When leaving a job, most people automatically transfer, or â€œroll,â€ their 401(k) accounts to an individual retirement account. Now, some companies are urging departing employees to leave their savings right where they are – and there could be some good reasons for doing so.
When an employee leaves a job, he or she is generally free to roll 401(k) money into an IRA; such accounts typically offer a much wider array of investment options. But while most employers have historically encouraged departing employees to make transfers, a growing number of companies now say they’re eager to keep former employees’ savings within their plans.
As baby boomers start to retire, â€œcompanies are realizing that participants with the biggest balances are going to be leaving the plan relatively soon,â€ says Katharine Wolf, a senior analyst at research firm Cerulli Associates. When assets decline, companies have less leverage to negotiate with plan administrators and fund companies for lower fees and unique investment options, she says.
In considering whether to keep money in a 401(k), departing employees must consider a range of factors, including fees, investment options and whether they may need protections from creditors or early access to their savings.
Participants in some 401(k) plans may discover that it’s cheaper to stay put. Often, plans with assets of $100 million or more receive access to low-cost investment products, including collective trusts, which resemble mutual funds but generally charge lower fees. (To find out what you’re paying in investment and administrative fees, ask your plan administrator or go to BrightScope.com, which rates plans.)
A 401(k) plan also may offer greater protection from creditors. While federal law shields the assets in 401(k) plans from a variety of claims, it only safeguards IRA assets in cases involving bankruptcies, says Ed Slott, an IRA consultant in Rockville Centre, N.Y.
Some states, including New York, have laws that provide greater protections for IRAs. But â€œthat’s not the case in every state,â€ cautions Mr. Slott.
After leaving a company at age 55 or older, a former employee also has leeway to take penalty-free withdrawals from that company’s 401(k) account. In contrast, those with IRAs generally must pay a 10% penalty on distributions taken before age 59[frac12], says Keri Dogan, a senior vice president at Fidelity Investments. (SMARTMONEY, MAY 11, 2011)
Did you lose money after your broker encouraged you to invest in real estate investment products to generate income or to diversify your portfolio?
It is well known that real estate values have dwindled in America over the past few years. Regardless, many banks and brokerage firms have continued to encourage their clients to invest in real estate products to diversify their portfolios or to generate income. Many brokers led investors to these risky products with attractive yield percentages and misled investors by selling these products as â€œCD alternatives,â€ â€œpreferred stocks,â€ or even â€œbonds.â€ Unfortunately, the true risks associated with these products were not disclosed, and investors have lost all or a significant amount of their investments, have not received the yield percentages that were touted, or are unable to access the money they invested.
Investors are filing claims against banks and brokerage firms for losses suffered in the following:
1). Non-Traded REITs â€“ Non-traded (or private) REITs are securities offered by your bank or brokerage firm that are not listed or traded on a public exchange. These products often offer attractive yields; however, many have reduced the advertised distribution amounts, have stopped making distributions to investors, or have forbidden investors from accessing their money. In other words, many investors in non-traded REITs are finding that they are receiving much less income than anticipated, no income at all, or that they cannot access any of their investment dollars.
2). Traded REITs â€“ Traded REITs are securities sold by your bank or brokerage firm that are listed and traded on a public exchange. These securities often offer attractive yields and trade similarly to common stocks; however, traded REITs share the downside risks of common stocks. Your broker may have told you that you were purchasing a â€œbondâ€ or â€œpreferred stockâ€ when you actually purchased a REIT. Many investors in traded REITs have suffered significant losses due to decreases in share price or have been unable to find buyers for their now worthless shares due to financial problems of the underlying real estate company.
3). Other Real Estate Projects â€“ Many investors have been approached by representatives of banks and brokerage firms to invest in or make loans to real estate projects organized by that representative or a business partner or friend of that representative. Investors are often approached despite not having a relationship with the particular bank or brokerage firm. The projects often promise attractive returns or yields much greater than what is offered by the bank or brokerage firm. The investments are not offered by the bank or brokerage firm and often involve condominium and commercial real estate developments and oil/gas exploration. Unfortunately, investors often lose all or a significant portion of their investments in these projects and find that the projects were scams or were poorly managed. The bank or brokerage firm, however, still may be liable for investor losses in these projects.
