss.
Issue 2. Deduction limitations.
… A's theft loss is an itemized deduction that is not subject to the limits on itemized deductions.
My comment: I deleted the content showing how Section 165 works to significantly reduce loss deductions due to limitations on Schedule A and go right to the punch line above. You still need to use Form 4684 which feeds into Schedule A, but without limitations, it’s treated like an ordinary loss. That means you don’t reduce AGI, which otherwise would have been a good thing to do to reduce taxes in other areas of your tax return. For further guidance on how to deduct the loss on your tax return, follow Rev. Proc. 2009-20 to the letter of the law (see below).
Issue 3. Year of deduction.
Section 165(e) provides that any loss arising from theft is treated as sustained during the taxable year in which the taxpayer discovers the loss. Under 1.165-8(a)(2) and 1.165-1(d), however, if, in the year of discovery, there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss for which reimbursement may be received is sustained until the taxable year in which it can be ascertained with reasonable certainty whether or not the reimbursement will be received, for example, by a settlement, adjudication, or abandonment of the claim.
My comment: MF Global was not declared a theft loss and it doesn’t qualify for Rev. Ruling 2009-09 “safe harbor” relief. The key is criminality. Some CCC members have wondered if MFG CEO and ex-Senator John Corzine has a get-out-of-jail card and Teflon-political status from criminal prosecution. MFG traders had to wait for the loss to be sustained by a court in January 2013 (see our March 7, 2013 blog ).
A may deduct the theft loss in Year 8 the year the theft loss is discovered, provided that the loss is not covered by a claim for reimbursement or other recovery as to which A has a reasonable prospect of recovery. To the extent that A's deduction is reduced by such a claim, recoveries on the claim in a later taxable year are not includible in A's gross income. If A recovers a greater amount in a later year, or an amount that initially was not covered by a claim as to which there was a reasonable prospect of recovery, the recovery is includible in A's gross income in the later year under the tax benefit rule, to the extent the earlier deduction reduced A's income tax... Finally, if A recovers less than the amount that was covered by a claim as to which there was a reasonable prospect of recovery that reduced the deduction for theft in Year 8, an additional deduction is allowed in the year the amount of recovery is ascertained with reasonable certainty.
My comment: This shows how the gross income in a later year works. This shows the problem with Section 165 losses that don’t qualify for Rev. Ruling 2009-09 relief. Section 165 theft losses may be significantly limited on Schedule A, and then the recovery income is gross income without limitation in a subsequent year. That’s tax inefficient.
Issue 4. Amount of deduction.
My comment: I deleted this section because it applies to the Madoff Ponzi-scheme. Madoff investors had to keep track on their investments over the years, their reported income and distributions. It all was part of the final accounting in Rev. Ruling 2009-09, as it was fraudulent over the years.
Most PFG self-directed traders have it easier because they did not engage PFG for investment management services. Look at your last monthly statement or better yet, the amount submitted to and confirmed by the bankruptcy trustee as your original theft loss amount. Reduce that amount by any amount later recovered by the trustee and paid to you.
If you started 2012 with $75,000 in your PFG account and had a trading gain of $25,000 before the bankruptcy, and no additions or withdrawals during the year, your trading account balance at the bankruptcy date should be $100,000. If it was a different amount, then account for the difference in your trading gain to be reported.
PFG traders should report their 1099 income or loss during 2012 up until the bankruptcy. The trustee sent 1099-Bs for Section 1256 contracts. We understand from a PFG forex client that he also received a 1099-B, which normally is not sent for spot forex, only forex forwards. Perhaps the trustee wants to make sure that all PFG traders report their income during the year.
Issue 5. Net operating loss.
Section 172 allows as a deduction for the taxable year the aggregate of the net operating loss carryovers and carrybacks to that year. In computing a net operating loss, nonbusiness deductions of noncorporate taxpayers are generally allowed only to the extent of nonbusiness income. For this purpose, however, any deduction for casualty or theft losses allowable under 165(c)(2) or (3) is treated as a business deduction.
My comment: This is great news and one of the best parts of this safe harbor relief. Many PFG traders did not qualify for trader tax status/business treatment, so in accordance with Section 165, they couldn’t deduct their theft losses as a business loss in the year sustained. Normally, NOLs only are comprised of business losses, not capital losses and not itemized deductions.
Under 172, a net operating loss generally may be carried back two years and forward 20 years. However, under 172(b)(1)(F), the portion of an individual's net operating loss arising from casualty or theft may be carried back three years and forward 20 years.
