Lesson From The Tax Court: The Multiple Paths For Loss Deductions

Section 165 permits certain groups of taxpayers to deduct certain losses of capital under certain circumstances.  I emphasize to my students that §165 is, at bottom, a capital recovery provision.  There is no deduction for lost opportunities, lost profits, or lost pets.  It's only for losses of capital “sustained during the taxable year and not compensated for by insurance or otherwise.” §165(a).

Ronnie S. Baum and Teresa K. Baum v. Commissioner, T.C. Memo. 2021-46 (Apr. 27, 2021) (Judge Kerrigan) teaches a nice basic lesson on the multiple ways taxpayers can deduct the loss of money under §165.  There the taxpayers claimed to have lost money in a stock purchase deal gone bad.  They tried to claim a theft loss deduction of $300,000 for tax year 2015.  The Tax Court said no.  The lesson I see is not so much about the rules for theft losses.  Rather, the reasons why these taxpayers lost gives a nice lesson in the various options taxpayers have in deducting losses.  It's a woulda-coulda-shoulda lesson.  In fact, I think the Baums may still be able to get the deduction, for a different reason in a different year.  I may be wrong!  I invite your thoughts below the fold.

Law: The Basic Structure of Loss Deductions
As with all deductions, taxpayers must search through the Tax Code for authority to deduct losses.  Section 165 gives us a starting point for that journey.  It authorizes a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.”  Section 165(c) then limits that general rule for individual taxpayers by permitting deductions only for:

(1) losses incurred in a trade or business;
(2) losses incurred in any transaction entered into for profit, though not connected with a trade or business; and
(3) except as provided in subsection (h), losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from...theft.

Despite the broad language of §165, it is not the path for deducting all types of losses. There are also some important side-paths for certain subsets of losses, side paths often dictated by the need to create characterization rules to prevent taxpayers from sheltering ordinary income.

First, a taxpayer who has invested in corporate securities such as stocks or bonds or debentures, can take a loss deduction if those securities became worthless during the year.  But the taxpayer must treat the loss as if arising from the sale or exchange of a capital asset. §165(g).  Thus, as explained in Treas. Reg. 1.165-1(c)(3), the amount of the loss deduction will be governed by the rules in §1211 and 1212 and associated regulations.  So for those kind of losses you leave §165-land and enter §1211-land.  That includes situations where the decline in the value of the stock or bond is attributable to fraudulent or bad acts of the corporation or its officers or directors. See Rev. Rul. 77-17 (losses on open-market transactions not theft losses even when fall in market value resulted from fraud committed by insiders).

Second, a taxpayer who has lost money because of an unrepaid debt must use the rules over in §166.  While business bad debts are deducted against ordinary income, non-business bad debts must be treated as short-term capital losses.  We learned a lesson on those rules in Lesson From The Tax Court: The Pain of Disappointment, TaxProf Blog (Feb. 4, 2019) (a/k/a the Nick Saban case).

Common to all loss deductions, however, is the taxpayer’s burden to show both entitlement to the amount and timing of the loss.  A word on each.

    1. Entitlement
This may be obvious, but it is still important.  An individual taxpayer has the burden to show that the loss falls within the scope of §165(c).  For example, a taxpayer claiming a §165(c)(1) deduction must properly connect the loss to their trade or business.  To claim the §165(c)(2) deduction, the taxpayer must identify the transaction which, instead of producing the intended profit, produced a loss.  And to claim a loss under §165(c)(3) a taxpayer must show a sufficient connection to an identified casualty or theft.  For a lesson about that causality requirement for casualty losses, see Lesson From The Tax Court: The Proper Role Of Market Value In Casualty Loss Deductions, TaxProf Blog (Aug. 26, 2019).

Entitlement to a theft loss deduction can present particular problems.  At first blush, it may seem that a theft loss deduction is authorized only by §165(c)(3).  If true, that would be bad news for tax years through 2026 because until then §165(h)(5) disallows all (c)(3) loss deductions unless they are "attributable to a Federally declared disaster."  So if (c)(3) is the only authority for theft loss deductions, it would likely nuke all theft loss deductions.  While it is not hard to imagine theft losses occurring during a disaster (like a hurricane), it is difficult to imagine a theft loss being attributable to a disaster.  One cannot prove Mother Nature’s intent to steal!  I look forward to seeing a case on this.

Fortunately, the IRS has sensibly ruled that the magic word “theft” solely in (c)(3) does not make all theft losses deductible solely under (c)(3).  After all, (c)(3) pretty plainly says that it is the path for taxpayers whose losses are not incurred in a trade or business or transaction entered into for profit.  Thus, the IRS has said that theft losses connected to a taxpayer’s trade or business or a transaction entered into for profit are deductible under §165(c)(1) or (c)(2) as appropriate.  Rev. Rul. 2009-09.  Of course, for that to work, taxpayers need to properly connect the theft to their trade or business (or transaction entered into for profit), in addition to proving the theft.

