Avoid Identity Theft During Tax Season

During tax season, fraudsters use the latest strategies to steal identities. With the tax filing season in full swing, taxpayers need to remain vigilant for strategies that may involve text messages, emails, phone calls or potential unemployment fraud.

The Internal Revenue Service (IRS) notes, “With filing season underway, this is a prime period for identity thieves to hit people with realistic-looking emails and texts about their tax returns and refunds. Watching out for these common scams can keep people from becoming victims of identity theft and protect their sensitive personal information that can be used to file tax returns and steal refunds."

1. Text Message Scams— There has been an uptick in text messages from senders that claim to represent the IRS. These fraudulent messages often include links to bogus websites that purport to be the IRS. The IRS emphasizes it does not use text messages other than the IRS Secure Access service. The IRS also will not send direct messages through social media platforms.
   
   If you receive a text message that claims to be from the IRS, you should take a screen shot and send it to [email protected]. With the screenshot, include the date and time you received the text message and your phone number. You can take a screenshot on an iPhone by simultaneously pressing and releasing the side button and volume button. On other smartphone models, you may press at the same time the side button and home button or the top button and home button. The screenshot may then be accessed through your phone’s photos app and emailed to [email protected].


2. Unemployment Fraud— There is a surge in efforts by organized crime rings to steal identities and file fraudulent unemployment claims with state agencies. Your state office will then issue IRS Form 1099-G, Certain Government Payments to the recipient and the IRS. If you receive a fraudulent or inaccurate Form 1099-G, you should report it to the state agency and obtain a corrected Form 1099-G. For information on unemployment fraud and to report an incident, go to DOL.gov/fraud. If you receive any communication from a state agency about an unemployment claim that you did not file or a notice from your employer about an unemployment claim that is improper, you should also report it.


3. Email Phishing Scams— The IRS emphasizes that it does not contact taxpayers through email to request personal or financial information. If you receive an unsolicited email, do not click on any links in the email. Send the email as an attachment to [email protected]. The "Report Phishing and Online Scams" webpage at IRS.gov provides additional information.


4. Phone Scams— The IRS notes it does not leave urgent or threatening messages on your phone or voicemail. Scammers will often threaten victims with arrest, deportation or revocation of a driver's license. It is possible to "spoof" caller ID numbers. The scammer may attempt to spoof the caller ID number of a sheriff's office, department of motor vehicles or federal agency. The IRS emphasizes it will never call and demand payment through a prepaid debit card, gift card or wire transfer. It will also not ask for a credit or debit card over the phone.
   
   If you receive a threatening call, hang up the phone. You can report the caller ID and callback number on [email protected]. You also may report the call on FTC.gov and note "IRS Telephone Scam" on your report.
   
   If you owe tax or think you might have a tax bill due to the IRS, you should hang up the phone. You can create an online account on IRS.gov and review your information. There may be a phone number on a billing notice from the IRS or the general IRS number is 800-829-1040.
   
   If you are a victim of identity theft and a fraudster has used your Social Security number to file and claim a fraudulent refund, you may be contacted by the IRS. You should immediately respond to any IRS notice and call the listed number.
   
   You may file IRS Form 14039, Identity Theft Affidavit. If you are a victim of identity theft, you still must file and pay taxes. Many individuals use a paper form to pay their tax in this circumstance.

Editor's Note: IRS tax filing season always causes fraudsters to intensify their efforts. Taxpayers should be familiar with the principal ways scammers attempt to steal identities and file fraudulent returns.

Investment Scam Losses Deductible

In a legal memorandum (ILM 202511015), the Internal Revenue Service (IRS) clarified which types of scams qualify for a Section 165-theft loss deduction, stating that taxpayers who fell victim in three specific types of scams would be eligible for a deduction. However, taxpayers affected by two other scams would not qualify.

There is a theft loss deduction under Section 165 for victims of investment-related scams. However, individuals of other types of scams may not qualify. The memorandum reviews the five types of scams. In each type of a scam, a taxpayer sustained a loss and there was a taking of property that is defined as criminal theft under state law.