My comment: For casualty or theft losses, the carryback is increased to three years. But, the third year back (2009) was not a good income year for most traders, and that could mean using the NOL carryback at lower tax rates. Remember with NOLs, you can elect to forgo the NOL carryback and carry it forward 20 years instead. It might be better to apply the NOL in 2013 and 2014 against Obama-era tax hikes. The IRS said that capital loss carryovers can't reduce unearned income, so we expect that NOL's won't either for purposes of the ObamaCare Medicare tax on unearned income.
To the extent A's theft loss deduction creates or increases a net operating loss in the year the loss is deducted, A may carry back up to three years and forward up to 20 years the portion of the net operating loss attributable to the theft loss.
Rev. Proc. 2009-20 guidance
Excerpt from RIA: "A “qualified investor” using the Rev. Ruling 2009-09 safe harbor treatment must:
(1) mark “Revenue Procedure 2009-20” at the top of the Form 4684, Casualties and Thefts, for the tax return for the discovery year. The taxpayer must enter the “deductible theft loss” amount from line 10 in Part II of Appendix A of Rev Proc 2009 -20 on line 34, section B, Part I, of Form 4684 and shouldn't complete the remainder of section B, Part I, of Form 4684;
(2) complete and sign the statement provided in Appendix A of Rev Proc 2009 -20 ; and
(3) attach the executed statement provided in Appendix A to the qualified investor's timely filed (including extensions) federal income tax return for the discovery year.
My comment: We confirmed with IRS chief counsel that taxpayers can file an extension with no mention of Rev. Proc. 2009-09 losses or Rev. Proc. 2009-20, and execute the strategies mentioned here with their 2012 tax return filed before the extended due date of Oct. 15, 2013. That’s what is meant by “including extensions” above. Just make sure you file a “valid extension,” otherwise your extension is null and void. Read more about extensions on our March 20, 2013 blog .
By executing the statement provided in Appendix A of Rev Proc 2009 -20 , the taxpayer agrees not to:
(1) deduct in the discovery year any amount of the theft loss in excess of the deduction permitted under the rules;
(2) file returns or amended returns to exclude or recharacterize income reported with respect to the investment arrangement in tax years preceding the discovery year."
State tax treatment
(RIA excerpt) - “Each state may treat these losses differently. New York, for example, has announced that it will recognize the safe harbor under Rev. Proc. 2009-20 for purposes of determining the amount of New York state itemized deductions for the theft loss. However, itemized deductions in New York are reduced for taxpayers with income in excess of certain thresholds (that is also the case for federal income tax purposes, but the IRS has explicitly excepted these losses from those reductions). And the NOL provisions permitted for federal purposes aren't permitted for New York because the state allows NOL deductions only for losses attributable to a business, trade, profession, or occupation carried on in New York. The losses from a Ponzi-like fraudulent investment arrangement generally won't qualify.”
Bottom line from Green
Deducting PFG losses is nuanced and complex. It’s important to understand Section 165 and Rev. Ruling 2009-09, read the CCC site PFG tax news, read our tax blogs, and then crunch the numbers with a good CPA who understands all these rules and different tax-filing scenarios and options. If used, apply Rev. Proc. 2009-20 to the letter of the law. What you should ultimately do is highly dependent on your overall income and loss and tax posture in perhaps a number of tax years. We are helping many new clients on PFG and MFG losses, so contact us for help soon. March 20, 2013
Extensions & Section 475 MTM elections are due by April 15
By Robert A. Green, CPA and Darren L. Neuschwander, CPA
We have a few Webinar recordings available on this topic.
The deadline for filing a 2012 individual and partnership income tax return is April 15, 2013. (The deadline for filing a 2012 S-corporation and calendar-year C-corporation income tax return was March 15, 2013.) Also, external 2013 Section 475 MTM elections for existing individual and partnership taxpayers are due April 15, 2013.
Unfortunately, there’s no Form 1127-A economic hardship relief for 2012, but the IRS announced today new relief on late-payment penalties in connection with fiscal-cliff tax law changes.