    2. Timing
Taxpayers must prove they are deducting the claimed loss in the proper year.  That can be difficult.

Some rules help taxpayers with the difficulties.  For losses arising from theft, for example, taxpayers can take the loss in the year they discover the theft, regardless of the year in which the theft actually occurred. Treas. Reg. 1.165-8(a)(2).  For losses arising from bad debts, taxpayers take the deduction in the year in which the debt become uncollectible.  While that is a highly facts-and-circumstances test, see e.g. Estate of Mann v. United States, 731 F.2d 267 (5th Cir. 1984), at least taxpayers do not have to obtain a court judgment against the deadbeat.

One rule, however, is a huge problem for taxpayers: the reasonable prospect of recovery rule.  Section §165(a) restricts the amount of loss to that which is not compensated by insurance or otherwise.  The Treasury Regulations interprets that language to mean so long as the taxpayer has a “reasonable prospect of recovery” of the loss, the taxpayer may not take the loss deduction.  Treas. Reg. 1.165-1(d)(2)(i).  Whether the taxpayer actually has a reasonable prospect “is a question of fact to be determined upon an examination of all facts and circumstances.” Id.

This reasonable prospect of recovery rule means a taxpayer must wait to claim a loss deduction until a year where they can basically prove a negative: they no longer have a reasonable shot at getting back that which they have lost.

The IRS has crafted a important safe harbor timing rule, but only for some types of theft losses.  Rev. Rul. 2009-9 and Rev. Proc. 2009-20 (issued the same day) give taxpayers who get swindled by Ponzi Schemes a safe harbor for the timing of their loss deductions.  You might call it the Bernie Madoff safe harbor.  The Rev. Rul. deals with entitlement and the Rev. Proc. deals with timing, saying that the IRS will not challenge a taxpayer’s choice of what year to take the deduction, if the taxpayer takes the deduction “in the discovery year described in section 4.04 of this revenue procedure.”  That section, in turn, gives the following bright line timing rule: “A qualified investor’s discovery year is the taxable year of the investor in which the indictment, information, or complaint described in section 4.02 of this revenue procedure is filed.” Rev. Proc. 2009-20, §4.04.

The Rev. Proc.’s bright-line timing rule thus eliminates that messy “reasonable prospect of recovery” issue that causes so much headache.  But if a taxpayer fails to qualify for the safe harbor, or else elects out of it, the taxpayer must follow the usual “no reasonable prospect of recovery” rule.  That was the lesson we learned in Lesson From The Tax Court: To Get Administrative Grace You Must Follow Administrative Rules, TaxProf Blog (Nov. 2, 2020).

In today’s case, the taxpayers stumbled on both the entitlement and timing steps.

Facts
In 2012, Mr. and Ms. Baum bought shares of Globe Protect, Inc., a closely held company that was in the business of purifying, disinfecting, and desalinating water.  They were convinced to do so by Mr. Scott Zeilinger who assured them company was about to be sold for $50 million and they would reap a 300% return on their investment.  Oh, and he wanted them to buy the shares from his mum!  Are your alarm bells going off?  Why on earth would Ms. Zeilinger want to cash out if those representations were true?  It seems Mr. Baum heard the same bells.  He was no fool.  He testified in Court that he did due diligence on his own.  Rather than just relying on the sweet-talking Mr. Zeilinger, Mr. Baum reviewed the patents held by Globe, went to a demonstrations of the technology that gave value to the company, read the letters of intent from the alleged buyers of Globe, and even talked to them.  Only then did he kiss goodbye to $300,000 that he will apparently never see again.

By 2015, Globe had not been sold and Mr. Zeilinger had filed bankruptcy under Chapter 7.  That’s the chapter where a debtor gives most of his assets to the bankruptcy Trustee who then distributes them in an orderly fashion to creditors who have filed claims.  Other folks who had invested in Globe filed bankruptcy claims against Mr. Zeilinger, and so did the Baums, on June 24, 2015.

In 2018, Globe had still not been sold and Mr. Zeilinger’s bankruptcy case was still going on.  The Baums apparently figured they would never see that $300,000 again so they decided to take a theft loss deduction.  At that point they had not filed either their 2015 or 2016 returns.  So in Spring 2018 they filed both returns.  For reasons that do not appear in the record they decided to claim the theft loss on their 2015 return.

