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Jeremy Wells

When Good S Elections Go Bad and How to End Them Properly

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When businesses elect S corporation status, they often focus on the self-employment tax savings. But what happens when that election no longer makes sense—or worse, when it accidentally terminates? In episode 14 of Tax in Action, tax expert Jeremy Wells, EA, CPA, explores the complex process of ending S corporation elections, based on his firm’s recent experience with businesses struggling in the post-pandemic economy.

“A lot of small businesses that started up during the COVID-19 pandemic have seen business taper off quite a bit in the last year or two,” Wells explains. “Businesses that a few years ago actually made sense to be S corporations, nowadays not so much. And the owners want to stay in business, they want to keep operating, but it can be pretty burdensome to run an S corporation when profit margins aren’t what they were.”

Three Ways Your S Election Can End

Under IRC Section 1362, an S election remains in effect until termination, which can occur in three ways. Wells breaks down each path and the triggers that set them off.

1. Revocation by Choice

The most straightforward way to end an S election is to revoke it voluntarily. “An S corporation can revoke the S election for any taxable year,” Wells notes, “including the first year.”

The process requires shareholders owning at least half of the corporation’s shares (including non-voting shares) to consent in writing. Each consenting shareholder must provide their name, address, tax ID, number of shares owned, the date they acquired the stock, the date their tax year ends, and the corporation’s name and tax ID.

Timing matters. As Wells explains, “The corporation files that revocation statement by the 15th day of the third month of the taxable year. In general, if you’re working with a calendar year S corporation, that’s March 15th.” File after that date, and the revocation takes effect the following tax year.

This creates planning opportunities. “We’ll usually plan to go ahead and close out that calendar year as an S corporation,” Wells says when dealing with mid-year decisions. “But we’ll go ahead and get the paperwork ready and send in that revocation statement and make it effective as of the beginning of the following year.”

Corporations can also file prospective revocations for future dates and even rescind them if circumstances change. However, there’s a catch: if new shareholders join after the revocation is filed, they must also consent to any rescission.

2. Failing to Qualify

The second termination path occurs automatically when a corporation ceases to meet S corporation requirements. Wells emphasizes that “those qualifications have to be met continuously. It’s not just meeting those qualifications, electing S, and then not worrying about it anymore.”

Common disqualifying events include:

  • Exceeding 100 shareholders
  • Adding a nonresident alien shareholder
  • Having a shareholder that isn’t an individual (with limited exceptions for estates, trusts, and tax-exempt organizations)
  • Creating multiple classes of stock

The stock class issue causes particular confusion. “Voting versus non-voting stock does not create a second class,” Wells clarifies. “You can have voting and non-voting stock in an S corporation.” The problem arises when shares have different rights to distributions or liquidation proceeds.

“In an S corporation, every share of the corporation stock has to confer identical rights to distributions and liquidation proceeds to every other share of stock,” Wells explains. “So if I own 10% of the stock, I get 10% of the distribution. If somebody else owns 20% of the stock, they get 20% of the distributions.”

This is especially important for LLCs electing S status. “If you’re working with an LLC that’s considering electing S, it’s incredibly important to get a copy of the operating agreement, review it, and make sure there are no preferential rights, no waterfall distribution schedules,” Wells warns.

3. Excessive Passive Investment Income

The third termination trigger only affects S corporations with C corporation history. If a corporation has C corporation earnings and profits and generates passive investment income exceeding 25% of gross receipts for three consecutive years, the election terminates.

“Congress intended to make S Corporation provisions available only for businesses that are engaged in active operations of businesses, not those that are mainly involved in passive investment activities,” Wells explains.

The rules here get complex. Passive income includes dividends, interest, rents, royalties, and annuities not earned in the ordinary course of business. However, Wells notes important exceptions. For example, rent from a business actively managing properties doesn’t count as passive if the corporation “performs significant services or incurs substantial costs in the rental business.”

Since many modern S corporations started as LLCs and never operated as C corporations, this rule often doesn’t apply. Wells shares a close call from his practice: “The individual thought he needed to put his individual stock holdings into an LLC and then, for some reason, thought he needed to elect S for that LLC.” The only thing that saved this client was that the LLC had no C corporation earnings and profits.

The Hidden Withdrawal Option

Perhaps the most valuable tool Wells reveals is the withdrawal provision, found in Internal Revenue Manual 3.13.2.27.10.

“If the IRS accepts the withdrawal request, then the entity is treated as if the classification had never been elected,” Wells explains. This option is available only before filing the first S corporation tax return—March 15th for calendar-year corporations.

The withdrawal can be requested through correspondence or by filing Form 8832. Wells has used this for clients who received bad online advice. “We’ve done this before with small businesses that hadn’t even really gotten started yet. The taxpayer got some bad advice online and thought an S corporation starting off was the way to go.”