IRS penalty relief related to fiscal-cliff tax law changes
On March 20, 2013, the IRS published IR-2013-31. “The Internal Revenue Service today provided late-payment penalty relief to individuals and businesses requesting a tax-filing extension because they are attaching to their returns any of the forms that couldn’t be filed until after January. The relief applies to the late-payment penalty, normally 0.5% per month, charged on tax payments made after the regular filing deadline. This relief applies to any of the forms delayed until February or March, primarily due to the January enactment of the American Taxpayer Relief Act. Taxpayers using forms claiming such tax benefits as depreciation deductions and a variety of business credits qualify for this relief. A complete list of eligible forms can be found in Notice 2013-24, posted today on IRS.gov. Individuals and businesses qualify for this relief if they properly request an extension to file their 2012 returns. Eligible taxpayers need not make any special notation on their extension request, but as usual, they must properly estimate their expected tax liability and pay the estimated amount by the original due date of the return. The return must be filed and payment for any additional amount due must be made by the extended due date. Interest still applies to any tax payment made after the original deadline. Further details on this relief, including instructions for responding to penalty notices, is available in Notice 2013-24.”
What does this mean? If you had a schedule/form that was not available until late February or March this year, such as Form 4562 (most business traders have this form for deprecation), you’re eligible for this relief. If you file a good faith estimate/extension by April 15, 2013 and still owe taxes with the filing of the extended return that has one of these late-issued forms, the late-payment penalty on the outstanding balance will be waived.
Most traders need extensions
The April 15 deadline for filing 2012 tax returns is unreasonable for most securities traders because they’re just receiving complex and error-prone 1099-Bs now. (See our March 4, 2013 blog “Caution, downloading securities Form 1099-Bs into TurboTax often leads to incorrect tax filings.”) No worries. The IRS grants automatic extensions until Oct. 15, 2013 for individuals and Sept. 16, 2013 for entities (because the 15th is a Sunday) if you file a valid automatic extension by the original tax deadline above.
Pass-through entities — like a partnership or S-corporation tax return which most trading businesses use — file a simple automatic extension IRS Form 7004. It’s a very easy filing since there’s no federal tax due. Most states also don’t tax pass-through entities; some accept the federal Form 7004 and others have their own state extension form.
Don’t miss filing these entity extension forms on time. Missing the deadline will trigger late-filing federal penalties of $189 per partner, per month (up to five months), and state late-filing penalties generally will apply, too. There is no good excuse in our book for missing the extension filing deadline, since it doesn’t require a calculation of tax liability.
Individuals need to calculate their taxes before April 15
A valid automatic extension for individuals is different, as individuals need to calculate and pay their taxes owed by the April 15 deadline. Generally, “valid” means you have to pay at least 90% of your 2012 tax liability calculated in good faith with the automatic extension filed by the original tax deadline of April 15, 2013. It’s an extension to file, not an extension to pay. For further details on what good faith means, see our extension blog last year.
To make these calculations, enter your 2012 tax information statements like W-2s, 1099s and K-1s into tax software and use conservative estimates for items you are not sure about like wash sales and trader tax status-related business expenses.
If you have material income in Q1 2013 for which there are no tax withholdings, you may owe 2013 estimated taxes by April 15. Rather than pay a separate Q1 2013 estimated tax payment, overpay your 2012 extension instead. That gives you a bigger cushion on final 2012 tax liability, ensuring your 2012 extension is valid. If there is an overpayment on your 2012 tax return, you can apply that credit to Q1 2013 estimated taxes later on.
Can’t pay your taxes?
To accommodate taxpayers in the last recession, the IRS allowed taxpayers to use “economic hardship” as a reason for granting relief from late-payment penalties in 2011. Taxpayers could file Form 1127-A (2011) “Application for Extension of Time for Payment of Income Tax Due to Economic Hardship” as explained in our March 29, 2012 blog.
As of this date, the IRS has not issued Form 1127-A economic hardship relief for 2012, so taxpayers need to qualify for penalty relief under more restrictive Form 1127, “Application for Extension of Time for Payment of Tax Due to Undue Hardship.” Form 1127 instructions state “File Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return ... and do not file Form 1127 (instead).”
State individual extensions
Some states don’t require an automatic extension if you’re overpaid, as they accept federal extensions. Generally in all states, if you owe taxes, you need to file a state extension with 90% payment, too. Check the extension rules in your state. States tend to be less accommodating than the IRS in waiving penalties, so it’s usually wise to cover your state first if you are short on cash.
Don’t forget 2013 Section 475 MTM elections for existing taxpayers are due by April 15
Making a Section 475 MTM election could be tricky based on using unreliable trading gain or loss tax information from the cost-basis reporting mess. This information can affect your decision to file or skip the Section 475 MTM election. Generally, we recommend Section 475 MTM on securities only, providing the business trader doesn’t have capital loss carryovers. Traders need capital gains to use up capital loss carryovers — not Section 475 MTM ordinary income. On the other hand, wash sales from 2012 can be converted into Section 475 MTM ordinary losses in 2013 with a Section 475 MTM election.