The bankruptcy case dragged on.  In early 2019 the Trustee reported $53,000 available for distribution to all creditors.  In August 2019 the Trustee filed a Final Account Distribution Report Certification.  The opinion is silent on whether any of that $53,000 went to the Baums.

In 2019, the IRS disallowed the tax year 2015 theft loss deduction.  The Baums timely filed their Tax Court petition.  The Court agreed that they could not take this deduction on their 2015 return.

Lesson:  Denial of Theft Loss Deduction Does Not Preclude Other 165 Loss Deductions
It is not clear why the taxpayers believed they had a theft loss deduction.  Apparently they were pissed at Mr. Zeilinger and believed he lured them into what turned out to be a bad investment.  But that’s not theft unless they showed he told falsehoods simply to induce them to give him the money.  That is hard to prove under the best of circumstances because the intent part almost always requires circumstantial evidence, as Judge Kerrigan points out.  She then notes that “the only evidence of fraud that petitions offered was petitioner husband’s testimony at trial.”  That will rarely suffice and it did not work here.  What made this theory even more implausible was the fact that Mr. Baum engaged in due diligence by contacting the prospective buyers who confirmed Mr. Zeilinger’s representations.  Mr. Baum would now need to prove they were in on the fraud as well.  While it is easy to convince friends and fellow travelers of your conspiracy theories on Facebook or Twitter, it’s much more difficult in court where you must actually give—ya know—proof.

But theft is not the only path to entitlement for a §165 loss deduction.  After all, the Baums had purchased shares of stock.  That meant they could point to a transaction they had entered into for profit.  They would be entitled to a deduction for any loss incurred in connection with that transaction, and not need to prove theft.  Further, they had purchased a security.  If the stock became worthless, they could be entitled to a deduction under §165(g).  Those are alternative paths to loss deductions.

Eventually, the Baums’ attorney figured that out and filed a post-trial brief asking for the Tax Court to approve either a §165(c)(2) loss deduction or a §165(g) loss deduction.  Judge Kerrigan rejected the belated arguments as untimely, then added some dicta on why the arguments would fail anyway, for lack of proof.

But notice that nothing in the rejection of these theories precludes the Baums from using them to support a $300,000 deduction, either in 2015, if that was indeed the proper year, or in some later year if 2015 was too soon.

That takes us to the timing problem where our taxpayers got buzzsawed by the “reasonable prospect of recovery” rule.  Judge Kerrigan pointed out, repeatedly, that “[p]etitioners have not proved that there was no reasonable prospect of recovery of their investments in 2015.”  After all, the bankruptcy case was still ongoing and “[p]etitioners could not have known in 2015 whether Mr. Zeilinger had sifficient assets to allow them to recover their investments in Globe.”

The timing requirement would also prevent deductions under either §165(c)(2) or §165(g) in 2015.  Although Judge Kerrigan rejected those arguments as untimely presented to the Court, she also took the time to lay out, in dicta, what the taxpayers needed to do to prove entitlement to those deductions.  The main point was that the same reasonable prospect of recovery rule that precluded a theft loss deduction in 2015 would also prevent a §165(c)(2) deduction in 2015.

As for the §165(g) deduction for worthless stock, one must show that the stock is---ya know—worthless.  The simple loss of market value of a stock is not entitled to deduction under §165(c)(2).  Rev. Rul. 77-17, supra.  But just because the taxpayers failed to show entitlement for loss deductions in 2015 does not mean they cannot show it became worthless in a later year.  Treas. Reg. 1.165-1(b) says that a loss fixed by identifiable events.  Generally, a sale is the best event to point to.  But the Tax Court has long allowed taxpayers to prove worthlessness by other means, as long as they prove that there is neither any current liquidating value nor any future potential future value in the stock.  Both factors of value must be wiped out before the amount of loss can be “fixed” within the meaning of the regulation.  MCM Investment Management, LLC v. Commissioner, T.C. Memo. 2019-158.

Here, the stock here was that of Globe, Inc.  The company still has this LinkedIn profile, suggesting it may still be extant, although the website url is no longer operational (but is for sale if you want to buy it).  The best evidence of worth would be an actual sale of the shares.  The best evidence of a zero liquidating value would be to show attempted sales but no buyers.  But the Baums would then also need to show zero future potential value.  That might be done, for example, by showing the dissolution of the corporate entity or its loss of patents and other assets.

Bottom line: while the taxpayers here offered no proof to support either a §165(c)(2) deduction nor a §165(g) deduction, they might well be able to take either of those in another year, a year that is still open, such as 2019.

That’s the lesson I see here: the multiple paths to deducting the loss of capital.  I welcome any thoughts or corrections. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech School of Law.  He invites readers to return to TaxProf Blog each Monday for another Lesson From The Tax Court.