An individual may deduct a theft loss under Section 165 if it is incurred in a trade or business or in a "transaction entered into for profit." Theft is any type of criminal appropriation that may include “swindling, false pretenses or any other form of guile.” The taxpayer must establish that there was an illegal taking with criminal intent and there is no "reasonable prospect of recovery."

If there is a substantial possibility that the recovery may be made from the fraudster or a third party, the deduction is not permitted. The amount of the deduction is generally the adjusted basis of the taxpayer under Section 1011.

A deduction is generally allowed under Section 165(h)(5), but the Tax Cuts and Jobs Act disallowed personal casualty losses under Section 165(c)(3) unless the losses relate to a Federally declared disaster.

The theft loss deduction also does not qualify as a "Ponzi scheme" unless it meets specific requirements. The Ponzi scheme deduction is available if the investor receives reports of income that are partially or wholly fictitious, the fraudster makes payments to one investor with funds obtained from other investors and the fraudster appropriates part or all of the investor’s cash. The lead figure also must be charged with a theft crime by indictment or information under state or federal law.

The five scenarios assume that Scammer A obtains funds from Taxpayer (the victim) through criminal fraud, larceny or embezzlement and Taxpayer has no reasonable prospect for recovery. The following is each scam and the IRS determination on deductibility:

1. Compromised Account Scam — Taxpayer was contacted by Scammer who claims to be a fraud specialist at Taxpayer’s bank and states the victim’s bank accounts had been compromised. To protect the Taxpayer’s funds, Scammer A persuades Taxpayer to transfer funds from an existing IRA or non-IRA account into new investment accounts. Scammer A has access to the new investment accounts and transfers the funds overseas. Taxpayer contacts his or her financial institution and discovers the scam. Because the funds are overseas, there is little or no prospect of recovery. The financial institution will generally not repay funds that have been voluntarily transferred by Taxpayer to new accounts.
2. Pig Butchering Scam — The second scam is called "pig butchering." Scammer A contacts the victim and promises large profits. The victim initially deposits a small amount of cash and is rewarded with a large increase in value. When the victim makes a withdrawal, it appears like this is a legitimate account. The victim makes a second larger deposit and again has a large gain and makes a modest withdrawal. Because the victim has had a positive experience, the victim now invests a much larger amount, perhaps including a withdrawal from a traditional IRA. The victim expects a similar gain and the ability to withdraw funds. When the victim tries to withdraw the funds, Scammer A has absconded with them. The funds are now overseas with no reasonable prospect of recovery. The victim has lost his or her funds and must pay federal income tax on withdrawal from a traditional IRA.
3. Phishing Scam — Scammer A sends an email and claims to be a "fraud protection analyst." The email usually has a link to the scammer website and a phone number. The email further explains that the victim must immediately call Scammer A to protect his or her funds.
   
   After communications by phone and email, Scammer A directs the victim to click on the link in the email and then logs in to the victim’s tax-deferred retirement account. Scammer A claims that he or she will be able to determine whether there has been any fraudulent attack on the victim’s account. However, the email also downloads malware to the victim's computer. With this malware, Scammer A can identify the account username and password. Scammer A may also persuade the victim to take the same action with his or her bank or other financial account. Subsequently, the victim discovers that both the retirement account and bank account funds have been transferred overseas.
   
   Because the financial institution was not involved in the loss, there is no reasonable prospect of recovery. In addition to losing the funds, Taxpayer will report the distribution from a tax-deferred retirrement account as taxable income.
4. Romance Scam — Scammer A sends an email or text message to the victim. Through a series of text or email messages and the attachment of attractive pictures, Scammer A creates a virtual romantic relationship. Scammer A shares a very moving story that a close relative needs urgent medical assistance, but Scammer A does not have the funds for this expensive medical care. The victim is persuaded to transfer funds from both a traditional IRA and a bank account to Scammer A to cover the emergency medical care. Scammer A transfers the money overseas and is no longer in contact with the victim. There is little or no prospect of recovery.
   