If you wish to discuss your investment in REITs or other real estate investments offered by representatives of banks or brokerage firms or have questions about securities fraud and want to know if you have a case, please contact us at (727) 461-7474 or visit our Investor FAQs page and fill out the Do I Have a Case form at www.colemanlaw.com.
For more information about Securities fraud, or estate planning, particularly if you are in Clearwater, Palm Harbor, Tarpon Springs or the Tampa Bay, Florida area, go to our website www.colemanlaw.com.
Have You Suffered Losses in Morgan Keegan Bond Funds?
Have you purchased Morgan Keegan Bond Funds, particularly the Regions Morgan Keegan High Income Fund; Regions Morgan Keegan Multi-Sector High Income Fund; Regions Morgan Keegan Select High Income Fund; Regions Morgan Keegan Strategic Income Fund; Regions Morgan Keegan Advantage Income Fund; or the Regions Morgan Keegan Select Intermediate Bond Fund?
Many investors have filed suitability and fraud claims against Morgan Keegan for substantial losses suffered as a result of the sales practices related to these funds. Much of the abysmal performance of the funds has been attributed to the risky and speculative securities purchased by the funds’ manager, and Morgan Keegan allegedly concealed and misrepresented the true risks associated with these funds. Morgan Keegan’s alleged egregious conduct includes making material omissions and misrepresentations in marketing materials and regulatory filings; withholding information from and misrepresenting information concerning the funds to the Morgan Keegan Sales force; and failing to adequately supervise its employees. In other words, Morgan Keegan kept investors and their trusted advisors in the dark regarding the true risks of these funds.
If you wish to discuss your investment in Morgan Keegan funds or have questions about securities fraud and want to know if you have a case, please contact us at (727) 461-7474 or visit our Investor FAQs page and fill out the Do I Have a Case form at www.colemanlaw.com.
For more information about Securities fraud, or estate planning, particularly if you are in Clearwater, Palm Harbor, Tarpon Springs or the Tampa Bay, Florida area, go to our website www.colemanlaw.com.
If you have purchased a variable annuity, or any annuity for that matter, it is likely that you do not fully understand how it works, what it does and does not offer you, or why you even purchased it in the first place. It is also very likely that your insurance agent, banker, broker, or financial planner does not fully understand what he or she sold you either, yet he or she likely presented the annuity idea to you with the uttermost zeal. What these financial salespeople clearly understand, is that annuity sales typically generate higher commissions than sales of other investment products. Be careful when being persuaded to purchase an annuity, and be extra careful when someone encourages you to transfer your annuity to a new annuity.
You should be particularly careful when considering transferring your money from one annuity to another. This procedure is often referred to as a 1035 or tax free exchange and is different from simply transferring money from one investment choice to another within the same annuity. Here, you actually exchange an existing variable annuity contract for a new annuity contract. There are legitimate reasons for a 1035 exchange; however, there are several potential downsides that your annuity salesperson may or may not know or remember to mention, including: 1) surrender charges for surrendering the first annuity; 2) possible subjection to a new and potentially longer surrender charge schedule for the new annuity; 3) ineligibility for a tax free transfer; 4) or higher fees for the new annuity.
In addition to the foregoing, numerous annuity beneficiaries have suffered tremendous losses at the hands of annuity salespeople who knowingly or negligently failed to address the potential detrimental effects of 1035 exchanges on the value of the initial annuity contract’s death benefit. Death benefits come in various forms, but most variable annuity contracts guarantee that the beneficiaries of the contract will receive, upon the annuitant’s death, the original amount invested in the annuity contract, adjusted for withdrawals. This provides peace of mind in that the beneficiaries will receive at least what was invested in the contract, regardless of investment performance. Some contracts offer beneficiaries a death benefit guaranteeing beneficiaries the higher of the original invested amount or the highest appreciated value of the annuity, determined at certain prescribed future dates. Regardless, fees are assessed for the death benefit feature, and the death benefit guarantee can be very important and powerful in the event of decreased investment values.