It’s important to read Chapter 2 of Green’s 2013 Trader Tax Guide on Section 475 MTM elections. We cover many different examples of decision making. Blowing a Section 475 MTM election decision is the biggest mistake business traders make. Our guide contains the Section 475 MTM election statement. It’s a two-step process for existing taxpayers: First, file the Section 475 MTM election statement by April 15 for individuals and partnerships. Second, file a Form 3115 with the 2013 tax return in 2014. If you have questions about Section 475 MTM, consider a 30-minute consultation with Robert A. Green, CPA.
Section 475 MTM is beneficial because it exempts business traders from the onerous Form 8949 (cost-basis reporting), wash sale losses and the capital loss limitation of $3,000 against ordinary income. Section 475 MTM transactions are reported on Form 4797 Part II (ordinary gain or loss) and these business ordinary losses are part of a NOL two-year carryback and/or 20-year forward.
Note: You can’t attach a Section 475 MTM election to an e-filed automatic extension. You must mail the extension with a Section 475 MTM election statement attached to the federal extension Form 4868. “New taxpayers” like new entities in 2013 file Section 475 MTM elections internally within 75 days of inception of the new entity.
If you need help with a last-minute extension filing – and perhaps a Section 475 MTM election too — consider a 30-minute consultation with Robert A. Green, CPA. A few weeks before the April 15 deadline, we stop taking on tax compliance clients, as we don’t have sufficient time left to review all tax information, plus we expect open items and issues. Robert A. Green, CPA has time to work with new clients to prepare quickie extensions based on their key tax information documents like W-2s and summarized tax information like trading gains or losses and expenses. We do these quickie extensions with no liability to our firm. Clients are then welcome to sign up for our full tax compliance service after the extension deadline. This system has served everyone well over the years. If you have any questions, please contact us soon.
Focus on what’s important now for April 15: filing a valid extension and considering a Section 475 MTM election for 2013. Consider a consultation with our Robert A. Green, CPA to discuss these issues and more. Don’t bury your head in the tax quick sand — that’s always the worst choice. March 7, 2013
MF Global & PFG Best deposit losses have nuanced tax treatment
By Robert A. Green, CPA with Mark Feldman, JD and Darren Neuschwander, CPA
March 22, 2013 postscript: Good news: The CCC was successful in winning IRS Rev. Proc. 2009-20 tax relief for PFGBest customers. Read our new March 31 blog update.
Postscript on March 8: Our CPAs enjoyed participating on the CCC call yesterday. Robert Green spoke up to correct another CPA participant, who made an otherwise cautionary suggestion to attach a theft statement to 2012 extension filings by April 15, 2012 (to preserve possible Rev. Ruling 2009-09 treatment). Darren Neuschwander, CPA read the Rev. Proc. 2009-20 differently and alerted Robert Green who raised his hand on the call to correct this suggestion (see details below). We received confirmation from the IRS today that we are right on this point.
Per Darren Neuschwander, “I called the IRS on this point (after the CCC call). Peter Ford of the Office of Associate Chief Counsel (Income Tax and Accounting, Branch 2) called me this morning in regards to Section 6.01(3) of Rev Proc. 2009-20. Peter confirmed that our understanding of the writing of that section of the Rev. Proc. is accurate in that Appendix A of the Rev. Proc. is attached to a timely filed federal income tax return. A 'timely filed federal income tax return' includes a return that has been extended. Appendix A is NOT attached to the actual extension. As such, if you are filing a tax return before 4/15, then Appendix A must be attached to the tax return. If you are filing extension for the 4/15 deadline, then Appendix A is attached to the tax return that is filed on or before the extended deadline of 10/15.”
We at GreenTraderTax congratulate CCC tax attorney Ms. Hilary Escajeda for doing an excellent job in dealing with the IRS in requesting tax relief for PFG victims under Rev. Ruling 2009-09. We hope Ms. Escajeda is successful in getting a positive answer from the IRS, promised to her by March 22. As a careful tax attorney, Ms. Escajeda did not give specific tax answers on the CCC call; she referred callers to seek out competent tax advisors in this area of the tax law. CCC promised an upcoming “tax call” and hinted our CPAs would be part of it. We will try to be part of it, as we have experience in Rev. Proc. 2009-20 on Madoff victims in the past. We also have experience with Section 165(l) tax losses just in case the IRS does not allow Rev. Ruling 2009-09 application to PFG victims. Following 2009-20 is like following tax form instructions; it’s well laid out, technical and it requires careful execution.
