Category: Deposit losses: MF Global, PFG And More

Tax Treatment Of Forex Losses In Wake Of Swiss Surprise

January 17, 2015 | By: Robert A. Green, CPA

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If you are one of many who got caught on the wrong side of the forex trade when the Swiss National Bank (SNB) surprised the markets with a huge policy change this week, you probably incurred significant losses. Here’s a quick primer on how to handle these losses on your tax returns.

First, it’s important to segregate your losses into two camps: the forex trading loss (Section 988 or capital loss) incurred on your open positions that were liquidated or closed by you or your broker, versus losing a deposit in an insolvent financial institution (Section 165). The latter also happened to traders who made money on this market event.

Forex tax treatment
By default, forex trading losses are Section 988 ordinary losses, unless you filed an internal contemporaneous capital gains election at any time before this new trading loss was incurred. In that case, it’s a capital loss subject to capital loss limitations of $3,000 per year against ordinary income. With a capital gains election in place, if you trade major currencies and don’t take or make delivery, you probably use Section 1256(g) lower 60/40 capital gains rates.

If you qualify for trader tax status (business treatment), Section 988 losses are business losses includible in net operating loss carry backs and forwards. But without trader tax status, you’ll need other income to absorb the forex ordinary loss, because the negative income part is otherwise wasted. If you’re using Section 1256(g), you can file a net Section 1256 loss carry back election for 2015 to carry the loss back three years to offset Section 1256 gains in those years. (Read more about forex tax treatment in our Trader Tax Center).

Deposit loss tax treatment
Hopefully, other banks and brokers will rescue teetering forex brokers and not too many forex traders will lose their deposits in insolvent financial institutions. That would be unfortunate since there is no FDIC or SIPIC money-protection on forex accounts. If U.S. and foreign forex brokers fail, hopefully the firms have private insurance that pays out the deposit holders in full for their deposit losses. If there is less than full recovery of deposit losses through insurance or otherwise, sustained losses are subject to Section 165 tax treatment.

We addressed similar issues when we covered the MF Global insolvency and recovery efforts over the past few years.

Excerpt from our Trader Tax Center
Many investors, traders and hedge funds got sideswiped by the MF Global and PFG bankruptcies over the past few years. Unfortunately, futures and forex account holders are not afforded government protection like bank account holders with FDIC protection and securities account holders with SIPIC protection. Tax treatment is far better when the IRS declares the loss a “theft loss”and allows application of IRS Revenue Procedure 2009-20, originally enacted to provide tax relief for investors in the Bernie Madoff Ponzi scheme. Theft losses receive ordinary loss treatment plus acceleration of losses on tax returns. Otherwise, Section 165 applies to deposit losses in insolvent financial institutions like MF Global. Investors are stuck choosing between capital loss treatment, which may trigger capital loss limitations, or itemized deduction treatment with various restrictions and haircuts. Business traders with trader tax status benefit from business ordinary loss treatment. Taxpayers with Section 165 losses must wait for the loss to be “sustained”so trustees have ample time for fund recovery. MF Global futures account holders recovered their losses in full, although forex account holders may have some sustained losses. (Read our blogs, PFG investors can deduct theft losses on 2012 tax returns with Rev. Proc. 2009-20 safe harbor relief, and MF Global & PFG Best deposit losses have nuanced tax treatment.)

I imagine bankruptcy trustees for these failing forex brokers will seek to recover funds from customers who incurred forex trading losses in excess of their deposits, unless the account agreements say otherwise. I also envision there will be arguments over who bears responsibility for excess losses, the broker or customer in cases where brokers liquidated positions and sometimes too late.

Disregard of CFTC rules
Many American forex traders disregarded CFTC rules (for retail off-exchange forex) by trading with non-registered offshore brokers offering leverage far above CFTC limits of 50:1 on major currencies and 20:1 on minor currencies. Several offshore brokers and a few U.S.-based forex brokers are facing financial strain or insolvency as a result of offering excess leverage to their customers during the SNB shockwave. When markets are extremely volatile the broker and customer may not be able to exit a trade before incurring a significant loss well in excess of the customer’s deposit amount. Let’s see how the money protection issue works out offshore.


PFG investors can deduct theft losses on 2012 returns

March 31, 2013 | By: Robert A. Green, CPA

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.

Some traders may want to skip it 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.

Issues
(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.

Facts…
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.

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.

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.

In our green_button, we have a 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.


IRS issues guidance on MF Global missing customer funds

April 12, 2012 | By: Robert A. Green, CPA

As posted on the Commodity Customer Coalition (CCC) Website, the CCC requested tax guidance from the IRS on how to handle missing customer funds from MF Global for tax years 2011 and 2012.

The CCC website shows this IRS reply letter and the IRS tax guidance matches the tax guidance we gave in our blog The MF Global Tax Trap & How to Handle 2011 Tax Extensions.

CCC sent an email update to its members on April 12, 2012 which included our Forbes blog for further tax guidance. Excerpt:

Information for Your Tax Preparer
CCC members should consult with their own legal, tax or financial advisor before filing any tax returns with the Internal Revenue Service. The following is not meant to provide any legal or financial advice but rather provide CCC members with an update from the IRS and general information concerning MF Global tax issues.

