A taxpayer could not take a theft loss deduction for her ex-spouse's failure to transfer marital property to the taxpayer as ordered by a divorce decree.
Background
Lisa Bruno married Stephen Bruno in 1987. Over the years, Stephen developed a very successful career in the financial sector, earning over $2 million in 2005. In 2008, the couple divorced.
Stephen owned most of the couple's assets, and the divorce decree directed him to transfer specified property to Lisa. But Lisa also possessed some marital property, including a bank account titled in her name and some real property in Connecticut. The divorce decree directed that she was to liquidate those assets and split the proceeds with Stephen.
Stephen was unhappy with the property settlement and appealed the divorce court's decision. However, on appeal, the property settlement was upheld. According to Lisa's accounting, her half of the marital property was worth just less than $2.5 million.
Stephen, however, persistently refused to comply with the terms of the divorce decree. Despite repeatedly being held in contempt by the divorce court and being ordered to pay interest on his unpaid obligations to Lisa, he did not transfer any of the couple's marital property to Lisa as ordered under the divorce decree. Lisa did not go penniless, though, as the court in 2010 transferred title to the couple's marital residence to her with instructions to sell it, keeping the first $300,000 of the proceeds and putting the rest into escrow. Lisa sold the property for $1,902,890, but she ignored the divorce court's instructions and kept all the proceeds from the sale, earning her a contempt citation in 2015.
Later in 2015, Stephen filed a Chapter 7 bankruptcy case, in which he sought discharge for Lisa's claims against him for her share of their marital property. He maintained that he no longer owned any of his and Lisa's marital property and had a bankruptcy estate of only $2,500. He also asserted that he had claims for half the proceeds from the sales of both the marital residence and the Connecticut real estate, as well as half of Lisa's bank account balance at the end of the marriage (in total $1,078,183).
After the first creditors' meeting in the bankruptcy case in 2016, Lisa came to the conclusion that Stephen and his new wife, Christina, had fraudulently transferred funds from an investment account that was marital property of Stephen and Lisa to several New Hampshire LLCs to buy real property. Lisa promptly filed suit against Christina over the alleged fraud. (Stephen was not added because of his bankruptcy filing.)
Also in 2016, Lisa filed a proof of claim in the bankruptcy court of almost $4 million for "Domestic Support Orders/Alimony" (the $2.5 million awarded under the divorce decree, plus alimony in arrears and interest, less the amount Lisa owed Stephen under the divorce decree), which she argued was a priority claim in Stephen's bankruptcy. She also stated the claim was secured by a court-ordered injunction on $200,000 of funds in the marital investment account. The divorce court had issued this injunction when Lisa had moved to add Christina and Stephen's mother as parties to the divorce proceedings.
In 2017, the bankruptcy trustee commenced an adversary proceeding against Stephen, Christina, Stephen's mother, the New Hampshire LLCs, and certain others, alleging fraudulent and preferential transfers. Lisa intervened in the case.
The adversary proceeding was settled in 2019. Under the settlement, Lisa ended up receiving more than half the proceeds on the sale of a parcel of property that was held by one of the LLCs, in exchange for her dropping her case against Christina and Stephen's mother. The settlement also specifically stated that she did not release any of her claims against Stephen or his assets. The bankruptcy court subsequently issued a notice stating that Stephen had waived his right to a discharge of his liabilities in the bankruptcy case.
Lisa claimed a theft loss stemming from Stephen's failure to transfer marital property as ordered by the divorce court on her Form 1040-X, Amended U.S. Individual Income Tax Return, for 2015, which she filed in March 2017. The property allegedly stolen consisted of roughly $2.5 million of marital property that Stephen had not transferred to her after his unsuccessful appeal of the divorce court's decision. Lisa claimed: "[U]nder the facts and circumstances of . . . [Lisa's] case, in which Mr. Bruno has declared bankruptcy (a fixed and identifiable event) and claims to have no assets including taxpayer's property there was not a reasonable prospect of recovery at the end of 2015 and this loss is allowable in 2015." The IRS processed Lisa's 2015 Form 1040-X as a claim for a refund, which it denied.
Lisa challenged the IRS's determination regarding the theft loss for 2015 in Tax Court.