Right after the CCC call, Green tweeted our blog to @JAMESKOUTOULAS and he retweeted our blog and later updates from @neuschwandercpa. Join our tweeting on this issue @GreenTraderTax and @neuschwandercpa.
Here’s an important update on dealing with tax write-offs for MF Global (MFG) and PFG Best (PFG) deposit losses and reporting taxable income in subsequent years if more money is recovered for customers over the tax loss amounts taken.
According to the Commodity Customer Coalition (CCC), both MFG and PFG bankruptcies are still active files with several unresolved issues, including tax treatment. That puts tax treatment decisions for 2012 up in the air. The CCC has an important conference call update on March 7, 2013 at 3:30 PM EST. (Dial-in number: 1-712-432-3100; conference code: 134556.) We will be there.
From the start, we thought it was outrageous for MFG futures trading customers to lose any part of their deposits under proper application of “segregation of customer fund” rules applicable to futures brokers — who otherwise don’t have FDIC and SIPIC federal insurance coverage. We argued the MFG trustee should claw back monies moved to counterparties days before the bankruptcy, as that money was inappropriately taken from segregated customers’ futures accounts. Turns out that may finally be the case by the time the liquidation is settled.
The CCC’s email invitation for the conference call indicates 100% recovery of customer accounts might occur as part of the final overall liquidation plan with MFG’s UK affiliates. Even though the MFG bankruptcy trustee and court already approved a settlement plan for 93% recovery of customer accounts (December 2012 and January 2013, respectively), these matters are fluid until final liquidation. While it’s great news for customers, it does complicate tax matters even more.
Our last blogs about MFG tax treatment
We last wrote about tax treatment for MFG deposit losses in April 2012 (IRS issues tax guidance on MF Global missing customer funds and The MF Global Tax Trap & How to Handle 2011 Tax Extensions). PFGBest filed for bankruptcy in July 2012, and their retail customers also have deposit losses too.
Section 165(l) is the default tax treatment
Generally, the IRS labels these losses “deposit losses in an insolvent financial institution” codified in Section 165(l) (Section 165 is for “Losses”). With the exception of two elections to accelerate Section 165(l) losses onto Schedule A, these losses are reportable on a tax return in the year the loss is “sustained.” That means evidenced by fixing the final amount of the loss. RIA research states the following: “It's sustained during the year the loss occurs, as evidenced by a closed and completed transaction (a specific and final event that fixes the time and amount of the loss and as fixed by identifiable events, occurring in that year).”
Section 165(l) has very specific tax treatment choices and investors face the prospect of either limitations on Schedule A as a theft/casualty loss or miscellaneous itemized deduction, or on Schedule D with a capital loss limitation of $3,000 against other gross income. Business traders qualifying for trader tax status make out much better under Section 165(l). They are allowed full business ordinary loss treatment in the year the loss is sustained, not when it’s discovered or reasonably estimated.
When is an MFG Section 165(l) loss sustained?
Is a deposit loss in an insolvent financial institution sustained when it’s agreed upon by the trustee with all parties to a settlement, or when the bankruptcy court approves of the final settlement, or during liquidation?
That’s a big difference for MFG victims since the trustee’s settlement was agreed upon on Dec. 22, 2012, and the bankruptcy court approved the settlement six weeks later on Jan. 31, 2013. There’s now indication that a final liquidation plan could include 100% recovery of customer funds, more than the 93% agreed upon in the December 2012 settlement.
Can MFG victims report a sustained loss in 2012, or should they wait until 2013? If it turns out there is 100% recovery of customer funds in liquidation, is there any benefit to reporting a loss in 2012 and then income in 2013?
For business traders with full ordinary business loss treatment in 2012, this can be helpful if they want to lower their 2012 tax bills at Bush-era tax rates. Keep in mind the gross income reported in 2013 - from more recovery of customer funds - could be subject to higher Obama-era taxes in the top tax brackets. This applies to investors with capital gains and loss treatment, too. Maybe they can use a capital loss in 2012 and don’t mind capital gains income in 2013. Remember, until there is a final liquidation, one never knows for sure.
But it’s probably not a good idea to take Schedule A deduction treatment in 2012. You want to avoid restricted tax deductions in one year (with waste) and gross income reported in a subsequent year. That’s tax inefficient. File an extension and get further clarity on the liquidation plan.
Section 165 sustained loss with “reasonable certainty”
Reg. 1.165-1(d)(3) states: "Any loss arising from theft shall be treated as sustained during the taxable year in which the taxpayer discovers the loss (see §1.165-8, relating to theft losses). However, if in the year of discovery there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained, for purposes of section 165, until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received."