Assume, for example, you invested $500,000 with XYZ variable annuity company and, due to market declines and/or inappropriate investment choices, the variable annuity decreased to $250,000 in value. Assuming no withdrawals, the death benefit would still be $500,000. In this scenario, many competing financial salespeople likely would encourage you to consider a different annuity with different investment choices or additional bells and whistles, and a $250,000 or 50% portfolio decline may encourage you to do so. Annuity transferor beware! If you were to transfer your XYZ annuity to a PDQ annuity, your new death benefit would be based on the new investment value of $250,000 and not $500,000.
Similar scenarios have played out where death occurred while investment values continued to decline or before the investment values could hope to close the 50% loss gap. Many investors and beneficiaries have brought claims against annuity salespeople and their employing firms for intentionally failing to or not knowing to disclose the potential loss of death benefit value when conducting a 1035 exchange.
If you wish to discuss the circumstances of your annuity investment or have questions about securities fraud and want to know if you have a case, please contact us at (727) 461-7474 or visit our Investor FAQs page and fill out the Do I Have a Case form at www.colemanlaw.com.
For more information about Securities fraud, or estate planning, particularly if you are in Clearwater, Palm Harbor, Tarpon Springs or the Tampa Bay, Florida area, go to our website www.colemanlaw.com.
Have You Suffered Losses in Lehman Brothers Structured Notes Sold by UBS and Other Major Brokerage Firms?
Many investors are filing claims against UBS Financial Services and other major brokerage firms alleging that they were deceived as to the risks of investing in Lehman Brothers structured notes. Brokers pitched the notes, including notes with a principal protection feature, as conservative and safe investments with no risk and sold them to conservative investors seeking yield and preservation of investment principal. The true risks associated with these products were not disclosed by the brokers selling them, and investors were actually subject to significant amounts of risk. In fact, investors in the notes may lose all or a majority of their principal investments in the notes, as Lehman Brothers filed for bankruptcy protection on September 15, 2008.
If you wish to discuss your investment in Lehman Brothers structured notes or have questions about securities fraud and want to know if you have a case, please contact us at (727) 461-7474 or visit our Investor FAQs page and fill out the Do I Have a Case form at www.colemanlaw.com.
For more information about Securities fraud, or estate planning, particularly if you are in Clearwater, Palm Harbor, Tarpon Springs or the Tampa Bay, Florida area, go to our website www.colemanlaw.com
THE AVAILABILITY OF ORDINARY LOSS TREATMENT FOR CERTAIN INVESTMENT LOSSES UNDER THE INTERNAL REVENUE CODE
Jeffrey P. Coleman and Jennifer R. Newsom
- The Definition of Theft. 3
- Examples of Conduct Giving Rise to Theft for Purposes of IRC § 165. 4
- The Use of Judicial Estoppel to Support a Theft Characterization. 7
- The Use of the Service’s Safe Harbor for Theft Loss Treatment for Losses Resulting From Ponzi Schemes. 9
- The Totality of the Facts and Circumstances Govern Reasonable Prospect of Recovery and Reasonable Certainty Tests. 28
- Shifting the Burden of Proof on the Issue of Timing of the Theft Loss Deduction to the Service Under IRC § 7491. 34
- A Portion of a Loss Determined, With Reasonable Certainty, to be Non-Recoverable Is Deductible Notwithstanding the Existence of Pending Claims or Litigation as to the Remaining Loss. 35
- The Defrauded Taxpayer or Theft Victim is Not Required to File Litigation Against the Perpetrator as a Prerequisite to Taking a Theft Loss. 37
The classic Ponzi scheme may soon be renamed the Madoff scheme, simply by virtue of the massive amounts of monies, an estimated $50 billion, invested with Madoff. It is now known that Bernie Madoff, like his famous predecessor, Charles Ponzi, used monies given to him by new investors to pay prior investors promised returns on their earlier investments. Madoff, like Ponzi, and also allegedly like Arthur Nadel and others, robbed Peter to pay Paul. Their massive scams wrongfully deprived thousands of investors of billions of dollars.
