TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Wednesday, April 30, 2008

Tax Court Denies $1.34m Loss Deduction on WorldCom Stock

The Tax Court yesterday denied a former employee of WorldCom a $1.34 million loss deduction on WorldCom stock.  Taghadoss v. Commissioner, T.C. Summ. Op. 2008-44 (4/29/08):

Petitioner was employed by the WorldCom for 17 years. During the course of petitioner's employment, he received options to purchase shares of WorldCom stock that he exercised on October 31, 2001, for a "hold". Petitioner also acquired shares of WorldCom stock on the open market, through WorldCom's section 401(k) retirement plan, and through WorldCom's employee stock purchase plan (ESPP). Unfortunately for the shareholders of WorldCom, it filed a chapter 11 bankruptcy petition on July 21, 2002. Fraudulent accounting practices by certain WorldCom officials contributed to WorldCom's bankruptcy filing. Bernard Ebbers, WorldCom's chief executive officer, was convicted of violating the securities laws for fraud, conspiracy, and filing false financial statements with the SEC. Two other WorldCom officials pleaded guilty to fraud and conspiracy.

The bankruptcy filing and the fraudulent accounting practices caused the value of WorldCom securities to significantly decline. Because the value of petitioner's securities had severely declined, he claimed a $1,344,863 deduction for a casualty or theft loss on his 2003 Form 1040.

The Tax Court denied the $1.34 million deduction on the casualty loss and theft loss grounds claimed by the taxpayer and, on its own motion, considered and rejected the possibility that the taxpayer's losses on the WorldCom stock were deductible as worthless securities:

A. Casualty Loss

In Furer v. Commissioner, T.C. Memo. 1993-165, affd. without published opinion 33 F.3d 58 (9th Cir. 1994), the taxpayers claimed a casualty loss on account of their securities' decline in value that was attributable to a stock market crash. The Court disallowed the loss stating: "In order for a loss to qualify as a casualty loss it ordinarily must be the result of physical damage to the taxpayer's property."

Similar to Furer, there is no physical damage to petitioner's securities. Rather, petitioner's losses arise from the misconduct of certain WorldCom officials, WorldCom's bankruptcy filings, and the liquidation of his securities pursuant to WorldCom's plan of reorganization. Therefore, petitioner did not sustain a casualty loss within the meaning of § 165(c)(3).

B. Theft Loss

Although certain WorldCom officials caused the publication of fraudulent financial statements and filed the statements with the SEC, the Court finds that petitioner has failed to prove that he suffered a theft under Virginia law. There is no evidence in the record establishing that WorldCom officials wrongfully took petitioner's money or property (i.e., the value of his securities) with the requisite intent to deprive him permanently thereof. Moreover, petitioner did not purchase his securities from the WorldCom officials; rather, his acquisitions were conducted through brokers on the open market, through WorldCom's section 401(k) retirement plan, and through WorldCom's ESPP. The WorldCom officials had no direct dealings with petitioner. ...

To the extent that petitioner is attempting to claim a deduction for the corporation's theft loss rather than his own theft loss, he cannot do so. It is well settled that a corporation is a taxable entity separate from its shareholders. ... Consequently, shareholders generally cannot claim a deduction for a theft loss where the corporation itself was the victim of the theft. ...  Although the Court sympathizes with petitioner's circumstances, the Court concludes that § 165(c)(3) does not support the allowance of his claimed theft loss deduction. Accordingly, respondent's determination denying a $1,344,863 theft loss deduction is sustained

Although the issue was not raised by the parties, the Tax Court also considered considered and rejected the possibility that the taxpayer's losses on the WorldCom stock were deductible as worthless securities:

In order to have deductible losses, petitioner must show that his securities had value at the end of 2002 and prove some identifiable event that establishes the subsequent losses in 2003. ...  Petitioner has failed to establish both elements.

There is no evidence as to the value of petitioner's securities in 2002. Moreover, petitioner's evidence, the account statement [which placed a value of 21 cents per share on 31,083 shares], indicates that his securities had retained some value in 2004. The record does contain countervailing facts: (1) WorldCom was insolvent in 2001 and filed for bankruptcy in 2002; (2) the plan of reorganization provided for the cancellation of petitioner's securities; (3) petitioner "abandoned" his securities in 2003; and (4) WorldCom closed their transfer books in 2004. But it was petitioner's burden to show that his securities had no value in 2003. ...  Therefore, the Court concludes that petitioner's losses are not deductible as worthless securities in 2003.[Fn.2]

Fn.2:  Even if the Court were to find that petitioner sustained a casualty or theft loss or that his securities were "wholly" worthless in 2003, the Court would nevertheless disallow the losses because petitioner failed to establish that there was no reasonable prospect of recovering his losses. See secs. 1.165-1(c)(4), (d)(2)(I), 1.165-8(a)(2), Income Tax Regs. Compare 15 U.S.C. secs. 77k, 77l(a)(2), 77o, 78j(b), 78t(a) (2000) and Rule 10b-5 (17 C.F.R. sec. 240.10b-5 (2007)) thereunder (provisions relating to securities law violations and liability therefor), with 15 U.S.C. sec. 7246 (2000) (discussing a disgorgement fund for the benefit of the victims of violations of certain securities laws).

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