We think an agreement of all parties on the settlement would constitute reasonable certainty for a sustained loss position in 2012. The bankruptcy judge approved the 93% recovery in January, 2013. News of potentially recovering more customer funds as part of a liquidation plan wasn’t known until after February, 2013. Based on the above definition, it seems reasonable to conclude that a 7% loss was sustained as of year-end 2012, reportable on 2012 tax returns, if one so chooses.
Notice “reasonable certainty” in the sustained loss definition is different from “reasonably estimating” a loss for accelerating a tax loss using the two tax elections available in Section 165(l), explained below. If you treat an MFG loss as sustained in 2012, there’s no need to use these elections to reasonably estimate a loss in 2012 — it’s the same tax year. We don’t think the MFG loss was reasonably estimated at year-end 2011. At that time, pundits projected the MFG loss would be much higher than the sustained loss of 7%. Alternatively, if you feel the MFG loss wasn’t sustained until the court approval in January 2013, then consider the tax elections for Schedule A deductions in 2012 (although, we generally don’t recommend that).
The March 6 CCC email said: “In the (liquidation) plan, a recovery analysis is discussed in which the plan's proponents ‘estimate a 100% recovery to all MFGI customer claims and a 28.3% – 79.6% recovery to holders of general creditor claims against MFGI.’ Basically, the settlement agreement and liquidation plan permit MFGH to loan MFGI the funds necessary to make customers whole.”
This CCC news does not change our opinion of the loss being sustained on Dec. 22, 2012. There was reasonable certainty of the loss on that date.
Ponzi schemes have ordinary loss treatment
Infamous Bernie Madoff may have been a scoundrel, but he sure did lead to a great IRS Rev. Ruling 2009-9 and Rev. Proc. 2009-20 for deducting losses from designated Ponzi schemes. Where Section 165(l) allows deposit losses with all sorts of limitations for investors and patience for the loss to be sustained, Rev. Ruling 2009-09 allows full ordinary loss treatment as soon as the loss is discovered. That’s the best, quickest tax treatment possible. Section 165(l) is quite different, although it does allow limited benefit elections to accelerate the loss into a year it can be “reasonably estimated” (for Schedule A treatment only, not Schedule D capital losses).
The CCC submitted a letter to the IRS on Feb. 20, 2013 arguing that PFG should fall under application of Rev. Ruling 2009-09, rather than Section 165(l). The IRS is stingy with this special relief. See further CCC news and my observations toward the bottom of the blog.
Here’s an excerpt from the RIA Client Letter on the Ponzi scheme IRS Rev. Ruling 2009-09 and Rev. Proc. 2009-20.
• Individual taxpayers would be limited to offsetting the loss against their capital gains, plus an additional $3,000 allowed as a deduction against ordinary income. Although the excess loss can be carried forward indefinitely, it would do little for losses of the magnitude incurred by the typical Madoff investor. So it was good news for investors when IRS announced that investors can take an ordinary loss deduction and the deduction isn't subject to the 2% of adjusted gross income (AGI) limit on miscellaneous itemized deductions, the income-based limitation on itemized deductions, or the 10% of AGI limitation on the deduction for casualty losses. For casualty or theft losses, the carryback is increased to three years.
• When the deduction is taken. Taxpayers can deduct the loss in the year the theft was discovered.
• The amount of the deduction. According to IRS, the amount of the theft loss is determined by adding to the amount of the initial investment any additional investments and any amounts the taxpayer reported as income and reinvested, minus any amounts withdrawn over the years and any reimbursements or likely recovery.
There are two elections in Section 165(l) to accelerate deposit losses
Section 165(l) certainly applies to MFG and it applies to PFGBest unless the IRS rules that PFGBest can use the Ponzi ruling 2009-09. Taxpayers have the option to file two different Section 165(l) elections to accelerate the deposit loss into an earlier tax year when they can “reasonably estimate” the loss as of the end of that tax year. You can’t use hindsight after year-end.
Both of these tax elections accelerate the tax deduction onto Schedule A (itemized deduction treatment) and there are many limitations that apply with Schedule A — in other words, you wind up wasting part of your loss deduction. See the limitations below.
On the other hand, if you are patient and wait for the loss to be sustained, you can choose potentially better tax treatment like short-term capital loss treatment (for investors), and certainly better business ordinary loss treatment (for business traders).
