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Thieves and fraudsters have always been taxed on their ill-gotten gains. Now, their victims may also be taxed on the losses suffered at the hands of the scammers. As reported by the Majority Staff of the Senate Special Committee on Aging, fraud victims must pay income taxes on funds that were stolen from their retirement accounts. 

The report released April 11, 2024, reviewed government data and found an alarming increase in scams using artificial intelligence and other sophisticated means to carry out these frauds. The FTC estimated that older Americans lost the most to investment and business imposters in 2022, about $675 million. 

Stolen funds taken from taxable or tax deferred retirement accounts, such as a 401(k) or IRA, are included in taxable income. Further, victims under 59 ½ on the date of distribution, may also be subject to the 10% penalty on early distribution from the account.  

However, the victims of these frauds may not be able to offset their taxable withdrawals with a theft loss deduction. The Tax Cuts and Jobs Act (TCJA), passed in 2017, modified the casualty and theft loss deduction, effectively eliminated the ability for fraud victims – and others who faced losses for reasons other than federally declared natural disasters – to deduct the losses when computing their federal income tax. 

The change can result in income tax being imposed on the stolen retirement plan funds adding to the severe financial losses of the victims. As a result, these victims were taxed on more than the amount of their true economic income. This artificial increase in true income resulted in extraordinarily higher tax liabilities for the victims and the potential loss of public benefits and other tax deductions or credits tied to an individual’s taxable income. 

IRS record show that prior to the TCJA changes, older Americans disproportionately used the theft loss deduction. The report describes ten fraud cases and the surprising tax consequences to the victims. The thefts follow a familiar pattern. A sophisticated thief, sometimes impersonating a government official or tech support agent, convinces a victim to withdraw funds from their retirement savings account and transfer those savings to investment or cryptocurrency accounts for the benefit of the thief. The report includes a description of the frauds suffered by these victims: 

• Larry, a retiree in his seventies from Pennsylvania, lost $765,000 to someone impersonating a Social Security Administration official. Larry was tricked into withdrawing money from his IRA, 401(k), and savings account to buy cryptocurrency. In addition to his loss of the stolen account balances, Larry owes more than $220,000 in federal income tax, bringing his monetary loss to nearly $1 million.
• Rohan, a retiree in his seventies, was contacted by scammers posing as Department of Homeland Security officials and was told his identity had been stolen. To “safeguard” his assets, Rohan was advised to make two dozen wire transfers, totaling more than $4 million representing nearly all of his retirement savings, over the course of a year. Because Rohan transferred his retirement funds to the scammer, he incurred a tax bill to the IRS totaling more than $900,000 and an Ohio income tax bill of more than $90,000.
• Kate, a retired secretary and widow from Pennsylvania, was befriended on Facebook by a man posing as a United Nations surgeon based in Iraq. Over a five-month online “romance,” Kate withdrew most of her retirement assets and other investment accounts. Compounding her loss were an additional $5,000 in federal income taxes due to the rescission of the theft loss deduction.
• Retirees Sally and Bill, who are in their seventies, were victims of a person impersonating a bank officer. Convinced they needed to protect their assets; the couple moved more than $900,000 of their retirement savings into “special accounts.” Having lost their life’s savings, Sally and Bill also owed about $240,000 in federal taxes and about $65,000 in state taxes.

Some taxpayers have treated their losses as being incurred in a trade or business or a transaction entered into for profit. These types of losses remain deductible after the changes of the TCJA. However, hurdles remain. A victim must prove they had a financial motive rather than a personal or protective purpose for the withdrawals. 

Having a financial motive may not provide full relief. A loss is treated as incurred in the year the taxpayer discovers the loss. Often a taxpayer does not discover the fraud in the year the funds were withdrawn and subject to tax. The fraud is discovered and deductible in a later year. Unless the taxpayer has sufficient income in the year of discovery, a full loss deduction may not be usable in that year. Instead, the loss must be carried over to future tax years. All the while, the tax bill for the year of withdrawal must be addressed. 

Administrative relief from this fraud induced tax liabilities has not been readily available to victimized taxpayers. Legal Action of Wisconsin, a nonprofit providing legal services to low-income individuals, recounted its efforts on behalf of some victims to use the IRS’s offer in compromise (OIC) procedures to address these unimagined tax liabilities. 

An OIC allows a taxpayer to settle a tax debt for less than the full amount owed. There are three grounds upon which the IRS will consider an OIC: inability to pay, doubt as to liability, and circumstances warranting special treatment for public policy and equity reasons. Because of the TCJA’s clear elimination of the theft loss deduction may be no doubt as to a taxpayer’s liability for the tax due. Instead, any claim for OIC must be based upon an inability to pay or considerations of public policy and equity. 

Some commenters referenced in the report characterized the OIC program as complex, burdensome, and harsh. Legal Action found that IRS agents commonly understood that a tax liability resulting from a financial crime does not qualify an OIC for acceptance based on policy and equity. This is despite a provision of the Internal Revenue Manual recognizing circumstances where another party’s criminal act created the tax liability can give rise to consideration for settlement based on public policy and equity. 

Taxpayers facing a tax debt should consider the availability of an IRS installment agreement. An installment agreement is a payment plan that allows taxpayers to pay their tax debt over time, rather than in a lump sum. This can be helpful for taxpayers who cannot afford to pay their entire tax bill at once. The IRS offers several types of installment agreements, including short-term and long-term payment plans. To apply for an installment agreement, taxpayers must submit a request to the IRS and provide financial information to determine their ability to pay. 

Taxpayers who are unable to pay their tax debt due to financial hardship can request the debt tax bill be classified as “currently not collectible.” A currently not collectible status is a status that the IRS may grant to temporarily stop collection actions, such as levies and wage garnishments, and will not require the taxpayer to make any payments on their tax debt. However, interest and penalties will continue to accrue on the unpaid balance. To apply for currently not collectible status, taxpayers must submit a request to the IRS and provide financial information to demonstrate their inability to pay. 

Given the difficulties of addressing the tax consequences of stolen funds taken from taxable or tax deferred retirement accounts under current law, the report of the Senate Special Committee on Aging calls for reinstating, retroactively, the casualty and theft loss deduction. The proposed Tax Relief for Victims of Crimes, Scams, and Disasters Act (H.R.6938) would allow fraud victims and others who have experienced theft and casualty losses outside of federally declared disasters since passage of the TCJA to claim the loss deduction on current or amended tax returns. 

While the proposed legislation may offer some relief to taxpayers who have been victimized by financial crimes, it is uncertain whether it will be enacted or when. Therefore, taxpayers who are facing tax liabilities due to stolen funds should explore other options for resolving their tax debts, such as an installment agreement, a currently not collectible status, or an offer in compromise. Taxpayers should also report any fraudulent activity to the appropriate authorities and cooperate with any investigations. By doing so, they may be able to recover some of their losses and reduce their tax burden.