The advantage is that, unlike revocation, withdrawal doesn’t trigger the five-year waiting period before re-electing S status. “That corporation could elect S, withdraw its election, and then the next year decide to elect S again. And there’s no problem with that,” Wells notes.

When State and Federal Rules Diverge

State administrative dissolutions can come as a surprise to business owners. Many panic when they forget to renew their state LLC registration, but Wells offers reassurance based on multiple IRS Private Letter Rulings.

“The IRS still considers the S corporation in existence. So a state law administrative dissolution of an LLC does not translate into a termination of the S election,” he explains. “As long as the business continues operating and continues fulfilling its tax filing requirements, the IRS doesn’t appear to really care about what happens at the state level.”

There’s no need for a new S election when the entity gets reinstated at the state level. “Just keep operating as if everything is fine, at least at the federal level, and try to get that corporation or LLC reinstated at the state level,” Wells advises.

Critical Documentation and Next Steps

Wells emphasizes the importance of maintaining proper records. Keep the original Form 2553 and the IRS acceptance letter, as you’ll need to know which service center processed the election if you later want to revoke it.

Processing delays have become a challenge. “I’ve seen it take anywhere from six to 18 months for that S election to get processed,” Wells notes, partly because Form 2553 still requires wet-ink signatures and must be paper filed.

This episode is part one of a two-part series. Wells promises to cover the implications of termination, including the five-year rule and handling split years when termination occurs mid-year, in the next episode.

For tax professionals dealing with struggling businesses or succession planning complications, understanding these termination options preserves flexibility for clients whose circumstances change. As Wells demonstrates through his firm’s experience, what made perfect sense during the pandemic boom might need reconsideration today.

Ready to dive deeper into S corporation terminations and their implications? Listen to the full episode of Tax in Action for Wells’ complete analysis and practical guidance for navigating these complex scenarios.

The IRS Can Hit Your Clients With Criminal Charges for Bad Bookkeeping (And Most Tax Pros Don’t Know It)

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If you’ve ever received a shoebox full of receipts from a client or struggled with QuickBooks files where half the expenses are labeled “miscellaneous,” you know the frustration. But according to Jeremy Wells, EA, CPA, in this episode of Tax in Action, poor recordkeeping isn’t just a workflow problem. It’s a legal violation that could cost your clients thousands in penalties.

Most tax professionals treat recordkeeping like a suggestion. But it’s actually a federal requirement with serious consequences, including a 20% penalty on underpaid taxes and even potential criminal charges. Understanding these requirements can transform your practice and create new revenue opportunities.

Your clients are breaking the law (and they don’t know it)

Wells starts with a section of the tax code that most practitioners overlook. IRC Section 6001 doesn’t suggest or recommend. It requires taxpayers to “keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time provide.”

The Treasury regulations spell it out even more clearly. Taxpayers must keep “permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return.”

“The way I read this,” Wells explains, “you as a taxpayer, in order to file a tax return, need to have permanent books and records you can rely on in order to justify and substantiate any amount of gross income, deductions, credits, or anything else that you’re putting into that return.”

Here’s what catches many people off guard: tax returns themselves don’t prove anything. In Wienke v. Commissioner (T.C. Memo 2020-143), the Tax Court established that returns are “merely statements of claims and are not considered evidence of the claims themselves.” The real evidence must come from the taxpayer’s books and records. So when your client thinks their signed tax return proves their income to a lender, they’re wrong. Without proper records backing it up, that return is just a piece of paper with numbers on it.

The penalties for inadequate recordkeeping can devastate a small business. Section 6662 imposes a 20% accuracy-related penalty on any underpayment due to negligence, which specifically includes “any failure by the taxpayer to keep adequate books and records, or to substantiate items properly.” That’s 20% on top of the taxes owed, plus interest.

But it gets worse. Section 7203 makes willful failure to keep records a criminal offense. The penalties are up to $25,000 for individuals or $100,000 for corporations, plus up to a year in prison. While Wells notes that your typical shoebox client probably won’t face jail time, the existence of criminal penalties shows how seriously the IRS takes recordkeeping requirements.

The three warning signs every practitioner must recognize

These requirements create ethical obligations for practitioners too. Circular 230, Section 10.34(d) allows you to rely on client information, but requires “reasonable inquiries if the information as furnished appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete.”

Wells calls these the “three I’s” that should trigger immediate concern. He shares a common example: “When I ask them what their business mileage is, they’ll just tell me a flat number that has three or four zeros at the end of it. As soon as I see that information, I already know, just in my gut looking at that information, whether it appears to be incorrect, inconsistent, or incomplete.”

