Investment theft loss

Client purchased a tax credit years back, used up part of it, and carried the remainder forward (prior to be my client). He eventually found out it was fraudulent and there were no assets to back up the credit. The IRS also found out and he recently had to pay back on the prior year return.

He got a tax attorney involved and the tax attorney says he can deduct this loss on the 2021 return as this was the year the fraud was adequately resolved. Originally he told me client it was reported like a Ponzi scheme - which is a schedule A theft loss (and the rules appear to be pretty specific to Ponzi schemes). He now told my client that is an above-the-line deduction.

How would this be an above the line deduction? Anyway other than capital loss?

Sure seems like a theft loss as described in Rev Rul 2009-9 and, if the purchase of the credits was a transaction entered into for profit, is an itemized deduction not subject to the personal theft loss limits.

How much did he pay for the credits, and how much did they purport to be?

How is purchasing tax credits an investment?

Client invested about 300K into an LLC. They said he wasn't an owner but he received a K1 that showed the 300k as a capital contribution and the only other amount on the K1 was a $450k tax credit. (No profit/loss/capital contribution percentages.) As presented to client the only purpose of this was to get the tax credit...not to reap any profits from the LLC.

So, client did engage in the transaction for profit...a $150k profit, which seems to meet Rev Rul 2009-9... which means itemized deduction.

Under what scenario could this be an above the line deduction?

What about the ongoing or soon to commence IRS audit regarding the bogus credit/sham transaction?

I'm supposing that the tax atty is figuring that since it's a biz investment into an LLC, generally income/losses would flow thru to Sch. E, tax credits of course way below....so maybe he's thinking it's a biz loss somehow. Sure sounds like an investment loss, tho'.

That has been resolved - client has already paid the tax credit back in full.

What do you mean the client paid back the tax credit?

Based on first sentence of OP, he probably means there turned out to be no credit to sell, so, since he had claimed it as a credit, he had to py back the added tax now due because there was no real credit.

Based on first sentence of OP, he probably means there turned out to be no credit to sell, so, since he had claimed it as a credit, he had to py back the added tax now due because there was no real credit.

Yes, this is what I meant.

If the sole motive for making the investment was for tax savings, then the IRS might question whether there was actually a profit motive, as they have done in several rulings and court cases in the past.

if taxpayer thought the investment was for a legitimate tax credit, those typically meet the profit motive (the tax credits and operations would project a positive economic return to the taxpayer)

It's easy to see that the transaction has potential economic benefits to the buyer. Unfortunately, that does not answer the question. So I did a little googling and learned that buying and selling tax credits are capital transactions.

I'd have no issue with reporting a capital gain, but I'd have to do some more research before reporting a loss.

Two asides:
1. If allowed, I'm thinking the loss would be an ordinary abandonment loss.
2. The term "tax-motivated transaction" crossed my mind.

Tax motivated investments are permitted with tax credits, including solar, rehabilitation, etc. And the tax losses typically stemming from these investments due to depreciation do not cause heartburn when the economic benefits are sufficient. These are absolutely tax shelters, specifically blessed by the code to incentivize investment.

Sophisticated advisers are typically used in setting up the appropriate structures.

Why would it be an abandonment loss rather than a theft loss?

Open question. To me it's a reporting position I could probably recommend without much hesitation.

“Ordinary “ abandonment loss

Would be a better answer if the facts support

I don't know that abandonment loss would work - Client received a partial recovery of fees paid (contribution on the K1) which could be seen as a distribution. Also, there was no intent to abandon the ownership or notification of intent to abandon. It seems to me this is a a theft loss - owner of LLC even went to prison... but that doesn't get it above-the-line deduction.

We're talking about a return position. Recovery and distributions are immaterial. Notification is unnecessary (and probably uncommon.) As to his intent, that's a subject for discussion -- with the client understanding the stakes before telling you his intent. If he stopped litigating, you could use that date as the date of abandonment. (I suppose an abandonment can occur in this situation even with continuing litigation.) In any event, depending on the numbers, it may be preferable for the client to hire a different preparer.

Well, it's intriguing. Let's look at a few scenarios of choosing between abandonment and some other treatment. The timing is, I think, critical.

1 - X buys tax credits for cash. He claims the credits and then has to pay more tax because they turn out to be fraudulent, non-existent. His cash was, essentially, stolen on day one. He has a theft loss, to be treated as in RR 2009-9, an itemized deduction, not subject to the recent limits or the 2% rule. He has a worthless claim against the thief, which he abandons but gets no deduction because he has no tax basis in the claim. He abandoned the laim, not the tax credit.

2 - Y owns stock that has a tax basis. It becomes worthless. He abandons it, but it had already become worthless, which requires capital loss treatment on 12/31 of the year it becomes worthless, per 165(g).

3 - Z (also known as Nilodop), owns stock that has a tax basis. He had dreams of retiring on its ultimate value. Dreams did not come true, and it's now worth about 30 cents per share, compared to its tax basis of about $9.00 per share. Z held it way too long. Now he can either sell it for 30 cents and have a per share cap loss of $8.70, limited to $3,000 per year, or abandon it, apparently after being told the tax consequences of both choices and with a need to ascertain both his intent and an affirmative act of abandonment. Z would want the abandonment treatment, I guess, because that makes itan ordinary loss as there is no sale or exchange.

Do I have those 3 right?