For individual investors, the Internal Revenue Code (IRC) generally treats investment losses as capital losses, deductible only to the extent of $3000 in excess of the capital gain experienced by the taxpayer for the year in question. Even though the excess capital loss may be carried forward to later tax years, the deductibility of these losses is still subject to the same limitations.  In addition, because a capital gain is only experienced upon the sale or exchange of property (see IRC § 1221), capital gains are less likely to be recurring income. Thus, there is the potential that a significant loss suffered by a defrauded investor may never be utilized in the investor’s lifetime.
Theft losses, on the other hand, are not limited in the same manner that capital losses are limited. More importantly, a theft loss can be used by individuals as a deduction against ordinary income such as wages or interest income to the extent that the theft loss is not covered by insurance or otherwise. In addition, in Revenue Ruling 2009-9, 2009-14 I.R.B. 735, issued March 17, 2009, the Internal Revenue Service (Service) announced that theft losses resulting from investment transactions are deductible under IRC § 165(c)(2) rather than (c)(3). As such, they are not subject to the limitations of IRC §165(h), limiting certain losses to the excess of $100 and 10% of adjusted gross income. Nor, announced the Service, are theft losses resulting from investments subject to the limitations on itemized deductions found in IRC §§ 67 and 68.
Ordinary income, of course, is more likely to be recurring, substantial, and taxed at higher marginal rates. Thus, a theft loss deduction that can be deducted against ordinary income can give the victim of a fraudulent investment scheme greater, more immediate relief than can a deduction for a capital loss. But, is it proper under federal income tax law, to treat an investment loss as a theft loss? The answer for victims of Ponzi schemes is often yes. For victims of other kinds of investment loss caused by securities fraud or other wrongdoing, theft loss treatment might be available under certain circumstances.
The court in Edwards v. Bromberg, 232 F. 2d 107 (5th Cir. 1956) provided what is the most often-cited definition of theft for purposes of IRC § 165, as follows:
[T]he word ‘theft’ is not . . . a technical word of art with a narrowly defined meaning but is . . . a word of general and broad connotation, intended to cover . . . any criminal appropriation of another’s property to the use of the taker, particularly including theft by swindling, false pretenses, and any other form of guile. . . [T]he exact nature of the crime, . . . is of little importance so long as it amounts to theft.
The broad approach of the Bromberg court to the definition of theft is reflected in the Treasury Regulations promulgated under IRC § 165, deeming theft to include, but not be limited to, larceny, embezzlement, and robbery.
Whether a theft has occurred depends upon the law of the jurisdiction where the loss was sustained. Either state or federal law can provide the requisite basis for establishing a theft loss to the extent applicable to the conduct at issue in the jurisdiction where the theft occurred.
And the record before us establishes that Livingstone’s fraud in obtaining money from petitioners brings this case within the applicable Florida criminal statute in respect of obtaining money by false representations or pretense, Fla. Stat., sec. 811.021(s), as well as within the provisions of the United States Code which makes it a crime to use the mails to defraud, 18 U.S.C., sec. 1341. The crime under either Florida or Federal law was a â€˜theft’ within section 165 of the Internal Revenue Code.
Furthermore, it is unnecessary that the perpetrator of the theft be convicted or even charged with theft.
The Bromberg Court’s inclusion of any other form of guile within the ambit of theft for purposes of § 165 is certainly broad enough to include the Ponzis, the Madoffs, and the Nadels. The court’s emphasis, in particular, on swindling, false pretenses, and any other form of guile potentially includes securities fraud within its scope. The Service acknowledged this possibility in Chief Counsel Advice 200811016.
In CCA 200811016, the investors invested in Company X, a mortgage lending company. Company X was later acquired by Company Y, but Company X remained in existence and continued soliciting funds from investors. After some time, Company Y was staying afloat only through loans from Company X, and Company X was solvent only by treating its loans to Company Y as assets on its financial statements. Company X’s officers and directors misrepresented the financial condition of Company X in its financial statements and prospectuses, and the officers and directors were later criminally charged with securities fraud. In addition, at least one Company X Officer was indicted for obtaining property by false pretenses under the applicable state law.