When you spot these red flags, you can’t just ignore them. Wells describes the uncomfortable conversation that follows when he asks for a mileage log. “Nine times out of ten, they’re going to tell me they didn’t actually keep up with one.” At that point, you face a tough choice. Do you push harder for documentation, accept questionable information, or potentially end the client relationship?

“It might be a tough decision to stop working with a taxpayer because they want to claim a certain amount of miles,” Wells acknowledges. But when clients repeatedly ignore recordkeeping requirements despite annual reminders, “at that point, we might have to reconsider the relationship.”

How good records flip the script on IRS audits

While penalties provide the stick, there’s also a powerful carrot for maintaining proper records. Wells reveals how good recordkeeping can completely change the dynamics of an IRS dispute.

Normally, the IRS holds all the cards. The Supreme Court established in Welch v. Helvering (1933) that “the commissioner’s determinations have a presumption of correctness while the taxpayer bears the burden of proving the IRS position wrong.” Wells calls this “a tough hill to climb, especially for a taxpayer that has not kept good books and records.”

But IRC Section 7491 flips this burden. When taxpayers introduce credible evidence, comply with substantiation requirements, and maintain proper records, the burden shifts to the IRS to prove the taxpayer wrong.

“If a taxpayer shows up to an examination or an audit with good books and records,” Wells explains, “then the auditor knows that under Section 7491, now it’s on the IRS to prove the taxpayer is wrong.”

This creates “a more positive settlement climate,” according to a 2003 Tax Notes article Wells cites. Auditors become more willing to negotiate reasonable settlements rather than risk losing in court. He notes that even when a taxpayer takes a “technically incorrect position,” having good records to explain their reasoning can lead to much better outcomes.

Why the Cohan Rule won’t save your clients

Many practitioners rely on the Cohan Rule as a safety net, but Wells warns it’s been dangerously misunderstood. This 1930 court decision allows taxpayers to deduct “a reasonable estimate of the amount of a verifiable trade or business expense if the exact figure is unavailable.”

“I’ve heard, between bad tax advice on social media and some practitioners who haven’t really read the court case,” Wells says, people claiming “if the client doesn’t know how much, we’ll just fill in a number and appeal to the Cohan rule.” But that’s not how it works.

Courts take a harsh view of taxpayers trying to use Cohan without basis. In Barrios v. Commissioner (2023), the court stated it “bears heavily against the taxpayer who failed to more precisely substantiate the expense.” Translation: courts will slash your estimates, sometimes to zero.

Wells cites Williams v. US (1957), where the court refused to “guess” at expenses, calling relief without evidence “unguided largesse.” The message is clear: you need some reasonable basis for any estimate, not just a number that feels right.

Making matters worse, Section 274 completely blocks the Cohan Rule for certain expenses:

  • Travel
  • Entertainment
  • Business gifts
  • Listed property (especially vehicles)

For these categories, taxpayers must keep contemporaneous logs showing time, place, amount, and business purpose. Wells emphasizes how strict this is: “There have been tax court and federal court cases where the mileage log was simply thrown out and no deductions were allowed because the taxpayer attempted to recreate that log after the fact.”

Turn recordkeeping problems into profitable services

Instead of fighting poor recordkeeping every tax season, Wells outlines specific services that transform this challenge into recurring revenue.

His foundation is a “bookkeeping review service.” You’re not doing actual bookkeeping. Instead, you review the client’s records quarterly and flag issues. “We’re probably not going to look through a lot of five, ten, twenty dollar office expenses,” Wells explains. “But we might look through some expenses that are four or five, six figures.”

During these reviews, you might spot expenses that should be capitalized instead of deducted, deposits miscategorized as revenue when they’re actually loans, or aging receivables signaling cash flow problems. The key is efficiency. “They don’t take nearly as much time as actual bookkeeping does,” Wells points out.

He also strongly advocates for direct communication with clients’ bookkeepers, eliminating the game of telephone that wastes everyone’s time. Set up quarterly check-ins to discuss categorization questions, journal entries, and ownership changes before they become tax-time emergencies.

“This should not be free,” Wells stresses. “This should not be just included. You should not just start doing this out of the goodness of your heart.” Whether bundled into tax prep fees or structured as a monthly subscription, these services must generate revenue.

Some practitioners take this even further with preferred partner networks. Wells knows firm owners who refuse to prepare returns unless the books come from their vetted bookkeepers. While it sounds extreme, the benefits are clear. “They’re never going to have to worry about whether a deposit was really revenue or contribution of equity or new line of credit, because they trust the bookkeeper to have taken care of that already.”

For maximum scalability, Wells suggests creating educational resources. Use screen recording tools to solve common problems once, then share those videos with multiple clients. “Each time a client asks you a question, you know others have that same question,” he notes. This transforms repetitive education from a time drain into a reusable asset.

