Taxpayer denied theft loss deduction for investment loss

The Tax Court held that a taxpayer was not entitled to a Sec. 165 casualty or theft loss deduction for his lost investment in a company of which he was president for six months and later was its managing director. The court also held that the taxpayer was not entitled to a Sec. 162 business expense deduction for legal fees and expenses from litigation related to the company’s activities.

Background

In February 2014, Michael Shaut, an experienced lawyer and businessman, began investing in Downing Investment Partners LLP, initially transferring $250,000 to it and later making additional investments. Shaut also made several loans, which were never repaid, to Downing from approximately 2014 through 2016 as the partnership experienced cash flow issues.

Shaut served as Downing’s president from March 2014 to September 2014. In February 2015, Shaut became a managing director of Downing so that he could raise funds for the company. In this role, he recruited several individuals to each invest $1 million or more.

Though Downing purported to be engaged in the development of patentable technology, it was what Shaut described as a Ponzi scheme. Shaut maintained that, along with the outside investors in the company, he was unaware of this. Investors in Downing eventually became aware of Downing’s fraudulent activities around 2016, and 17 lawsuits were ultimately filed related to them. Shaut was named as a defendant in these lawsuits, which were resolved in the two years after the investors’ 2016 discovery of the fraud.

Two of Downing’s principals were eventually investigated, prosecuted, and sentenced to prison in 2019 for their roles in the Ponzi scheme. Shaut claimed he spent approximately $600,000 on legal fees and expenses in the various lawsuits, and his investment losses in Downing cost him the rest of his money, leaving him broke.

Shaut timely filed a return for 2019, which the IRS audited. In April 2022, the IRS issued a notice of deficiency for the 2019 tax year, in which it determined a deficiency of $38,149.

After receiving the deficiency notice, Shaut realized that he had “botched” his original return filing. Therefore, he filed an amended return, which included Form 4684, Casualties and Thefts, on which he claimed a fraud or casualty loss related to Downing. His purported loss was composed of a $720,000 investment in Downing and approximately $600,000 in legal fees and expenses. On the Form 4684, Shaut stated that he was the victim of investment fraud, with no recovery made. However, the IRS did not process or accept the amended return.

Shaut filed a petition with the Tax Court challenging the IRS’s determination in the deficiency notice. He argued that he was entitled to a casualty or theft loss deduction for his investment in Downing and his legal fees and expenses related to the Downing litigation or, in the alternative, he was entitled to a business expense deduction for the legal fees and expenses.

The Tax Court’s decision

The Tax Court held that Shaut had failed to substantiate that he was entitled to a theft loss deduction in 2019, finding that he had not proved he discovered the alleged theft in that year or that he was a victim of theft. The court also held that Shaut was not entitled to a Sec. 162 business expense deduction for the legal fees and expenses he incurred in litigation related to Downing.

Sec. 165 theft loss deduction rules:A taxpayer may take a deduction for losses arising from a qualifying casualty or loss, including theft, not compensated for by insurance or otherwise (Secs. 165(a) and (c)). Theft includes, but is not limited to, larceny, embezzlement, or robbery (Regs. Sec. 1.165-8(d), construing Sec. 165(c)(3)).

Under Sec. 165(e), to deduct a theft loss, a taxpayer must prove the existence of a theft, the amount of the deductible loss, and the year in which the loss was discovered. The Tax Court has held that the act resulting in the alleged theft loss must have been criminal under the law of the state in which the alleged theft occurred (Paine, 63 T.C. 736, 740 (1975), aff’d without published opinion, 523 F.2d 1053 (5th Cir. 1975)).

A theft loss is treated as sustained during the tax year in which the taxpayer discovers the loss (Sec. 165(e)). Moreover, to take a theft loss deduction, there can be no reasonable prospect of recovery of the theft loss (Regs. Sec. 1.165-8(a)(2)).

Theft loss deduction: Based on Shaut’s own testimony, the Tax Court found that his investment in and purported loans to Downing all occurred before 2019, and most of his legal fees were also attributable to years before 2019. In addition, Shaut had testified that he had become aware in 2016 that one of Downing’s principals had been misleading him and other investors, was dishonest, and could not be trusted. Thus, the court determined that if a theft occurred, Shaut had not discovered it in 2019.

With regard to whether Shaut was a victim of theft, the Tax Court found that his self-serving testimony to that effect was belied by his history with Downing. The court noted that he had served as Downing’s president for six months, and, notwithstanding his testimony to the contrary, he had been intimately involved in Downing’s operations after he ceased serving as the company’s president, raising millions of dollars for the company during that time, including from investors who were ultimately victims of the Downing Ponzi scheme.

The Tax Court also found that, even if Shaut was unaware of what was happening at Downing, he had not proved that his investments in the company “were anything more than a bad business decision,” noting that, as it had previously expressed in earlier opinions, the Sec. 165 casualty and theft loss provision was not intended to cover all economic losses a taxpayer might incur.

Furthermore, the Tax Court found that there was no credible evidence that Shaut lost all the funds he invested in Downing and was never repaid for the loans he made to the company, so his claim that he lost the total amount he invested or loaned was improbable. Therefore, the court found that, as well as not proving that a theft loss occurred, he had not proved the amount of the purported loss.

Shaut had included in the casualty or theft loss he claimed on his 2019 Form 4684 the legal fees he had incurred related to the Downing litigation. The Tax Court has held that legal fees or expenses can be “further or additional or collateral theft losses” (Ander, 47 T.C. 592, 595 (1967)). Because it held that Shaut had not incurred a casualty or theft loss, however, the Tax Court also held that he could not deduct his legal fees and expenses as casualty or theft losses.

Business expense deduction: Under Tax Court precedent, a taxpayer must maintain adequate records to substantiate a claimed business expense deduction. Generally, a taxpayer’s self-serving testimony is not a sufficient substitute for records.

The Tax Court determined that Shaut failed to present reliable evidence substantiating the legal fees and expenses he claimed were associated with a business for 2019. The court found that many of the legal invoices were for years other than 2019 and thus did not substantiate a deduction for 2019. Furthermore, to the extent that the expenses were incurred in 2019, Shaut did not provide proof that they were ordinary and necessary business expenses.

The Tax Court also found that a greater problem with Shaut’s business-expense argument was that it was entirely inconsistent with the role he claimed he had played at Downing. On one hand, Shaut testifiedthat he was merely an individual who helped raise money for Downing and that he had no role in its day-to-day operations. On the other hand, he claimed that he was engaged in a business at Downing, entitling him to deduct his approximately $600,000 in legal fees and expenses as ordinary and necessary business expenses. As the court stated, “Mr. Shaut cannot have it both ways.”

Reflections

In addition to the theft loss deduction, Shaut sought to deduct a net operating loss (NOL) carryforward from 2018 and relied on his returns for 2017 and 2018 and his own testimony to substantiate the deductions. However, relying on its own precedent, the Tax Court found that absent some other credible corroborating evidence, the tax returns and Shaut’s self-serving testimony were insufficient to substantiate his entitlement to an NOL carryforward for 2019.

Also, as the Tax Court pointed out, Shaut’s returns for 2017 and 2018 were inconsistent, with the 2017 return showing a carryforward to 2018 of less than $6,000 and his 2018 return showing a carryforward from 2017 of over $109,000. Not surprisingly, the court found that these inconsistent positions on the prior-year returns undermined Shaut’s credibility and his entitlement to the NOL carryforward deduction he claimed for 2019.

Shaut, T.C. Memo. 2024-103

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.