If an individual taxpayer buys a security in a company through a stockbroker who is not a conduit for the company issuing the security and the company commits fraud, a theft loss is generally not allowed. However, if an individual taxpayer buys a security directly from a company that commits fraud, he or she may be allowed a theft loss. Similarly, if an LLC buys a security directly from a company that commits fraud rather than through an intermediary, it may be allowed a theft loss that, if the LLC elected to be taxed as a partnership, would flow through as a theft loss to the partners.
But how would an estate be taxed if its gross estate holdings included an interest in an LLC that held investments that became worthless because of fraud?According to the Tax Court, in a case of first impression, the estate was entitled to a theft loss deduction (Estate of Heller, 147 T.C. No. 11 (2016)).
In this case, the taxpayer, the estate of James Heller, held a 99% interest in a family LLC, the only asset of which was an account with Bernard L. Madoff Investment Securities LLC. Between the time of the decedent's death and the discovery that Madoff was running a Ponzi scheme, the estate received distributions of more than two-thirds of the alleged account assets, but the remaining account assets became worthless when the Ponzi scheme was discovered. The estate then claimed a theft loss deduction for the balance that remained in the account immediately prior to the discovery of the fraud. The IRS took the position that the LLC itself incurred the loss, not the estate. The court, in a summary judgment, sided with the estate.
The difference in taxpayer treatment stems from the IRS's and court's interpretations of different sections of the Internal Revenue Code.
Theft Losses for Individuals
The courts have traditionally relied on state law to define theft (see, e.g., Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956)) in cases where the propriety of a theft loss deduction is at issue. In most states, to prove a theft occurred, it must be shown that the perpetrator of the theft had a specific intent to deprive the victim of the property, and for this intent to exist there must be direct privity between the perpetrator and the victim (see Chief Counsel Advice 201213022). In cases of securities fraud, in which an investor makes an investment through a stockbroker who was not a party to the fraud, there is no direct privity between the investor who gave money to a stockbroker, and the person who committed the fraud. The chain of privity was broken by purchasing the security though a broker. Thus, the investor generally is not a theft victim under state law and, thus, is not entitled to a theft loss deduction. Consequently, the resulting loss is a capital loss rather than a theft loss. While a taxpayer can deduct theft losses in full, possibly creating a net operating loss that can be carried back two years and forward 20 years, capital loss deductions for individuals are limited to $3,000 in excess of capital gains for each year and can only be carried forward.
Theft Losses for Estates
Sec. 2054 governs theft losses for estates:
For purposes of the tax imposed by section 2001, the value of the taxable estate shall be determined by deducting from the value of the gross estate losses incurred during the settlement of estates arising from fires, storms, shipwrecks, or other casualties, or from theft, when such losses are not compensated for by insurance or otherwise.
The IRS in Estate of Heller conceded that the fraud occurred but argued that, under New York state law, the LLC was the victim of the theft, not the estate. However, rather than relying on the state law definition of theft, the Tax Court analyzed the language of Sec. 2054 to determine whether a deductible theft loss had occurred. The court reasoned that because Sec. 2054 uses the term "arising from," it "allows for a broader nexus . . . between the theft and the incurred loss" than the IRS's interpretation. Since the losses in this case were direct and proximate to the fraud, the loss suffered by the estate related directly to its interest in the LLC. Finding that the nexus between the estate and the LLC was "direct and indisputable," the court held that while the LLC incurred a loss, so did the estate. The court did not apply the same logic that the purchase by the LLC broke the chain of privity between the estate and the loss. Thus, the losses arose from the theft and were deductible. The amount of a theft loss is the reduction of the value of the estate property.
Common Sense v. Consistency
The holding in the Heller case may seem like common sense, but, as noted above, it is not consistent with the position taken by most other courts on the similar issue of whether an individual can deduct a theft loss based on financial fraud under Sec. 165. Most courts addressing the issue under Sec. 165 have followed Edwards and its progeny, which heldthat whether a theft has occurred is determined under the law of the jurisdiction where the theft occurred. Since direct privity between the person who committed the theft and the victim of the theft usually is required by state law, brokered transactions are not usually allowable as the basis of a theft loss.
The application of this state law standard has been questioned by scholars (and the courts on occasion), since the basis of this often-repeated assertion that a theft must be a theft under state law does not come from the Code but instead from a nondispositive statement in the Edwards case.
It should be noted that Sec. 165, which covers a theft loss for individuals, does have similar language to Sec. 2054. Sec. 165(c) states:
In the case of an individual, the deduction . . . shall be limited to . . . losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. [emphasis added]
The Tax Court, in adopting an interpretation based on the language of Sec. 2054, rather than the state law definition of theft in the state in which the theft occurred, generally allows a broader nexus between the theft and an estate than the nexus allowed between an individual and a theft. For an individual, the diminishment of the assets' value because of the theft is not, in itself, enough to meet the nexus standard; instead, direct privity between the perpetrator of the theft and the victim is required (see, e.g., Taghadoss, T.C. Summ. 2008-44).
Changes in Code Interpretation
Some changes in the interpretation of individual theft losses in fraud cases may be on the horizon, though. In Goeller,109 Fed. Cl. 534 (2013), the Court of Federal Claims, which previously had not addressed this issue, questioned whether the traditional logic of requiring that a theft meet the definition under the state law in which the theft occurred was a "shibboleth." In this case, California-based taxpayers invested in an Ohio company, and whether a theft occurred depended on whether the controlling law was that of Ohio or California. The court however, reasoned that in this case it should define "theft" according to the plain meaning of the word.
In determining whether a theft loss deduction is allowed in cases of financial fraud, courts have generally applied a definition of theft based on state law, which generally requires direct privity between the perpetrator of the theft and the victim. As a result, victims that do not have direct privity with the perpetrator must treat their losses as capital losses, not theft losses. For estates, however, based on the holding in the Heller case, the fraud loss need only to have arisen from theft to qualify for a theft deduction.
Valrie Chambers is an associate professor of accounting at Stetson University in Deland, Fla. Brian Elzweig is an instructor of business law at the University of West Florida in Pensacola, Fla. For more information about this column, contact firstname.lastname@example.org.