• Theft/casualty loss election. This tax election accelerates a theft/casualty loss reported on Form 4684 which then transfers to Schedule A. The problem with theft/casualty loss tax treatment is that it’s only the amount that exceeds 10% of your AGI. Although it’s not an AMT preference, there are some limitations on itemized deductions in some states. Pease itemized deduction limitations apply to upper-income taxpayers in 2013. Schedule A deductions are often lost with negative taxable income too.
• Miscellaneous itemized deduction election. This tax treatment limits the ordinary loss up to $20,000. Here’s the catch: It’s not “ordinary” in the regular sense of the word — “above the line” from gross income — but rather it’s a miscellaneous itemized deduction only deductible in excess of 2% of AGI. It’s an AMT preference and the other Schedule A issues mentioned apply, too.
• Caution with these tax elections. Many hurricane loss victims used these tax elections to accelerate tax losses and it wound up being a bad tax deal for them when the final loss was sustained. They overestimated their losses in the acceleration year — thinking they were beating the tax man — but they wasted much of those tax deductions with the AGI limitations, AMT and other limitations. When a smaller actual loss was sustained, they had to report Other Income in Gross Income due to the difference. How is that a problem? While gross income is fully taxable, the Schedule A deductions were limited.
Selling your claim to a hedge fund
Another option was to sell your bankruptcy claim to a hedge fund and take a short-term and/or long-term capital loss. Soaking up this capital loss against current year or expected subsequent year capital gains was a good option, because you avoided Schedule A limitations. But you may have sold out too early, as the MFG final recovery percentage was much higher than many sold their claims for in 2012. Plus, some sellers are still stuck with unutilized capital loss carryovers.
Business traders might be sorry they sold their MFG claim for an unutilized 2012 capital loss rather than waited for a sustained ordinary business loss before year-end 2012. Section 165(l) only allows capital loss treatment for actual sales and exchanges.
There are better tax treatment choices with a sustained loss
With a sustained loss, you have the same options for Schedule A — theft/casualty or miscellaneous itemized deduction — only you don’t need to bother with reasonable estimates and you can get it right the first time. But again, Schedule A wastes too much of the loss for too many taxpayers. Consider these other choices.
• Non-business bad debt for investor tax status. Investors didn’t have trader tax status (business treatment) when their deposit account was frozen, so it’s considered a short-term capital loss. The capital loss is reported on Form 8949 in the “Other” category since it’s not a covered security. Proceeds from the trustee go in the “proceeds” column and the deposit account balance on the date frozen goes into the “cost-basis” column. Costs and expenses related to this crisis are added to cost-basis as well.
Capital losses can never be estimated in advance, which is why the capital loss choice isn’t available with the tax elections to accelerate losses as discussed earlier.
o IRS Pub 529 (Miscellaneous Deductions) page 10-11 says the tax acceleration election is available for a capital loss, but we strongly feel it’s an error. IRS Pub 547 (Casualty, Disasters & Thefts) page 3 contradicts IRS Pub 529 on this very point, stating that non-business bad debts are capital losses and they can’t be accelerated through elections like the Schedule A deductions. Our tax research on Section 165(l) confirms capital losses can only be reported when the loss is sustained.
o Capital loss treatment is OK if you can soak up the capital loss in the current year or expect to have capital gains in subsequent tax years. These taxpayers get a loss deduction in full from gross income and they avoid Schedule A limitations (partially wasted losses). Reducing capital gains income can also reduce the new 3.8% Medicare surtaxes on unearned income for AGI over $250,000 (married) and $200,000 (single) starting in 2013.
o Many traders already have large capital loss carryovers and they certainly don’t want more, so Schedule A may be better for them.
• Business bad debt for a taxpayer with trader tax status. These traders qualified for trader tax status (business treatment) when their deposit account was frozen and the account was part of their business working capital. For a business trader, the deposit loss is a business ordinary loss deduction.
o Business bad debts can only be deducted when deemed worthless or in the case of a “deposit losses on an insolvent financial institution,” when the loss is sustained. Section 165(c)(1) “losses incurred in a trade or business” allows business ordinary loss treatment.
o It doesn’t matter if the business trader elected Section 475 MTM (ordinary gain or loss treatment) or not; it’s the deposit account balance which is lost, not a security or other financial instrument (which is what Section 475 applies to).
o There are a few different ways to report the business ordinary loss. Both ways will have the loss contribute to any NOL generated.
You could deduct this deposit loss where you deduct your other trade or business expenses. For a sole proprietor, deduct it on Schedule C. Partnerships or LLCs filing a Form 1065 or S-corporations filing a Form 1120-S report it as a business expense line item.