Chief Counsel’s Office opined that these facts establish that a theft occurred, notwithstanding the structure of the transactions.
[A] loss that is the direct result of fraud or theft is deductible under § 165, even though the theft is accomplished through a purported borrowing or offer to sell a security.
Counsel’s Office relied, in part, on Revenue Ruling 71-381, as follows.
In Rev. Rul. 71-381, the taxpayer was induced to lend money to a corporation by fraudulent financial statements provided by the corporation’s president . . . As a result, the president of the corporation was convicted by a court for violating the state securities law by issuing false and misleading financial documents. . . . [S]ince the money was obtained by false representations constituting a misdemeanor under state law, the taxpayer was entitled to a theft loss deduction.
Citing the requirements reflected in Revenue Ruling 71-381 of (i) reliance on the part of the investor and (ii) specific intent to defraud or misappropriate monies, Counsel’s Office withheld a finding of theft as to any particular investor in X Company without additional facts.
In Revenue Ruling 77-18, 1977-1 C.B. 46, the Service similarly concluded that a theft loss occurred under circumstances in which a taxpayer received shares of stock in a company (X Company) in exchange for his shares of stock in another company (G Company) pursuant to a merger agreement between the two companies. Soon thereafter, X Company filed for bankruptcy. The bankruptcy trustee reported that the primary goal of the fraud participants was to inflate . . . the market price of X’s stock . . . by reporting nonexistent income and assets on the corporate books and failing to record liabilities.
The law of the state in which the taxpayer in Revenue Ruling 77-18 resided included within its definition of theft, the obtaining of property by false pretenses. Thus, the Service concluded as follows:
In the instant case, false representations about the financial condition of X were made to G’s stockholders with the intent to induce them to vote for the merger. The responsible X officials knew of the falsity of the financial statements they issued. The stockholders of G relied upon the false financial statements at the time they decided to exchange their stock for X stock which was worth substantially less than was represented. The exchange was a theft by false pretenses under the laws of . . . [the State] and therefore, meets the definition of theft for Federal Income tax purposes. 
A number of states include the obtaining of property by false pretenses within their definition of theft. Thus, circumstances that give rise (or would give rise) to a charge of theft by false pretenses are favorable to a characterization of theft under IRC § 165.
Circumstances resulting in criminal charges for the sale of unregistered securities can also give rise to a theft characterization under IRC § 165. In Vietzke v. Commissioner, 37 T.C. 504 (1961), the Tax Court upheld the taxpayer’s theft loss treatment for funds invested in what was purported to be an insurance company directly through the company principals. Contrary to the representations in the prospectus, the stock and the company were not properly registered. The company principals were criminally indicted on charges of violating Indiana Securities Law by selling unregistered securities through an unregistered agent. The Tax Court rejected the Service’s claim that the company principals lacked criminal intent, finding as follows:
To the contrary, we view it as a blundering but intentional attempt on the part of . . . [the principals] to increase their personal resources without benefit of law. We agree with . . . [the taxpayer’s] contention that he was swindled. 
Fortunately for the taxpayer in this case, the Tax Court found that the perpetrators were not fumbling fools, but felonious villains.
Interestingly, the Tax Court in Vietzke did not rely on the elements of the crime with which the principals were charged (i.e., the sale of unregistered securities) in concluding that the taxpayer had suffered a theft loss. Nor did the Tax Court rely on the statutory crime of theft under Indiana law, having found none denoted theft per se. Instead, the Tax Court pointed to the broad definition of theft established by the Bromberg Court.â€ The court was simply satisfied that, based on the facts, the principals acted with a criminal intent to deprive the taxpayer/investor of his funds.
