The limitation on theft loss deductions from the Tax Cuts and Jobs Act might not reach victims of “pig butchering” scams if the taxpayers can prove their profit motives, tax lawyers told Tax Notes.
Pig butchering — named for a Chinese phrase, sha zhu pan, referring to the ability to use every part of the animal — has taken the fraud world by storm. It also refers to how a victim is “fattened up” over the course of a long-term relationship.
The latest scam combines elements from several earlier frauds in a swindle monster that would impress Victor Frankenstein.
It starts like a romance scam, although the targets and approach may be different. There are the dating site connections, but random texts and LinkedIn messages are also used to start conversations.
That first step is focused on striking up a purely electronic relationship, much like in a romance scam, but the first payoff works a bit differently. Instead of asking for money for some sort of personal need — a medical emergency or something for a child, for example — the scammer tells the target about a great investment opportunity, usually involving cryptocurrency or other digital asset.
Maybe the scammer shows some evidence of investment gains, but eventually the target is directed to a website or app that looks legitimate. It may even mimic a real platform such as Coinbase.
The target then “deposits” some cryptocurrency with the fake platform. It may look for a while as if there’s some real investment activity, and the target might be able to make a small early withdrawal.
However, the money is already gone.
After the target has been encouraged to invest as much of their life savings as possible, the next stage of cuts begins.
When the target wants to make a substantial withdrawal, the response is that a substantial tax liability or other regulatory cost must be paid first. Maybe there’s a claimed wiring fee or legal costs.
But in the end, there was never an investment to grow, redeem, or protect.
One last layer to the scam: The scammers are often themselves victims of human trafficking forced to work by organized crime syndicates.
The limitations on theft loss deductions imposed by the TCJA have arisen in another prominent fraud, but a question remains whether they would apply to pig butchering victims.
It’s Just Business
Section 165(c)(3) and (e) used to allow any taxpayer to take a theft loss in the year the loss was discovered, so long as there no longer remained any reasonable prospect of recovery.
However, the TCJA added section 165(h)(5), which limits deductions for “personal casualty loss” from 2018 through 2025. It isn’t clear what will happen to the scheduled expiration of that limitation during Taxmageddon and the anticipated 2025 negotiations over expiring TCJA provisions.
That might not matter for pig butchering victims, Eric G. Lanning of Frost Law told Tax Notes.
Lanning pointed to section 165(c)(2), which allows deductions for losses from transactions entered into for profit but not in a trade or business.
Pig butchering victims are convinced they are investing and their motives are to build wealth, so they can argue their losses wouldn’t be covered by the TCJA’s restrictions on personal losses, Lanning said.
Travis Thompson of Boutin Jones Inc. agreed. The IRS has been treating cryptocurrency as property, and the victim intended to invest in that property, he said. Most of the rulings in this area involve investment advisers taking money from their clients, he added.
Tax attorney James R. Yandle told Tax Notes, “There is not a lot of current case law on the matter. It is still an evolving area.”
Thompson also highlighted the novelty of the issues involved, but focused on the cryptocurrency tax issues. It’s still “the Wild West,” he said.
A Broader Palate
On the other hand, victims of simple romance scams who send money to “loved ones” out of charity or affection would have a hard time arguing that their theft losses involved profit motive, Lanning said. Those losses are probably not deductible under the TCJA, he said.
Lanning said he’s also seeing clients who are victims of an intermediate sort of scam in which the victims are told their retirement or investment assets are being stolen. The victims are persuaded to move those assets somewhere the scammers can actually steal them, he said.
Victims of this latter scam may be able to interpret the “transaction” involved broadly to include not only their initial investments but also their later attempts to protect those assets, according to Lanning.
Tax advisers will probably be able to claim substantial authority for pig butchering loss deductions and maybe even “more likely than not” confidence because of the comparison to Ponzi schemes, Lanning said. The asset protection scam victims may reach only a reasonable basis confidence level that should accompany disclosure on a tax return, he said.
Recipe for Success
Lanning said the importance of profit motive makes every case highly factual, and that the pig butchering victims he’s represented have often had good facts.
Alyssa Maloof Whatley of the Law Offices of Alyssa Maloof Whatley said it’s best to take the position that pig butchering losses are deductible on an original or amended tax return. That would open up the simplest path to the Tax Court, through a notice of deficiency, if the IRS disagrees, she said.
Taxpayers may have to resort to making the argument as part of offers in compromise if their tax liabilities have already been assessed or if there’s a mismatch between the income from liquidating the assets fueling their “investments” and the discovery of the scam, according to Whatley.
Thompson agreed on the need to build a factual record to prove profit motive. He said he’d try to gather all of the victim’s communications to give to the IRS and try to find screenshots of the “investment platforms,” if possible.
Proof of annual returns might also help the case for victims of the intermediate investment protection scam, Thompson said. And in either case, he’d include the victim’s testimony, he said.
Could the IRS help clear the air for victims through some sort of guidance?
Thompson, Whatley, and Lanning all agreed that would help. Even an internal legal memorandum would be helpful, Lanning said.