Listen to transform your practice

Recordkeeping isn’t optional; it’s legally required, with penalties ranging from 20% of underpaid taxes to potential criminal charges. But understanding this framework doesn’t just protect you and your clients from disasters. It opens doors to shift audit dynamics in your favor, negotiate better settlements, and create profitable advisory services.

Will you keep wrestling with shoeboxes every tax season, hoping estimates will pass muster? Or build systematic solutions that generate recurring revenue while protecting everyone involved?

Listen to the full episode to learn exactly how to implement these strategies in your practice. Because when you understand the legal framework—the requirements, the penalties, and most importantly, the opportunities—you stop just surviving busy season and start building a practice that thrives year-round.

When Insurance Payouts Trigger Unexpected Tax Bills (and How to Avoid Them)

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Jessica watched helplessly as Hurricane Idalia turned her North Florida print shop into rubble. After a decade of building her business, the commercial building she owned was beyond repair. Her insurance company cut a check for $250,000—good news after such devastation. But when she decided to lease a new space rather than buy, she discovered an unwelcome surprise in her tax return: a $50,000 gain she could have avoided.

Her story opens the latest “Tax in Action” episode, the third in host Jeremy Wells, EA, CPA’s series examining what happens when bad things happen. After covering casualty losses and theft losses in previous episodes, Wells now turns to the aftermath: what happens when you need to replace destroyed or stolen property.

While these moments represent some of the most stressful times in anyone’s life, IRC Section 1033 provides opportunities to defer or eliminate taxes on insurance payouts and other compensation. But as Jessica learned, you need to understand the rules to benefit from them.

More Than Just Natural Disasters

Most tax professionals think of hurricanes, fires, and floods when involuntary conversions come up. But as Wells explains, involuntary conversions can include government actions and even credible threats.

The fundamental test centers on control, not catastrophe. “A conversion of property is compulsory or involuntary if the taxpayer’s property, through some outside force or agency beyond her control, is no longer useful or available to her for her purposes,” Wells explains.

While casualties and thefts automatically qualify, including government requisitions, condemnations, and seizures opens up planning opportunities many practitioners miss. When a government agency takes property for public use, such as highway construction or urban redevelopment, the owner faces a true involuntary conversion. The compensation offered might not match market value, but the lack of choice triggers Section 1033 treatment.

The Willis v. Commissioner case from 1964 provides an important limitation. A transport company’s ship ran aground along the Atlantic coast. After getting repair bids, the company decided to sell the vessel and buy a replacement. They tried to claim involuntary conversion treatment. The Tax Court sided with the IRS, which argued that since the ship could have been repaired, the company’s choice to sell instead disqualified it. The property remained useful; it just needed repairs that the owner chose not to make.

This draws a clear line: property damaged beyond reasonable repair qualifies; property that’s merely expensive to fix doesn’t.

Even more surprisingly, just the threat of condemnation can qualify. Revenue Ruling 81-180 offers a perfect example. A taxpayer read a news account quoting a city official who said the city would condemn his property if it couldn’t negotiate a sale. The taxpayer sold to a third party rather than to the government. The IRS ruled this qualified as an involuntary conversion because he acted under a real threat of condemnation.

But the threat must be specific and credible. Revenue Ruling 74-8 clarifies that vague rumors won’t work. Taxpayers must point to a specific government agency and credibly claim they believe condemnation is imminent. This requires concrete evidence like official statements or confirmed news reports.

In an unexpected twist, Revenue Ruling 81-181 says that even if you knowingly buy property already under threat of condemnation, the later forced sale to the government still qualifies as involuntary. The IRS determined that Section 1033 doesn’t require you to acquire property free from condemnation threats.

Understanding these broader definitions transforms Section 1033 from a disaster-response tool into a planning strategy for navigating government actions and credible threats, which are situations far more common than natural disasters.

Choosing Between Nonrecognition and Deferral

The choice between nonrecognition and deferral can dramatically impact your client’s recovery. As Wells explains, the nature of the replacement property dictates which path is available.

Mandatory nonrecognition under Section 1033(a)(1) represents the gold standard. When property converts directly into replacement property that’s “similar or related in service or use,” the tax code mandates complete nonrecognition of any gain. No election required, no gain recognized. The basis simply carries over.

But determining what qualifies as “similar or related” has sparked decades of litigation. The IRS uses a functional use test, examining how taxpayers actually use both properties. If your warehouse is destroyed and you replace it with another warehouse, the use clearly aligns. But what if the replacement serves a different function?

The appellate courts created what Wells calls the “investor exception” in the 1960s, and it’s a crucial opportunity for rental property owners. In cases like Loco Realty v. Commissioner and Lent v. Commissioner, taxpayers owned commercial properties leased to tenants. After involuntary conversions, they bought replacement properties serving different functions. Warehouses became apartment buildings, and commercial spaces became retail shops.

