Editor: Mark G. Cook, CPA, CGMA
Sec. 165 broadly allows taxpayers to deduct losses "sustained during the taxable year and not compensated for by insurance or otherwise." Some examples of losses that are allowed as a deduction under Sec. 165 include wagering losses (Sec. 165(d)), theft losses (Sec. 165(e)), worthless securities (Sec. 165(g)), and disaster losses (Sec. 165(i)). With respect to individual taxpayers, any deduction claimed under Sec. 165 is limited under Sec. 165(c) to:
- Losses incurred in a trade or business;
- Losses incurred in any transaction entered into for profit; and
- Losses arising from fire, storm, shipwreck, or other casualty, or from theft.
In addition, for the third category, Sec. 165(e) states that "any loss arising from theft shall be treated as sustained during the taxable year in which the taxpayer discovers such loss."
In a recent case, Baum, T.C. Memo. 2021-46, an individual taxpayer was denied a theft loss deduction of $300,000 that was claimed on his 2015 tax return. The taxpayer was unable to prove that a theft had actually occurred or that, if one had occurred, he had sustained the loss in 2015 as required by Sec. 165(e).
Ronnie Baum and his wife, Teresa, resided in California when they filed their petition, as well as during the tax years in question. In 2010, Baum was in search of a new investment opportunity. He was invited by Scott Zeilinger to invest in a water purification business called Globe Protect Inc. In June 2012, Baum acquired 100,000 shares of Globe for $150,000. A week or so later, he acquired an additional 100,000 shares of Globe for an additional $150,000.
In 2014, Zeilinger filed for bankruptcy. Two of Zeilinger's creditors received a judgment in their favor in bankruptcy court in 2016, related to their ownership of shares in Globe. Zeilinger's bankruptcy case was finalized in 2019.
The Baums reported a theft loss deduction in the amount of $300,000 on their Schedule A, Itemized Deductions, which was attached to their 2015 federal income tax return. The couple asserted their losses were theft losses because Zeilinger had committed "fraud in inducement" by making false representations with the intent to defraud them of their investment in Globe.
Generally, in order to deduct a theft loss, a taxpayer must prove that a theft occurred under the law of the jurisdiction wherein the alleged loss occurred (Monteleone, 34 T.C. 688 (1960)). In California, fraud in the inducement falls into the category of theft by false pretenses; therefore, it was necessary for the Baums to prove that Zeilinger committed the offense of theft by false pretenses under California law.
In California, there are three elements to theft by false pretenses: (1) the defendant made a false pretense or representation to the owner of property; (2) with the intent to defraud the owner of that property; and (3) the owner transferred the property to the defendant in reliance on the representation.
According to Baum's testimony, his decision to invest in Globe was based upon more than Zeilinger's representations, and the Baums provided some records of communication with Zeilinger. Baum also testified that before investing in the company, he had reviewed patents owned by Globe and letters of intent purported to be from individuals interested in acquiring Globe or its technology and had spoken to those individuals to confirm their interest in purchasing Globe.
The Tax Court found that the records the Baums gave to the court failed to provide specific evidence that Zeilinger's representations were false or that they were made with the intent to defraud them of their investment in Globe, leaving Baum's testimony as the only evidence of fraud. The court concluded that this was not enough to prove Zeilinger committed theft by false pretenses under California law and held that the couple were not entitled to a theft loss deduction for the loss of their investment in Globe.
Year in which loss was sustained under Sec. 165(e)
The court also held that, even if a theft pursuant to California law had occurred, the petitioners would still not be entitled to deduct a theft loss because they did not meet the requirement of Sec. 165(e) that the loss was sustained in 2015. Under Sec. 165(e), a loss arising from theft is generally treated as "sustained during the taxable year in which the taxpayer discovers such loss." However, Regs. Sec. 1.165-1(d)(3), provides:
if in the year of discovery there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained, for purposes of section 165, until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.
Thus, in order to claim a theft loss deduction, there must not be a reasonable prospect of recovery on a claim for reimbursement. Regs. Sec. 1.165-1(d)(2)(i) states that "whether a reasonable prospect of recovery exists with respect to a claim for reimbursement of a loss is a question of fact to be determined upon an examination of all facts and circumstances."
The Tax Court found that the Baums had not proved that no reasonable prospect of recovery existed in 2015. The court observed that, in 2015, Zeilinger's bankruptcy proceedings were still ongoing and the case was not finalized until 2019; therefore, the Baums could not have known in 2015 whether there were enough assets in the bankruptcy estate to allow them to recover their investment in Globe. Accordingly, the Baums had not sustained the loss they claimed in 2015.
Worthless securities deduction
In their post-trial briefs, the Baums in the alternative argued that they were entitled to a deduction for worthless securities under Sec. 165(g), which states that:
If any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall, for purposes of this subtitle, be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset.
However, the court declined to consider the argument because, having been raised in the Baums' post-trial brief, it was untimely. The court further stated that if the argument had been timely raised, it would have been unsuccessful since the petitioners failed to provide any evidence that their shares in Globe became worthless in 2015.
Although not noted by the court, the Baums may have a valid argument to claim a Sec. 165(g) deduction in a different tax period when their investment in Globe is deemed to be worthless. In light of the facts and circumstances, 2019 may have been a more appropriate year to claim the Sec. 165(g) deduction since that is the year in which Zeilinger's bankruptcy case was finalized.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-623-0478 or firstname.lastname@example.org.
Contributors are members of SingerLewak LLP.