A Tax in a Pineapple Under the Sea

7/13/2015

You know what's even worse than paying tax on money you make? Try taking a loss on money that's already long gone. Make $100, pay a 40% tax, and you've still got $60 left. But lose $100, take a tax loss…and you're still out your $100! While you can deduct that loss against future income, that has all the same appeal as those "mail-in" rebates you get when you walk out of Staples with a new printer: It sounds good when you're still in the store, but by the time you get your new purchase back home, you realize that the once-prized rebate form will get no further than collecting large amounts of dust before eventually winding up in the trash.  

All that to say that it's never fun losing money in a bad investment. In fact, it can be downright devastating. But even worse is the realization that your hard-earned investments were lost as the result of some sort of fraud. And that brings us to this week's story, which starts out in the underwater city of Bikini Bottom.  

SpongeBob SquarePants is a kid's cartoon show chronicling the adventures of a sponge named Bob, who lives with his pet snail, Gary, in a pineapple on the ocean floor. (If you're the parent of a young child, you can just skip ahead to the next paragraph.) SpongeBob has become Nickelodeon's most popular series - amassing boatloads of awards, and spawning two movies over the last 16 years. In 2011, scientists working in Malaysia discovered a new species of fungus, which they proceeded to name spongiforma squarpantsii as a tribute to the famed cartoon character. In a nutshell, SpongeBob can be found everywhere.  

With a franchise that successful, every salesperson within 20,000 leagues wants a SpongeBob tie-in to promote their business. One group in particular, a company called SpongeTech, was full of such peddlers who were eager to get in on the action. However, don't let the word "tech" fool you; these guys were in the low-tech business of selling soap-filled sponges - including a SpongeBob SquarePants prototype filled with baby soap. Yet their real business was simply to scam investors. After all the hype was washed away, SpongeTech was just another penny-stock hoax.  

Robert and Penny Greenberger were two of those unlucky investors who watched their "investment" in SpongeTech circle down the drain. By the time the company filed for bankruptcy, the Greenbergers had lost $569,220. In 2010, they wrote the capital loss off on their taxes, which was fine, except for one thing: They can carry that loss forward to absorb future gains. But they can only deduct $3,000 per year against their ordinary income. At that rate, they'll still be writing it off in the 23rd century.  

But theft losses are deductible against ordinary income right now! So, in 2012, the Greenbergers amended their 2010 return to claim a theft loss, and asked the IRS to send them a refund for $177,102. The IRS rejected their request, and so both the Greenbergers and the Internal Revenue Service sailed off to meet in court. During the course of the proceedings, Judge James Gwin ruled that, to prove theft, the Greenbergers had to show two things: 1) that SpongeTech's scammers acted specifically to take their money through fraud, and 2) that the Greenbergers had transferred their property to the thieves. Unfortunately for our losing investors, they had bought their stock on "the open market, without any knowledge of who was on the other side of the transaction. " And with that, Judge Gwin sank the Greenbergers' case.  

Remember when you were a kid and your mom told you not to buy something just because there was a cartoon character on it? She was right, and she would tell you the same thing about your portfolio. The most important lesson here may be to make the right financial decision first, then find the most tax-efficient way to do it.