When do you take the loss?
By Kevin G. Diamond, Esq.
In the previous issue of SumNews, we discussed TRC Code Section 165(c)(2)-Theft Loss, and how it can result in a huge tax benefit for your individual clients. In fact, for the defrauded investor, this section of the IRC is one of the best-kept secrets and one that may allow him to recover up to 35 percent of his money that has been taken in a "theft." If you meet certain technical requirements of this section, you may be able to write off theft
losses to eliminate income taxes in the current year, and go back three years and forward for up to twenty years.
This is vital information to help your client who has been victimized by investment fraud. Usually in financial fraud cases, there is no one left from whom your client can recover. This article will help you identify and overcome the IRS's high hurdles, which include the need to establish the legal requirement of theft, privity and scienter.
When Do You Write Off the Loss?
The timing of the Section 165 loss can at first appear black and white. One interpretation of the IRS regulation appears to limit the write-off to "the year in which the loss is sustained."
The IRC at 26 CFR 1.165-1 (d) Year of deduction at (1) says "[a] loss shall be allowed as a deduction under section 165 (a) only for the taxable year in which the loss is sustained"
This wording makes it seem that you must claim the loss in the year it is sustained. However, this is not always easily ascertainable in theft losses. Seldom is a theft loss easily determined. The discovery of a theft loss usually starts with a suspicion, a rumor, a newspaper article, then an indictment, and finally a conviction some years later. The investor is usually left in the dark while the government and attorneys sort out the mess left behind by the particular fraud.
The draconian effect of the IRS regulation appears to deny the possibility of a claim as being untimely if not filed that year. This may not necessarily be the case.
Next, the Code Section itself states at Section 165 (a) "there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise"
So what does "compensated by insurance or otherwise" mean? The insurance issue is a question of fact as to whether there is a policy or not. I-iowever, with any insurance policy, there is a question of coverage, especially if there is fraud! Fraud is often a specific exclusion from many directors and officers insurance policies and many fiduciary bonds.
What is meant by "otherwise"? One could interpret that to mean litigation against the principal and other possible defendants who could be liable as an "aider and/or abettor" of the fraud. Any litigation has a life of its own and Could go on for a substantial period of time, so the question arises, does this preclude the taxpayer from writing off his losses while the ongoing litigation continues?
So when does a tax practitioner file the loss? In the year of discovery or when the curtain closes on the possible or ongoing litigation? These two positions from the Code and Regulations appear to be at opposite ends of the spectrum. How does the tax practitioner decide?
This issue is further compounded by IRC Section 6511 which acts as a statute of limitations on these claims whereby the taxpayer must file within three years from the date that the return was required to be filed or two years from the time the tax was paid, whichever was later.
What can the CPA do to protect his client and take advantage of this deduction?
An Extraordinary Case
How do you reconcile these two positions? What is the rule for taking theft losses?
A recent U.S. Tax Court case, fueled by an extraordinary set of facts, will help shed light on how the court interpreted the timing, of the claim.
Johnson and Johnson v. The United States, US-CL-CT, 2008 -1 US'1'C 50, 142 (January 24, 2008) demonstrates how this court analyzed and ruled on the timing issue.
The Johnsons sold their Detroit-based television station for over $175 million in 1997. They then purchased $83.5 million of jewelry from well-known Palm Beach jeweler Jack Hasson.
Late in 1997, the Johnsons discovered that the gems were worth only $5.4 million. As a result, the Johnsons lost $78,160,409 in this fraudulent scheme.
In 1998, the Johnsons took a deduction of $58 million on their federal income tax return. The Johnsons had the assistance of their accountants and lawyers in estimating that there would he an approximate $20 million recovery. Subsequently, 1-Iasson was convicted of fraud in 2001.
To begin the analysis, the Johnsons met the three requirements of the IRS for Section 165-Theft Loss to apply as they had already established: (1) theft, as Hasson was indicted and later convicted under Florida state law; (2) privity or reliance - the Johnsons bought the jewels directly from I lasson so that there was privity of contract; and (3) scienter-Hasson had the necessary "intent to deceive" as he knew at the time of the sale that he was deceiving and defrauding the Johnsons who had relied on him about the value of the stones he sold them.