The Service agreed that churning of, and unauthorized transactions in, the taxpayer’s brokerage account by his broker constituted theft under the applicable state law for purposes of IRC § 165 in Jeppsen v. Commissioner, 70 T.C.M. (CCH) 199 (1995). There, the taxpayer, a carpet installer, invested monies he was saving with a nationally-recognized brokerage firm. The broker (i) falsified the taxpayer’s new account documents, labeling him an experienced investor, (ii) engaged in unauthorized transactions, including purchasing stocks on margin, and (iii) churned the taxpayer’s account. Although finding the conduct constituted theft, the court nonetheless denied the theft loss deduction for the year in which the taxpayer claimed it as, in that year, the taxpayer was exploring the possibility of filing a lawsuit against the brokerage firms involved. Thus, the taxpayer’s claim of a theft loss was premature, as he retained, and was pursuing, a reasonable prospect of recovering his loss.
The test for theft characterization under IRC § 165, as previously explained, is not dependent upon a criminal indictment or conviction. Rather, the test depends upon whether the conduct evidences a criminal appropriation of another’s property by theft, false pretenses, and any other form of guile . . . without regard to the exact nature of the crime . . . . Thus, there have been cases in which the Service and courts have allowed theft loss treatment even in the absence of a criminal indictment or conviction of the perpetrators. Nonetheless, a criminal charge or conviction is helpful in supporting the specific intent required of the perpetrator.
When there is a criminal conviction of, or a guilty plea from, the perpetrator of the fraud, the defrauded investor should be able to assert that the Service is judicially estopped from contesting the characterization of the investment loss as a theft loss if the federal government has successfully prosecuted the perpetrator for the conduct at issue. Judicial estoppel prevents a party from asserting a position in a legal proceeding that is contrary to a position previously taken in the same or earlier proceeding.  The doctrine of judicial estoppel is similar to the doctrines of res judicata and collateral estoppel, which prevent parties from relitigating issues decided in prior proceedings by a court of competent jurisdiction. However, [j]udicial estoppel focuses [only] on the relationship between a party and the courts and seeks to protect the integrity of the judicial process by preventing a party from successfully asserting one position before a court and then asserting a contradictory position before the same or another court merely because it is now in that party’s favor to do so.
In Vincentini v. Commissioner, 96 T.C.M. (CCH) 400 (2008), the Tax Court applied judicial estoppel to prevent the Service from denying that a theft occurred with respect to a taxpayer’s investment in a convoluted factoring program involving U.S. and Costa Rican participants. The federal government had prosecuted successfully the principals of the factoring program on various federal charges, including money laundering, mail and wire fraud, and aiding and assisting the filing of false income tax returns. Rejecting the Service’s contention that the taxpayer was not a victim of theft, the Tax Court held as follows:
Because respondent’s position is inconsistent with the position asserted by the Government in the . . . criminal case, we conclude that the application of the doctrine of judicial estoppel is appropriate. Applying the doctrine, we hold that respondent is precluded from arguing that petitioner was not a victim of theft . . . .
In short, because the federal government’s position, in the criminal case, was that the taxpayer was one of the victims of the fraud for which the government was prosecuting the principals of the factoring program, the federal government, through the Service, was rightfully estopped from taking a contrary position in Tax Court.
- The Use of the Service’s Safe Harbor for Theft Loss Treatment for Losses Resulting From Ponzi Schemes.
On March 17, 2009, the Service issued Revenue Procedure 2009-20, creating an optional safe harbor for treatment of certain investment losses as theft losses (think Madoff). Under this Procedure, if the taxpayer elects the safe harbor, a theft loss is deemed to occur. The deemed theft loss, called a qualified loss, occurs when a taxpayer has invested in a specified fraudulent arrangement and one or more of the perpetrators has been criminally charged with one or more crimes that would meet the definition of theft for purposes of IRC § 165, provided certain other conditions are satisfied. This safe-harbor treatment is available to losses for which the discovery year, as specifically defined in the Procedure, is 2008 or later.
First, to utilize the safe harbor, the taxpayer must have invested in a
specified fraudulent arrangement.â€ A specified fraudulent arrangement is, generally speaking, a Ponzi scheme.