The Tax Court's decision
The Tax Court held that Lisa had not sustained a deductible theft loss in 2015 for the approximately $2.5 million of property awarded to her in the divorce that Stephen refused to transfer to her. The court found she did not have a deductible loss because she had failed to establish that she sustained a theft loss in 2015.
Sec. 165 allows individual taxpayers a deduction for losses arising from theft that are sustained during the tax year and not compensated by insurance or otherwise. To establish a theft loss, a taxpayer must prove two elements: (1) that a theft under the law of the relevant jurisdiction occurred; and (2) the amount of the loss and the year in which the loss was sustained.
Existence of a theft: Lisa claimed that Stephen's actions constituted felony embezzlement under Connecticut law. The IRS agreed that Connecticut law controlled in the case and that under it, felony embezzlement would be considered a theft, but it did not agree that Stephen's actions amounted to felony embezzlement.
The Tax Court indicated that it believed the IRS was correct on this point, noting that there was no case law or other Connecticut authority establishing that an ex-spouse has committed embezzlement when he or she is held in civil contempt for failing to pay a marital property debt. However, it declined to decide the issue because it found that even if it assumed a theft loss had occurred, the loss was not sustained in 2015.
Year the loss was sustained: A loss arising from theft is generally treated as sustained during the tax year in which the taxpayer discovers the loss. However, if there is a reasonable prospect of recovery for the loss through a claim of reimbursement, no portion of the loss for which reimbursement may be received is treated as sustained until it can be determined with reasonable certainty whether the taxpayer will receive the reimbursement. A reasonable prospect of recovery exists when the taxpayer has bona fide claims for recoupment from third parties or otherwise and there is a substantial possibility that such claims will be decided in his or her favor. This determination is based on the facts and circumstances.
Looking at the facts and circumstances in Lisa's case, the court first pointed out that at that time she already possessed the $1,078,183 of marital property she owed Stephen under the divorce decree and she conceded she had a reasonable prospect of recovery of this amount. She also had secured a claim for another $200,000 of marital property in her dispute with Stephen's mother, so the court found that she had already recovered $1,278,183 of the amount she claimed was stolen. In addition, she had already started litigation against Stephen, Christina, and Stephen's mother to recover the rest.
Because Stephen filed his bankruptcy petition in October 2015, Lisa relied on Stephen's assertion in his bankruptcy filing that he only had $2,500 in assets as proof that she could not reasonably expect at the end of 2015 to recover any more of the funds she claimed he had stolen. The court, however, concluded that a reasonable person in her position would not have believed this to be true. As the court explained, Stephen was a successful financial professional who at the time of the couple's divorce had earned in excess of $2 million a year and held assets of at least $5 million. Thus, the court found it was "objectively implausible" to assert in October 2015 he had essentially no assets.
According to the court, it was also obvious that Lisa did not believe that he had no assets because she filed a proof of claim against him in bankruptcy court, filed claims against Christina in a New Hampshire court, and joined the bankruptcy trustee in an adversary proceeding against Stephen, Christina, and Stephen's mother. While at the end of 2015 Lisa did not know where Stephen had hidden the marital assets, this did not in the Tax Court's eyes negate the fact that she had at the end of 2015 a reasonable prospect of recovery of the funds she claimed were stolen, from a variety of sources on existing claims for recoupment.
Based on these findings, the court determined that in December 2015 Lisa had bona fide claims for recoupment from Stephen, Christina, and Stephen's mother and that there was a substantial possibility that the claims would be decided in her favor. Thus, under Sec. 165, even assuming Stephen's refusal to pay her what she owed under the divorce decree was a theft loss, it was not a deductible loss for 2015.
Reflections
While a criminal conviction is not necessary to prove a theft occurred for purposes of the theft loss deduction, a criminal act is necessary. Lisa tried to conflate Stephen's civil law offense of failing to comply with the marital property settlement ordered by the divorce court (as evidenced by the court's repeated citations for contempt against him) with the criminal law offense of embezzlement. As the court noted, under Connecticut law, the unpaid marital property settlement would likely be treated as a debt owed by Stephen and not as property owned by Lisa that Stephen was withholding from her. Thus, his failure to pay the unpaid settlement amount would be a failure to pay the debt he owed to Lisa, not a criminal embezzlement of her property.
Bruno, T.C. Memo. 2020-156