   The IRS notes, "Notwithstanding the fraudulent inducement, [the taxpayer] did not have a profit motive when authorizing the distributions and transfers." As a result, these were personal casualty losses under Section 165(c)(3) and are not deductible. The victim is also subject to income tax on distributions from his or her traditional IRA.
5. Kidnapping Scam — Scammer A contacts the victim by text and phone and claims to be a kidnapper of Taxpayer’s grandchild. Scammer A has previously called the grandchild and recorded his or her voice. Using artificial intelligence (AI), the fraudster clones the voice of the grandchild. The spoofed voice then makes an emotional plea to the grandparent and explains that he or she will suffer great bodily injury or death if there is not an immediate payment.
   
   The grandparent, under extreme duress, transfers funds to the overseas account of Scammer A. At the urgent request of the supposed grandchild, the grandparent did not contact the police prior to sending the payment. After the payment has been made, the grandparent learns from family members there was never a kidnapping. However, the funds are overseas and there is no prospect of recovery. Because the grandparent did not have a profit motive, this is not a qualified loss and is nondeductible.

Losses could also be deductible if there is a Ponzi scheme. However, Ponzi scheme losses are only deductible if there is a fraudulent arrangement in which the lead actor is using funds of one party to transfer to funds of another party. In addition, the lead figure must be charged with a state or federal crime. Because most fraud schemes involve individuals from overseas who are not charged with federal crimes, the Ponzi scheme loss exception generally does not apply.

Editor's Note: The AI voice cloning is a major concern. If a scammer clones the voice of the victim, this gives him or her an extremely effective opportunity to prey upon the sympathy of a grandparent and obtain an immediate cash payment. This voice cloning risk will be even more serious in the future.

Contest Over 75% Fraud Penalty

Following a divided summary judgment ruling in North Donald LA Property, LLC v. Commissioner, the IRS and taxpayers are filing briefs in this syndicated partnership easement case. The taxpayer is requesting a ruling that a Section 6663 penalty of 75% on underpayment attributable to fraud does not apply. The taxpayer also is requesting a Seventh Amendment right to a jury trial.

The IRS claims the taxpayer is misinterpreting SEC v. Jarkesy, 144 S. Ct. 2117 (2024). Jarkesythat stated the IRS could not assert a fraud penalty at the partner level.

The IRS claims that it only consented to a taxpayer contest of the notice of final partnership administrative adjustment and not to a jury trial before the Tax Court. The IRS states the taxpayer request for a jury trial is a misreading of the Jarkesy case. If the public rights doctrine applies to a particular matter, there is no right to a jury trial under the Seventh Amendment before the Tax Court.

North Donald claims the IRS failed to prove fraud under Section 7454(a) and therefore cannot impose multiple penalties. The IRS proposes penalties under Section 6663(a) for intent to evade tax, Section 6662 for accuracy-related underpayment and Section 6662A for reportable transactions. In addition, the taxpayer claims the IRS cannot prove fraudulent intent because there has been extensive reporting.

Editor's Note: The IRS denied a $115 million conservation easement deduction for the syndicated partnership. The partnership stated that property acquired for $2,975 per acre in March 2016 had appreciated substantially by December 2017. The Tax Court will eventually have to determine the appropriate valuation for this conservation easement. If the valuation is reduced, the taxpayers are attempting to avoid the 75% fraud penalty.

Applicable Federal Rate of 5.0% for April: Rev. Rul. 2025-8; 2025-15 IRB 1 (17 March 2025)

The IRS has announced the Applicable Federal Rate (AFR) for March of 2025. The AFR under Sec. 7520 for the month of March is 5.4%. The rates for March of 5.4% or February of 5.4% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2025, pooled income funds in existence less than three tax years must use a 4.0% deemed rate of return. Charitable gift receipts should state, “No goods or services were provided in exchange for this gift and the nonprofit has exclusive legal control over the gift property.”