The IRS and Tax Court said these weren’t similar uses. But the appellate courts disagreed. “From the taxpayer’s perspective, it’s still rental property,” Wells explains. Whether tenants operate warehouses or flower shops doesn’t matter when the taxpayer’s function—holding property for rental income—stays the same.

When taxpayers receive cash, which is the more common scenario with insurance payouts, mandatory nonrecognition disappears. Instead, Section 1033(a)(2) offers an election to defer gain, but only with specific requirements and strict timeframes.

Wells offers an example to show how this works. Seth owns rental property with a $100,000 basis. A storm destroys it, triggering $300,000 in insurance proceeds—a $200,000 realized gain. Seth uses $250,000 to buy a replacement rental property within the allowed period, keeping $50,000 cash.

Seth must recognize $50,000 in gain, as that’s the amount he didn’t reinvest. He can elect to defer the remaining $150,000, but his basis in the new property equals only $100,000, or the $250,000 purchase price reduced by the $150,000 deferred gain. When Seth eventually sells, that deferred gain resurfaces. “He hasn’t gotten out of recognizing the gain,” Wells clarifies. “He’s just deferred that gain into the sale of the replacement property.”

Principal residences add complexity through the interaction with Section 121. When a primary home faces involuntary conversion, taxpayers first apply Section 121’s exclusion: up to $250,000 single or $500,000 married filing jointly. Only gains exceeding these amounts are eligible for Section 1033 deferral.

The code also allows taxpayers to acquire controlling stock (at least 80%) in a corporation that owns similar-use property rather than buying property directly. While Wells admits uncertainty about when this would apply, the option exists.

A key limitation is that taxpayers generally must recognize gain if they acquire replacement property from related persons, such as family members or controlled entities. However, if the related party bought the property from an unrelated person during the taxpayer’s replacement period, or if the total gain is less than $100,000, the prohibition doesn’t apply.

Understanding the Critical Timing Rules

Even the best tax strategy fails without proper timing. As Wells explains, the replacement period creates a ticking clock that starts when disaster strikes. Missing these deadlines turns potential tax deferral into immediate gain recognition.

The standard replacement period begins on the date of the casualty or theft, or when the taxpayer first learns of a credible threat of condemnation. From that starting point, taxpayers have until the end of the current tax year, plus two additional years, to buy replacement property.

But Congress recognized that some situations need more time:

  • Three years for business real property taken by condemnation
  • Four years for principal residences destroyed in federally declared disasters
  • Five years for specific disasters (Midwestern floods of 2008, Hurricane Katrina, September 11 attacks)

The IRS may grant a one-year extension, but only for reasonable cause, like unfinished construction. “The taxpayer can make the request before the end of the replacement period and provide a reasonable cause explanation,” Wells notes. But market conditions, such as claims that property is too expensive or scarce, won’t qualify.

Jessica’s case shows the real cost of missing these opportunities. She received $250,000 and had two years from the end of the year to purchase replacement property. Instead, she immediately decided to lease. That decision cost her $50,000 in recognized gain. Had she bought a $250,000 commercial property within the period, she could have deferred the entire gain.

State tax rules add another layer. Wells highlights Oregon’s requirement that taxpayers who buy replacement property outside Oregon must add back the deferred gain when they sell. Oregon may even require annual reporting on out-of-state replacement property.

For tax professionals, mastering these timing requirements transforms crisis response into strategic planning. When clients call after receiving insurance checks, the first question should be about starting the replacement period clock.

Turning Crisis into Opportunity

Jessica’s $50,000 tax surprise could have been avoided entirely, and that fact underscores the power and complexity of involuntary conversion rules. 

The distinction between nonrecognition and deferral reshapes how tax professionals approach these situations. When replacement property is truly similar, mandatory nonrecognition eliminates any current tax impact. But when insurance companies write checks, the deferral election becomes critical. Keep even one dollar of proceeds, and you need to recognize a gain on that dollar.

For tax professionals, mastering these rules means providing exceptional value when clients need it most. The difference between Jessica’s $50,000 recognized gain and complete deferral is capital that could have accelerated her business recovery.

Wells concludes his three-part series with a powerful reminder: “When disaster strikes, the last thing anybody wants to worry about is the tax implications. But with a little knowledge, you can make sure that you or your clients get the best possible tax treatment.”

Listen to Jeremy Wells’ complete “Tax in Action” episode above for his classroom-tested approach to these complex provisions. The episode reveals how to apply the rules strategically when clients face their most challenging moments.

Your Crypto Loss Might Not Be Deductible (Even Though Your Neighbor’s Is)

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When someone loses $100,000 to a cryptocurrency scammer, the financial blow is devastating. But finding out whether that loss is tax-deductible means navigating rules written decades before anyone imagined digital theft.