We prefer reporting the loss on Form 4797 Part II. Trustees may issue a 1099 to customers for the recovery amounts. Enter recovery amounts received in the Proceeds column on Form 4797 and put the total deposit impaired plus costs to deal with the mess in the Cost Basis column. The net amount on Form 4797 is the sustained ordinary loss amount.
PFGBest filed for bankruptcy in July 2012 and it was liquidated soon thereafter. PFG’s CEO Russell Wasendorf pled guilty to embezzlement in September 2012, and the judge sentenced him to jail in January 2013.
The CCC was formed to help futures traders with their MFG and PFG losses on all fronts. On Feb. 20, 2013, CCC posted a letter to the IRS requesting Ponzi ruling tax relief for PFG victims. According to the CCC Website, “The CCC seeks guidance as to whether or not PFGBest account holders can claim their losses due to the fraud as theft losses using Revenue Ruling 2009-9 and Revenue Procedure 2009-20, put into place to assist victims of the Madoff Ponzi scheme … The issues presented in the PFGBest case are novel and do not squarely fit within the IRS precedent in the Madoff case.” The CCC goes on to make some good comparisons between PFGBest and Madoff cases. We suggest filing a 2012 tax extension to wait for an IRS answer to CCC.
This CCC letter to the IRS is not a private letter ruling (PLR) which could only be relied on by one taxpayer; although other taxpayers could reference a PLR.
Our observations about the CCC IRS letter
We think the CCC did a good job with their letter and we also see many similarities between PFG and Madoff. Like them, we notice some potential differences, too.
Madoff victims had phantom income that they paid taxes on over the years, in some cases at ordinary rates — i.e., on short-term capital gains and non-qualifying dividends. It would be unfair for the IRS to force victims into significant limitations when reversing prior-reported phantom income included in deposit losses when reinvested. For example, picture huge capital gains reported in early years and then a huge capital loss with limitations after the Ponzi scheme was discovered. Many of Madoff’s victims have high AGIs and the 10% AGI limitation for theft and casualty losses would be very large and unfair. Hence, the Ponzi ruling waived the 10% threshold. Paying taxes on phantom income and not getting a corresponding tax deduction in subsequent year’s means you would have an added tax cost on top of your money being stolen.
In the case of MFG, the trustee sent 1099s to futures customers for 2011 and even though victims may have left their profits in the firm and lost some as a deposit loss, they had to report their actual 2011 trading gains and pay taxes accordingly — whether they got a Form 1099 or not. MFG traders didn’t have phantom income.
We don’t have all the information on PFG victims as CCC may have, and we wonder how many of our retail trading clients had phantom income issues with PFG. Our trader clients had retail accounts with only their actual trades made and they simply lost access to their accounts frozen in bankruptcy.
We agree with CCC that application of the IRS “Ponzi" revenue ruling 2009-09 doesn't hinge on the phantom income issue alone; theft and embezzlement counts, too. The IRS didn't intend 2009-09 to be a narrow ruling and they wanted it to apply to other thefts and frauds. Hopefully, the CCC letter request and conversations with the IRS works for PFG victims.
PFG update from CCC’s March 6 email
“PFGBest Tax Development. The CCC requested guidance from the IRS as to whether or not PFGBest customers could use the Revenue Ruling and Revenue Procedure enacted to aid victims of the Madoff Ponzi scheme claim their losses stemming from the fraud as theft losses. There was a question as to whether or not the fact pattern of the PFGBest fraud met the criteria the IRS had in mind for claiming theft losses. We have been in communication with the IRS and have worked to educate them on the PFGBest case. We have been informed to expect a response from the IRS around March 22, 2013 and the early indication is that PFGBest victims may be able to claim their losses as a theft loss using the Madoff Revenue Ruling and Revenue Procedure.”
It would be helpful to receive this news before preparing and filing 2012 tax extensions on April 15, 2013.
If you lost money on your MFG and PFG accounts or in another insolvent financial institution — without federal insurance coverage (FDIC or SIPIC) or private insurance reimbursement — it’s important to understand the different choices of tax treatment and elections available for a “deposit loss with an insolvent financial institution” under Section 165(l).
Speak with an expert like our firm, and if all is not clear on April 15, file an extension to have more time. With Section 165(l) losses and Revenue Ruling 2009-09, crunch the numbers to see which tax treatment comes out best for you over a multi-year time frame.
If you are a business trader and subject to Section 165(l) – not the IRS Ponzi ruling - then it’s generally best to wait for the loss to be sustained to have business ordinary loss treatment, rather than rush to sell your claim for capital loss treatment if you have capital loss limitations.