Ponzi Scheme Theft Losses And Clawbacks

Trusts, Estates And The Rights Of Individual Beneficiaries

The general rules limit the deduction of net operating losses available to estates and trusts to the taxpayer sustaining the loss. Net operating losses of an ongoing estate or trust are not typically deductible by its beneficiaries.

However, there is an exception in the general rule for estates and trust that are terminated. The exception applies to a terminating estate or trust that has a net operating loss carryover from prior taxable years of the estate or trust, if the carryover would be deductible in subsequent taxable years after the termination. The exception for net operating loss carryovers of terminating estates and trusts also applies to capital loss carryovers under Section 1212.

An estate or trust that incurs a net operating loss during its administration may carry the loss back and forward under the rules of Section 172. Similarly, an estate or trust may carry capital losses forward as provided in Sections 1211(b) and 1212(b). In the year of its termination, however, an estate or trust may have loss carryovers from prior tax years that are no longer of value to the estate or trust even though the losses could still be carried forward.

Under Section 642(h)(1), the remaining unused carryovers can be allowed to the beneficiaries succeeding to the property of the estate or trust.

These losses that can be carried over have the same character in the hands of the beneficiary as in the hands of the estate or trust. The carryover is a deduction for the beneficiary in the taxable year of the beneficiary in which, or with which, the estate or trust terminates. Furthermore, for purposes of determining the length of a beneficiary’s carryover period, the terminating year of the estate or trust and the beneficiary’s first carryover year are each treated as separate tax years.

The beneficiaries succeeding to the property of the estate or trust are the beneficiaries who can benefit from the losses for which a carryover is allowed if there is a termination of that estate or trust.

In the case of an estate or a trust, the beneficiaries succeeding to the property of the estate or trust are:

  • The residuary beneficiaries;
  • A pecuniary legatee only to the extent that the complete sum cannot be paid in full;
  • A beneficiary of a fraction of the net estate, or net trust property, after the payment of debts, expenses and other claims;
  • A non-residuary legatee or devisee to the extent of any deficiency in the legacy or devise resulting from the insufficiency of the estate to satisfy it in full; and
  • A surviving spouse electing under state law to receive a fractional share to the extent that the loss or deductions are taken into account in determining the share.

Carryovers are allocated among the beneficiaries succeeding to the property of the estate or trust according to the share of each beneficiary in the burden of the loss. If a specific legatee qualifies as a beneficiary succeeding to the property of the estate as to part of a gift but not as to the other part, only the amount that causes the beneficiary to qualify as a beneficiary succeeding to the property of the estate is taken into account when making an allocation.

The best guidance on the beneficiaries’ ability to use these losses is found in the Treasury Regulations.

Treas. Reg. 1.642(h)-1

Unused loss carryover on termination of an estate or trust.

Unused loss carryovers on termination of an estate or trust.

(a) If, on the final termination of an estate or trust, a net operating loss carryover undersection 172 or a capital loss carryover under section 1212 would be allowable to the estate or trust in a taxable year subsequent to the taxable year of termination but for the termination, the carryover or carryovers are allowed under section 642(h)(1) to the beneficiaries succeeding to the property of the estate.

(b) The net operating loss carryover and the capital loss carryover are the same in the hands of a beneficiary as in the estate or trust, except that the capital loss carryover in the hands of a beneficiary which is a corporation is a short term loss irrespective of whether it would have been a long term or short term capital loss in the hands of the estate or trust.  The net operating loss carryover and the capital loss carryover are taken into account in computing taxable income, adjusted gross income, and the tax imposed by section 46 (relating to the minimum tax for tax preferences). The first taxable year of the beneficiary to which the loss shall be carried over is the taxable year of the beneficiary in which or with which the estate or trust terminates. However, for purposes of determining the number of years to which a net operation gloss, or a capital loss under paragraph (a) of Section 1.1212-1 may be carried over by a beneficiary, the last taxable year of the estate or trust (whether or not a short taxable year) and the first taxable year of the beneficiary to which a loss is carried over each constitute a taxable year, and, in the case of a beneficiary of an estate or trust that is a corporation, capital losses carried over by the estate or trust to any taxable year of the estate or trust beginning after December 31, 1963, shall be treated as if they were incurred in the last taxable year of the estate or trust (whether or not a short taxable year).

Section 1.642(h)-3 Meaning of “beneficiaries succeeding to the property of the estate or trust”

(a) The phrase beneficiaries succeeding to the property of the estate or trust means those beneficiaries upon termination of the estate or trust who bear the burden of any loss for which a carryover is allowed, or if any excess of deductions over gross income for which a deduction is allowed, under section 642(h).

(b) In the case of a testate estate, the phrase normally means the residuary beneficiaries (including a residuary trust) and not specific legatees or devisees, pecuniary legatees, or other nonresiduary beneficiaries. However, the phrase does not include the recipient of a specific sum of money even though it is payable out of the residue, except to the extent that it is not payable in full. On the other hand, the phrase includes a beneficiary (including a trust) who is not strictly a residuary beneficiary but whose devise or bequest is determined by the value of the decedent’s estate as reduced by the loss or deductions in question.

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