When most people receive an e-mail from a Nigerian prince who is in need of assistance with his inheritance, they either delete the e-mail without fully reading it or read it, chuckle, and then delete it. Nonetheless, many taxpayers still fall victim to con artists, internet fraud, and a panoply of other schemes. In addition to these unfortunate souls, many sophisticated individuals fall victim to more elaborate frauds or forms of deceit. The Madoff scandal, the Bayou scandal, and many other investment scandals caused profound financial damage to taxpayers one would normally view as sophisticated. What links all of these together is the fact that the taxpayer suffered a real economic loss and is left feeling that they have been robbed.
What adds insult to injury for so many of these taxpayers is that, unlike a business, they cannot simply deduct losses for the events described above. Individuals can only offset their ordinary income with losses that: (i) are incurred in a trade or business1 ; (ii) are incurred in any transaction entered into for profit2 , though not connected to a trade or business; or (iii) are casualty losses (e.g. theft and fire).3 These three options are subject to myriad restrictions and caveats. Other types of losses are available, but they are typically capital losses that do little good for most individual taxpayers, such as losses for nonbusiness bad debt4 and worthless securities.5
I. Theft Losses
In most cases, taxpayers want to take a theft loss. Theft loss deductions must satisfy two separate tests. The first is whether there was in fact a theft; and the second is whether the converted property was used in a trade or business, held for investment purposes, or simply owned for personal use.
A. What Constitutes a Theft?
Section 165 does not define what constitutes a theft for federal income tax purposes. The regulations offer a modicum of additional information, stating that “the term ‘theft’ shall be deemed to include, but shall not necessarily be limited to, larceny, embezzlement, and robbery.”6 Case law has clarified that the term “theft” is to be “broadly interpreted for the purposes of Section 165,”7 and that it covers “a broad field of illegality, including…’swindling, false pretenses, and any other form of guile.’”8
The Service takes the position that this means the theft must be illegal in the jurisdiction in which it occurred and done with criminal intent.9 Although criminal intent is a requirement to take a theft loss, a criminal conviction is not.10 In other words, giving money to a grossly incompetent investment adviser who charges astronomical fees for atrocious advice to grossly mismanage money (and perhaps even charges fees for low quality investment conferences in beautiful beach locales) would not necessarily count as theft, even if a taxpayer felt as though he or she had been “robbed,” because the investment adviser may not have had criminal intent.11
Finally, one often overlooked factor is that the theft must be direct. In other words, the taxpayer’s property must have been stolen.12 The fact that a taxpayer’s property becomes worthless because of a related theft or fraud does not in and of itself generate a theft loss for an individual. Thus, a taxpayer who invests in a corporation whose stock becomes worthless after it is discovered that the CFO is embezzling money will generally be unable to take a theft loss.
B. When Can an Individual Take a Theft Loss?
Theft losses are treated as sustained during the year the taxpayer discovers the loss, as opposed to when the loss actually occurs.13 Further, a theft loss can only be taken when there is no “reasonable prospect of recovery” and when it can be “ascertained with reasonable certainty that no recovery or reimbursement will be received with respect to the stolen property.”14 There will generally be some recovery for stolen property (from insurance or otherwise), but when the taxpayer has “ascertained with reasonable certainty” that there will be no further recovery, the taxpayer may take his or her loss.
What constitutes a reasonable prospect of recovery is a question of fact. Nonetheless, a good legal adviser must take into account that having a claim for reimbursement may spoil a theft loss claim.15 Widely experienced losses may lead to special arrangements. Due to the outcry from wealthy individuals following the widespread investment fraud that swept the country during the Great Recession, Treasury and the Service provided a truncated procedure for determining when certain investment losses could be taken.16
C. How Much of a Theft Loss Can an Individual Take?
An individual taxpayer is only allowed to deduct any specific theft loss to the extent the loss exceeds $100.17 Additionally, an individual taxpayer is only allowed to deduct theft losses sustained during a given taxable year to the extent all such losses exceed 10% of the individual’s adjusted gross income.18 Importantly, these limitations on casualty losses only apply to casualty losses that are not incurred in a trade or business or a transaction entered into for profit.19 Thus, a taxpayer whose broker turns out to be a fraud who absconded with cash and never purchased securities will be able to deduct the full amount of the loss against ordinary income, provided the other rules for theft losses are met.
II. Where Does This Leave Us?
Sadly, all of this means that elderly victims of internet scams who wired money to what they presumed was the Service will often not be able to make full use of their losses.
The situation is even worse for those who lend money. Unlike theft losses, bad debt losses are only ordinary if they are tied to a trade or business.20 Otherwise, bad debt losses are capital losses, even if the loan was entered into to make money. All too often taxpayers document their ill-advised or foolish investments as loans. When an individual makes a loan to a business, and the business is incompetently run by wasteful individuals who take investor money and pay themselves generous salaries, the taxpayer will have a herculean task of proving theft. Without being able to prove theft, they are left with an often worthless capital loss.
A careful and conscientious tax counselor should make the strongest case possible for a loss that benefits a taxpayer, especially given the disparate and perhaps even unfair treatment of individuals who have suffered the same economic loss. ■
3 IRC §§ 165(c)(3), 165(h). Certain immaterial exceptions apply, such as being able to take $3000 of capital losses against ordinary income per year.
4 IRC § 166(d). Note that business bad debt is an ordinary loss.
7 Barry v. Comm’r, 37 T.C. M. 925, 927 (1978).
8 Kreiner v. Comm’r, 60 T.C. M. 1251, 1254 (1990), citing Edwards v. Bromberg, 232F.2d 107, 110 (5th Cir. 1956).
9 Rev. Rul. 72-112, 1972-1 C.B. 60.
10 Vietzke v. Comm’r, 37 T.C. 504, 510 (1961), acq., 1962-2 C.B. 6.
11 See, e.g. Riley v. Comm’r, T.C. Memo. 2016-46 (holding that the taxpayer could not take a theft loss because she could not prove an individual whose business she had invested $1.3 million had the intent to defraud her or made false representations, even though the individual bought himself luxury products and absconded); People v. Ashley, 267 P2d 271, 282 (Cal. 1954); Paine v. Comm’r, 63 T.C. 736 (1975); MTS International v. Comm’r, 169 F.3d 1018 (1999).
15 Treas. Reg. § 1.165-1(d)(2)(i); Adkins v. US, 117 AFTR 2d 2016-779 (Ct Fed Cl 2016) (holding that although taxpayers had clearly suffered a theft loss, their failure to abandon their claim for reimbursement that had been inactive for a number of years was fatal to their claim that there was no reasonable prospect of recovery), rev’d 856 F.3d 914 (Fed. Cir. 2017) (holding that Treas. Reg. § 1.165-1(d)(2)(i) sets forth a general totality-of-the circumstances test, that the abandonment of a claim for reimbursement is one potential test for determining the year of loss, and that an outstanding claim for reimbursement is not fatal to the claim that there is no reasonable prospect of recovery).
19 Rev. Rul. 2009-9. Prior to Rev. Rul. 2009-9, there was considerable confusion as to what was the appropriate manner in which to handle theft or other casualty losses related to transactions entered into for profit and whether a taxpayer could deduct the loss under a provision other than section 165(c)(3).