In this episode of Tax in Action, host Jeremy Wells, EA, CPA, tackles a confusing area of tax practice: theft losses. While theft has existed forever, the digital age creates entirely new ways for criminals to steal—from “pig butchering” scams to romance frauds—that challenge how we apply old tax laws to new crimes.

The Three Categories That Determine Everything

Before helping clients who’ve been scammed, tax professionals need to understand which of three categories their loss falls into. This distinction can mean the difference between a valuable deduction and no tax relief at all.

Under IRC Section 165, losses fall into three buckets. Losses from a trade or business and losses from transactions entered into for profit—even outside a business—are generally deductible. However, personal losses not connected to business or profit-seeking are the problem area.

The Tax Cuts and Jobs Act eliminated personal casualty and theft losses for 2018 through 2025. The only exception is losses from federally declared disasters. As Wells explains, this even includes theft during disasters, like the looting that happened after Hurricane Katrina when “there was just a general lack of any sort of law enforcement.”

This means two neighbors could lose the same amount to the same scammer, but only the one who was investing for profit gets a deduction. The retiree who sent money for personal reasons? They’re out of luck.

The Three-Part Test Every Practitioner Must Know

Beyond figuring out the category of the loss, Wells explains that courts have developed three essential criteria for any theft loss claim.

First, the theft must have occurred under state law where the loss happened. This requirement isn’t in the tax code or regulations; it comes from court cases trying to define “theft” when the IRS never did. The 1956 Edwards v. Bromberg case said federal courts must look to state law, but as Wells notes, that creates “probably about 50 different definitions, one for each state.”

Second, you must be able to determine the amount lost. For cash or stocks, this is straightforward. But for jewelry or collectibles? You’ll need insurance records, appraisals, or reasonable estimates. Proving value becomes nearly impossible without documentation from before the theft..

Third, you need to know when the taxpayer discovered the loss. This is crucial because it’s not when the theft happened, but when the victim realized it. Wells emphasizes: “That could be the same day, maybe a few hours later. It could be a few days later. It could be weeks, months, or even years later.”

The courts are clear about one thing: simple disappearance isn’t theft. Wells shares the Allen v. Commissioner case, where someone lost jewelry in a museum. Despite searching everywhere, publishing newspaper ads, and filing police reports, the court denied the deduction. Why? The taxpayer couldn’t prove someone actually stole it rather than it just being lost.

Timing Is Everything (And It’s Complicated)

The timing of theft losses works differently than most people expect, especially with digital assets and cryptocurrency.

A theft loss is deductible in the year you discover it; not when it actually happened. But Wells stresses a major catch: if you have a “reasonable prospect of recovery” through insurance or lawsuits, you can’t claim the loss yet. You must wait until you know with “reasonable certainty” whether you’ll be reimbursed.

“It’s not that you go ahead and claim it, and then wait until you receive the reimbursement,” Wells clarifies. “You have to wait until the outcome of that process is actually either known or within a reasonable certainty.”

With cryptocurrency scams, you might have three different dates spread over years: when the theft occurred, when you discovered it, and when you know recovery is impossible. Each delay pushes your potential deduction further into the future.

When Corporate Fraud Doesn’t Count as Theft

Surprisingly, even massive corporate fraud doesn’t create theft losses for shareholders. Wells uses Enron as an example. Investors lost everything due to “fraudulent and illegal activity,” but for tax purposes, these remain capital losses, not theft losses.

The 1975 Payne v. Commissioner case established this rule. Corporate executives don’t have “specific intent to deprive that particular shareholder” of their money. Even when executives commit crimes that destroy your portfolio, you haven’t been “robbed” in the tax law sense.

This distinction matters enormously for crypto investors. When an exchange halts withdrawals or a platform gets “hacked,” you need to determine whether it’s actual theft (potentially deductible if for profit) or platform failure (capital loss at best).

Five Modern Scams and the Profit Motive Test

In 2025, the IRS Chief Counsel addressed five common scams that don’t fit the traditional Ponzi scheme mold. The key factor? Whether victims had a profit motive.

Deductible scams (entered into for profit) include:

  • Pig butchering scams work by “fattening up” victims. Scammers start with small investments that show big returns. Victims invest more and more until the scammer disappears with everything. Because victims expected investment returns, the loss is deductible.
  • Compromised account scams involve criminals convincing victims their accounts need securing. Since victims move investment funds expecting to preserve them, the profit motive remains intact.
  • Phishing scams use fake websites to steal login credentials for investment accounts. Again, the investment nature preserves deductibility.

Non-deductible scams (personal losses) include:

  • Romance scams create fake relationships before asking for funds, often for medical emergencies. There’s no profit expectation; just personal generosity. As Wells emphasizes, “There’s no expectation of profit here. So that makes the theft loss nondeductible.”
  • Kidnapping scams involve fake ransom or bail demands. These are fear-motivated, not profit-motivated, making them personal and nondeductible.