Armed with the three needed requirements, the Johnsons filed for their theft loss in 1998. The IRS objected to the deduction and off to court they went. It was not until January of this year that the matter was fully resolved as noted above in the case of Johnson and Johnson v. The United States, US-CL-CI', 2008 -1 USTC50, 142 (January 24, 2008).
How Do You Write Off $78 Million?
The Johnsons' Position
As previously mentioned, the plaintiffs initially sought the theft loss in 1998 with the loss carry back to 1997. The plaintiffs tried to rely on IRt; at 26 CFR 1.165-1 (d) Year of deduction at (1); "[al loss shall be allowed as a deduction under section 165 (a) only for the taxable year in which the loss is sustained."
In a revised complaint, the plaintiffs filed for the loss in 1998 and in the alternative, for the loss deduction in 1999, 2000 and/or 2001. The plaintiffs relied on the "year of discovery" rule for the timing of their deduction. "1'he plaintiffs had established their damages based upon an estimate made by their lawyers and accountant's taxation experience using the "reasonable prospect of recovery" standard.
The IRS Position
The IRS argued that the plaintiffs were not entitled to a theft loss deduction in any amount neither in 1998, nor 2001 but instead only in the year in which all of the claims for reimbursement were resolved. The government asserted that the plaintiffs were not entitled to a theft loss deduction until, at the earliest 2005, when the plaintiff's last recovery efforts were concluded. The IRS used the Treas. Reg. Section 1.16:5-1(d)(2)(1) to support its "reasonable certainty" standard whereby it states that "whether or not such reimbursement will be received may be ascertained with reasonable certainty, for example, by a settlement of the claim, or by an adjudication of the claim, or by an abandonment of the claim."
The Verdict
The court held for both the plaintiffs and the IRS in a split decision as follows.
The judge ruled against the plaintiffs for a theft loss in 1998 as he stated that the plaintiffs did nothing more than anticipate the recovery in the pending litigation against
I lasson and his associates. He further stated that the plaintiffs' reliance on the "reasonable prospect of recovery" standard was misplaced, as it only applies in the year a taxpayer discovers a theft loss. The court agreed with the IRS on the use and application of the "reasonable certainty" standard. The judge wrote "the requirement that a taxpayer 'ascertain with reasonable certainty' means that a taxpayer must obtain a verifiable determination of the amount she will receive based on a resolution of the reimbursement claim before taking a theft loss deduction" Accordingly, the plaintiffs were not entitled to a theft loss deduction in 1998 for any portion of their loss.
However, the court ruled against the IRS's position that no deduction could he taken until 2005. The government had argued that Treas. Reg. Section 1.165-(d)(2) states that "no portion of the loss with respect to which reimbursement may he received is sustained ... until it can be ascertained with reasonable certainty whether or not such reimbursement will be received ... [t j he government interprets the phrase `no portion of the loss' to mean the regulation requires that a taxpayer refrain from taking any portion of a theft loss deduction until the taxpayer determines exactly how much of the entire loss the taxpayer will recover ... (h)owever contrary to the government's position the court held that `the regulation and the examples given therefore confirm the plaintiffs contention that once a portion of the recovery was established, they were entitled to take a theft loss deduction for that "portion" that they were reasonably certain they would never recover:' Accordingly, the court held that as of 2001, the plaintiffs had established with reasonable certainty that they had no prospect of recovering $37,216,383 of the estimated $78,160,409 loss.
Therefore, two of the key positions that the IRS held were ruled against: first, that theft losses can be calculated as the loss becomes reasonably certain; and second, that those losses can be incurred over several years and not held back until the total of the loss is determined.
Conclusion
Section 165(c)(2) - Theft Loss of the Internal Revenue Code is one of the best-kept secrets of the IRS, and the accountant has a duty to apply it to ally client situation that meets the requirements. Further, the use of the Section of the Code with the application of the above recent U.S. Tax Court case provides a new found flexibility for the tax practitioner to help his client recover theft losses from the only source remaining, Uncle Sam.
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Kevin Diamond, CPA. Esq. is an attorney licensed in Massachusetts and a Fellow of the MSCPA. He has previously been a federal investigator for the FDIC and fraud Litigator for the Massachusetts Securities Commision. His practice is in Holliston, and he can be reached at kevin@kevindiamond.com.