1. IRS Responds to CCC on Tax Issues

2. Forbes.com article about MF Global Tax Issues


The MF Global tax trap & how to handle 2011 tax extensions

April 4, 2012 | By: Robert A. Green, CPA

Forbes blog version: Caught Between MF Global And The Tax Man.

There is still significant money missing from MF Global customers’ futures accounts. The bankruptcy trustee sent MF Global customers 2011 Form 1099-Bs showing their realized and unrealized trading gains and losses from Section 1256 contracts. (Note: The cost-basis reporting crisis does not extend to futures. Taxpayers and tax preparers can rely on Form 1099-Bs for futures, whereas they cannot for securities 1099-Bs.)

MF Global’s bankruptcy trustee James W. Giddens added this note to the Form 1099-Bs: “Although you may not have recovered the entire value of your MFGI account in the SIPA Proceeding (bankruptcy process), your Form 1099 reflects all transactions credited to your MFGI account during 2011. You should consult your tax advisor to determine whether you may claim a deduction or loss for income tax purposes as a result of your not having recovered the full amount of your account.”

Giddens doesn’t say which year the loss may be taken. It’s the consensus of our CPAs and tax attorneys — and the consensus of others we have seen on the Internet — that a MF Global deposit loss recognition event most likely occurs after 2011.

Tax law for writing off deposit losses
The loss is not determined and the trustee still hopes to recover the entire amount (or much more) of missing customer monies. Certainly, they should, as these monies were taken inappropriately and as I pointed out in my Dec. 9 Forbes blog “How To Pay Back MF Global Customers 100%,” why can’t those last-minute transactions to pay counterparties with customer funds be reversed, and the monies recovered? I still believe that not doing this recovery is illegal and wrong. But, this has no affect on my discussion of tax posture.

The loss is not yet realized. Tax law for deposit impairment, casualty or theft loss or capital losses all require a known loss and a realization event of that loss. Again, the missing MF Global monies are being recovered slowly and some hold out hope for full or significant recovery. Although the bankruptcy and liquidation happened Oct. 31, 2011 and some courts ruled in early December 2011 on certain matters, the “missing money” file remains open and that is telling for tax purposes.

The tax code isn’t always logical or fair
It doesn’t matter if taxpayers took withdrawals of their trading gains during the year at MF Global or not — it has no effect on reporting their underlying trading gains and losses. If you made $200,000 trading futures in 2011 and $90,000 went missing — at no fault of your own — shouldn’t you be able to report $110,000 of net income on your 2011 tax returns? Then, if monies are recovered later, you would report that amount paid during the year it was received. This seems logical but currently it’s not an option.

The tax code works in strange ways that seem logical to accountants, but not so much to taxpayers. Accounting and tax principles always call for reporting transactions on a gross basis, without netting and offsetting transactions to change the character of income or loss. Taxpayers need to report their trading gains and losses separate from any loss on their deposits, just as Giddens said in his note.

An example of the tax trap
It’s tax time and we need to make decisions in spite of any uncertainty for a client with missing monies at MF Global. Mr. Giddens sent our client a 2011 Form 1099-B showing $1.7 million of Section 1256 trading gains. Our worksheet shows our client has still not recovered $1 million of his funds as of this date.

We’ve waited as long as we can for news, and now we must finalize his 2011 tax extensions due April 17, 2012. We’ve already entered his $1.7 million of Section 1256 contract trading gains on Form 6781. The good news is the lower 60/40 tax rates apply, so 60 percent is considered a long-term capital gain. But we don’t see a way to deduct all or a portion of his $1 million of unrecovered customer funds in 2011. Our client shows a significant tax liability and balance due with the extension filing. We have some ideas for clients who need to pay less below.

Business traders fare better in the tax trap
Let’s assume the worst — that our client never recovers the missing $1 million. If the trustee gives up and the money is declared fully lost in 2012, what happens next? Our client is luckier than many others since he qualifies for trader tax status (business treatment on trading futures) in 2012, and therefore his realized deposit-impairment loss will be a business bad debt. This means he’s entitled to Section 162 ordinary gain or loss treatment on a bad-debt loss, so it’s a full ordinary business loss. If there’s negative taxable income after this loss offsets any type of income, the client will have a net operating loss (NOL) carryback and/or carryforward.

MF Global customers can’t accrue a reserve or provision for 2011 taxes
Could a business trader on the accrual method of accounting accrue a reserve or provision before year-end 2011? Our tax attorney Mark Feldman said “no” and provided us with this tax research from RIA: “Reserves are generally not accruable. Although it is sound accounting and good business practice to deduct from current income estimated amounts to cover a variety of contingencies, these reserves (except for those few expressly authorized by the Code) are not deductible for tax purposes.” We reviewed the list of expressly authorized “reserves” or “provisions” which are allowed as tax deductions, and a deposit loss is not on that list.