The cruel irony? Two victims could withdraw the same amount from identical IRAs and send it to the same overseas account. But only the one expecting investment returns gets a deduction. The one motivated by love or fear gets nothing—plus they owe tax on the IRA withdrawal.

Lessons from the Experts Who Got It Wrong

Wells ends with a humbling case: Booth v. Commissioner. The taxpayer bought Civil War-era land rights that turned out to be invalid, then got sued after selling them to someone else.

Eighteen Tax Court judges split 10-8 on whether this was theft loss or capital loss. The Ninth Circuit reversed them, saying it was both. When Wells polled tax professionals, only 13% got it right.

“There are a lot of smart tax people out there and they can disagree and they can even be wrong,” Wells reflects. “The important part is that we keep thinking about these issues.”

What This Means for Your Practice

For tax professionals dealing with theft losses, three things matter most:

  1. Document profit motive upfront—not after the loss. The client’s intention when entering the transaction determines deductibility.
  1. Track timing carefully. Discovery dates and recovery efforts affect when (or if) clients can claim losses. This might mean waiting years.
  1. Know the current guidance. The IRS issues new interpretations as scams evolve. What wasn’t deductible yesterday might be tomorrow.

The collision between 1950s legal precedents and 2020s digital crimes creates daily challenges. While the basic rules haven’t changed in 70 years, applying them to cryptocurrency scams and online fraud requires both historical knowledge and modern insight.

For clients devastated by digital-age theft, understanding these rules helps you identify opportunities where they exist and provide clarity where they don’t.

Ready to master these distinctions? Listen to Jeremy Wells’ complete analysis in this episode of Tax in Action, where he breaks down additional examples, Form 4684 reporting details, and why even seasoned professionals struggle with these issues.

The Hidden Tax Trap That Turns Disaster Relief Into Taxable Income

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When Hurricane Ida slammed into Jessica’s print shop in northern Florida, it destroyed equipment worth tens of thousands and left her building damaged. But when she claimed a casualty loss deduction, she discovered that receiving $250,000 in insurance actually created a taxable gain instead of the tax break she expected. Her (fictional) story shows how complex disaster relief provisions have become for tax professionals and their clients.

In this episode of Tax in Action, Jeremy Wells, EA, CPA, begins a three-part series on disaster-related tax provisions. This first installment focuses on casualty losses and how the rules have changed since the Tax Cuts and Jobs Act (TCJA). As Wells notes, “the world’s changing in multiple ways, and one of those ways is that we see more and more frequent big storms, earthquakes, catastrophic events, and those can have serious financial implications.”

The TCJA limited personal casualty loss deductions to federally declared disasters starting in 2018. The documentation requirements are strict. Taxpayers must file insurance claims even when they seem unnecessary. And the calculations, based on the lesser of basis or fair market value changes, can produce unexpected results when insurance enters the picture.

Understanding What Qualifies as a Casualty Loss After 2018

The Tax Cuts and Jobs Act created a two-tier system that treats personal and business casualty losses differently. Starting with the 2018 tax year, personal casualty losses are only deductible if they result from federally declared disasters. This means a house fire, a tree falling on your car, or flood damage from a broken pipe no longer qualify unless FEMA declares your area a disaster zone.

A deductible casualty loss still requires three specific criteria. First, there must be actual damage, destruction, or loss of property. As Wells explains, “theoretical losses or potential losses don’t qualify.” Second, the damage must result from an identifiable event that can be isolated from other occurrences. Third, that event must be sudden, unexpected, and unusual in nature.

The “identifiable event” requirement plays out in interesting ways. Wells shares a Tax Court case where a taxpayer successfully claimed a casualty loss for his home in a Vietnamese village that was destroyed during the war. The court ruled in the taxpayer’s favor because the North Vietnamese invasion of that specific village was an identifiable event, distinct from the broader, years-long conflict.

But not all disasters qualify. When property values drop due to fear of potential mudslides without any actual damage, no casualty loss exists. Wells notes that “even though there’s going to be a significant economic and financial impact on the taxpayer, that doesn’t actually qualify as a deductible casualty loss because there’s been no damage, destruction or loss of property directly to the taxpayer yet.”

Between personal and business losses lies a tricky middle category: activities engaged in for profit but not rising to the level of a trade or business. These might include passive real estate investments or limited partnership interests. Courts consider whether the taxpayer’s main goal was economic profit independent of tax benefits. They also consider factors like the taxpayer’s expertise, reliance on qualified advisors, and success in similar ventures.

The insurance claim requirement often surprises taxpayers. Congress stated that choosing not to file an insurance claim doesn’t create a casualty loss. Instead, it represents “the taxpayer’s personal decision to forgo making a claim against the insurance company.” This means you must file a timely insurance claim to qualify for any casualty loss deduction, even for minor damage where you’d rather not involve your insurance company.