RIA observation: “The underlying principle is that the income tax law is concerned only with realized losses and expenses. Furthermore, since the amount of a contingent liability ordinarily cannot be ascertained with any definite degree of accuracy, the underlying reserve is not susceptible of computation within a reasonably narrow limit, there is no assurance that the amount of the reserve will accurately reflect the actual future liability.”

Investors get a shorter end of the tax stick
Many MF Global futures trading customers won’t qualify for trader tax status (business treatment) in 2012. Some lost their trading capital and had to exit their trading businesses. Others never traded enough to qualify anyway. See how to qualify for trader tax status in our Trader Tax Center.

Investors have two tax treatments available to them, and they should run proforma tax returns to see which one is best for their facts and circumstances. A personal or investment bad debt is a capital loss. Alternatively, the loss can be declared a casualty or theft loss, which is an itemized deduction on individual tax returns (Schedule A).

If an investor has a large short-term capital gain in 2012, then offsetting capital gains by reporting a large MF Global deposit loss as a capital loss may be the best choice. The loss isn’t wasted in this case. Conversely, if a client has a capital loss limitation, he or she may prefer to consider a casualty or theft loss, which is widely covered for MF Global on the Internet. Caution: A casualty or theft loss is an itemized deduction and the taxpayer must first clear a 10-percent AGI threshold amount, meaning 10 percent of AGI will be a wasted loss. Also, take into account additional wasted losses due to itemized deduction phase-outs on federal and state tax returns. Thankfully, casualty and theft losses are not AMT tax preferences. Learn more about casualty and theft losses on irs.gov — see IRS topic 515.

Any hope for a Private Letter Ruling?
Our firm considered and then dismissed the idea of filing a private letter ruling (PLR) for the client mentioned previously. We see no legal tax grounds to ask the IRS to allow our clients to deduct a reasonable estimate of a MF Global deposit loss in 2011 to avoid the MF Global tax trap. PLRs are a long shot, so don’t hold up hope for this requested relief. It would be good if the IRS granted relief from its own initiative, but it probably won’t.

How to handle MF Global matters on extensions
With minor uncertainty over the deposit-loss recognition, it’s prudent for some MF Global traders to file extensions for 2011. For some, a million-dollar question is whether or not to pay their tax bill in full with the extension filing. Some may decide to pay less, assuming they may ultimately be entitled to report some of the deposit loss in 2011; but this is a long shot at best.

Other clients simply cannot pay what is due with the extension, but extension rules may provide relief from IRS penalties. Will the IRS assess MF Global customers’ late-filing and late-payment penalties if taxpayers file a Form 4868 automatic extension with less than 90 percent of their tax liability due? Paying less could be a risky gamble on penalties.

The managing members of our CPA firm Green NFH, LLC, Darren Neuschwander CPA and I decided to prepare our MF Global clients’ 2011 tax extensions relying on their Form 1099-Bs and without taking into account any missing monies (deposit losses) in 2011. But, we don’t take the choice of paying less away from our clients; we provide them with the following ideas for further consideration.

Can clients pay less with their extensions?
In “Extensions: Some traders may qualify for IRS penalty relief,” we explained cases where clients may qualify for special penalty relief on new extension form 1127-A (for hardship). If you qualify to use Form 1127-A, then you can skip tax payments on April 17, and the IRS will waive late-filing and late-payment penalties. (Check with your state, too.) As stated in our article, the penalties are steep. Taxpayers with big tax bills based on MF Global trading gains or otherwise won’t qualify for this hardship relief; Form 1127-A states “you must owe less than $50,000 with the extension to qualify for this relief.”

In our article, we pointed out that some taxpayers can’t pay what they owe but if they follow the rules carefully, have “reasonable cause,” and show good faith, they may succeed in requesting the IRS to abate late-filing and late-payment penalties. In my view, the IRS would be doubly cruel to not provide relief to MF Global traders and then slap them with late-filing and late-payment penalties. They certainly have a good reason why they can’t pay by April 17.

Tax preparers have to follow the letter of the law
Based on information available to us at this time — just two weeks before April 17 — tax extensions need to be prepared based on the 1099-B and without taking into account the deposit loss in 2011.

For informational purposes only, we plan to show our clients how their tax bill for 2011 might be lowered if they were able to take into account a deposit loss for 2011. We will make those calculations based on their facts and circumstances. It would be so much better for most to deduct a capital loss against capital gains in 2011, and avoid the tax trap in 2012.

Caution tax preparers: Preparing extensions taking the deposit losses into account for 2011 might open the door to claims by clients for reimbursement for their tax penalties. The IRS could deny penalty abatement letter requests, making this approach risky. Or, the IRS could abate penalties, but your state may not. The choices are not great here, and the more conservative approach is suggested.

Bottom line
The MF Global saga is painful to those who have missing monies. They were locked out of trading for a while, they lost a material part of their trading capital, and they got the short end of the stick in bankruptcy so far. It’s wrong for the IRS to hit them a second time when they are down. Hopefully, the IRS will provide some relief. With the bankruptcy filing so close to year-end, the tax trap was certain to happen. While Rome still burns on the missing money, taxpayers must file their 2011 tax extensions and it’s very hard for many of them to pay their tax bills due. The tax monies they saved up are still missing.



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