Calculating Losses When Insurance Changes Everything

The basic formula seems simple: take the lesser of your adjusted basis or the change in fair market value, then subtract any insurance or reimbursement received. But each part carries hidden complexities that can dramatically change the outcome.

Jessica’s case shows how insurance can create unexpected results. Her building had a $200,000 adjusted basis, but insurance paid her $250,000. That created a $50,000 gain. Her equipment, with a $50,000 basis but only $30,000 fair market value when destroyed, generated a $30,000 loss. The net result? A $20,000 taxable gain reported on Form 4797, despite her business suffering major damage.

Revenue Procedure 2018-08 provides safe harbors for establishing fair market value when formal appraisals aren’t possible. Wells explains you can use repair costs as evidence if the repairs meet four criteria:

  1. they’re necessary to restore pre-casualty condition,
  2. not excessive,
  3. only fix casualty damage, and
  4. don’t increase value beyond pre-casualty levels.

Getting two qualified repair estimates and using the lower figure offers another safe harbor. But Wells acknowledges the challenge: “It might be difficult to get two different companies or crews to come by and give you estimates” when entire regions need repairs after a disaster.

For personal casualties, the calculation gets even tougher. After determining the basic loss, you reduce it by $100 per event, then reduce the net amount by 10% of adjusted gross income. Wells shares his experience with Florida clients: “It’s entirely possible after the netting of gains and losses, then the reduction by $100, then the reduction by 10% of adjusted gross income, they don’t really see much of any tax effect. And that can be frustrating and disappointing.”

The increased standard deduction under the Tax Cuts and Jobs Act adds another hurdle. Since personal casualty losses become itemized deductions, many taxpayers see no benefit even after suffering significant losses. A couple with $100,000 AGI suffering $20,000 in casualty losses might receive no tax benefit at all after the reductions and standard deduction comparison.

Business casualties avoid these personal loss limitations but face their own issues. Form 4797 captures these transactions and might trigger depreciation recapture, converting expected capital treatment into ordinary income. Mixed-use property requires careful allocation between personal and business portions.

Documentation and Timing: Making the Right Moves

The essential documentation includes several key items. First, you need the cost or adjusted basis for every damaged property. Next, you need fair market value immediately before and after the casualty, although Wells notes “people don’t usually see, for example, a hurricane is about to strike and then go hire an appraiser.” Insurance policies and filed claims are mandatory. For personal losses, you also need the FEMA declaration number.

A valuable option allows taxpayers to claim casualty losses from federally declared disasters on the prior year’s return. For example, if disaster strikes in 2023, you have until October 15, 2024, to elect to claim that loss on your 2022 return, potentially getting a refund much sooner. Wells explains this involves filing an amended return with Form 4684, marking the special election box.

Form 4684 splits casualty losses into two sections. Section A handles personal property with its various reductions and thresholds. The FEMA declaration number goes above line one as proof of deductibility. Section B streamlines business and income-producing property calculations.

Wells emphasizes the importance of cloud storage, especially for firms in disaster-prone areas. “A lot of firms in these disaster prone areas have had to deal with storms hitting and losing their clients’ records.” He strongly recommends digitizing records and backing them up to the cloud.

The timing rules mean casualties are deductible in the year they occur, regardless of when repairs happen. But this creates challenges. How do you prove repair costs for work not yet done? Deadline postponements in disaster areas offer some relief, but you might need to file extensions to gather proper documentation.

Key Takeaways for Tax Professionals

The casualty loss rules have become more restrictive and complex since 2018. Personal losses rarely generate meaningful deductions outside federally declared disasters. Insurance payments can turn apparent losses into taxable gains. And the requirement to file insurance claims even when you don’t plan to pursue them catches many taxpayers off guard.

Preparation is essential for taxpayers and their advisors in disaster-prone areas. Maintain cloud-based records of all property basis and insurance coverage. Document property condition periodically with photos. Understand which events typically qualify for federal disaster declarations in your region. And prepare clients for the possibility that insurance proceeds might create tax liabilities.

Wells, speaking from experience in Florida, observes that hurricanes “don’t happen all the time, but they happen every now and then and they’re becoming more frequent and more powerful.” This reality makes understanding these provisions essential for tax professionals who serve clients in vulnerable regions.

Listen to the full episode to hear Wells explain all the calculations and share details that could save thousands in unexpected tax liabilities. Over the next two episodes, Wells will cover theft losses (including Ponzi schemes and cryptocurrency disasters) and involuntary conversions (which could have helped Jessica defer her unexpected gain entirely). With natural disasters increasing in frequency and severity, this series provides critical knowledge every tax professional needs before the next storm hits.