Second, to utilize the safe harbor, one or more of the perpetrators must have been charged, criminally, by indictment, information, or complaint (not withdrawn or dismissed) under state or federal law. The criminal charges, as previously mentioned, must constitute theftâ€ under the law of the jurisdiction in which the theft occurred, consistent with the existing case law governing this issue.
It is worth noting that there are a number of reasons criminal charges may not be filed against the perpetrator, such as death of the perpetrator, a disinclination to prosecute while SEC civil investigations are ongoing, or the small size of the fraudulent scheme in comparison to other schemes given limited prosecutorial resources. The conduct of the perpetrator may nonetheless constitute theft under the law of the applicable jurisdiction, and the victims may still qualify for theft lossâ€ treatment for their investment losses, just not under the safe harbor of Revenue Procedure 2009-20.
The third requirement of a qualified lossâ€ under the safe harbor applies only if the criminal charges are by complaint versus indictment or information. If the charges are by complaint (versus indictment or information), then one of the following three factors must also be present: (i) the complaint must allege an admission by the lead figure,â€ or, (ii)a receiver or trustee must have been appointed for the specified fraudulent arrangement or, (iii) the assets of the specified fraudulent arrangement must have been frozen. The reason for this added requirement for criminal charges by complaint versus indictment or information is the lesser standard of probable cause generally applicable to criminal charges by complaint.
In addition, the taxpayer must have clean hands.â€ If the taxpayer had actual knowledge of the fraudulent nature of the arrangement prior to its public outing,â€ the taxpayer cannot utilize the safe harbor. Nor is the safe harbor available to investors in tax shelters (as defined in IRC § 6662(d)(2)(C)(ii)) or to those who invested in the fraudulent arrangement through a fund or other entity. This latter restriction retains the Service’s historic hostility to granting theft lossâ€ treatment to defrauded investors who were not in privity with the perpetrator of the fraud.
Under IRC § 165(e), all theft losses are treated as sustained during the taxable year in which the taxpayer discovers the loss. Discovery of the theft, whether from a fraud, embezzlement, or other kind of misappropriation of the taxpayer’s property, has not, however, ended the query. Taxpayers also have had to grapple with the general limitation applicable to all losses subject to IRC § 165(a). That general limitation has required consideration of whether there exists a reasonable prospect of recoveryâ€ from insurance or otherwise.
If a reasonable prospect of recovery exists as to part of a theft loss, then a deduction as to that part of the loss is unavailable until the year in which it can be determined, with reasonable certainty, that no recovery or reimbursement will be received. These two issues – – whether a reasonable prospect of recoveryâ€ exists and whether it can be ascertained with reasonable certaintyâ€ that no recovery or reimbursement will be received â€“ have generated much litigation, because they have are based upon the facts and circumstances of each case.
For victims of Ponzi schemes who choose the safe harbor provisions of Revenue Procedure 2009-20, the uncertainty concerning the timing of the deduction is eliminated. Under the Procedure, the year of discovery of the loss of a qualified investment,â€ is also the year that the amount to be deductedâ€ can be deducted. The discovery yearâ€ is the year in which occurs the previously-described criminal indictment, information, or complaint. 
The amount deductible in the discovery year is determined by simply applying one of two fixed percentages to the qualified investment.â€ Subject to certain exclusions, qualified investmentâ€ generally means all amounts (cash or basis of property) invested in the fraudulent arrangement, plus income from the arrangement previously included in income for federal tax purposes over amounts of cash or other property withdrawn from the arrangement, whether designated principal or income.
If recovery is not pursued against potential third parties,â€ ninety-five percent (95%) of the qualified investment is considered in the year of discovery. If recovery is being, or intended to be, pursued from potential third parties,â€ then seventy-five percent (75%) of the qualified investmentâ€ is considered in the year of discovery. The product of whichever of the foregoing formulas applies is then reduced by the following: (i) any actual recovery, (ii) any actual or potential claim for reimbursement under the qualified investor’s insurance policy, (iii) any actual or potential claim for reimbursement under contractual arrangements (other than insurance), and (iv) any actual or potential insurance recovery from SIPC. The resulting amount is then available as a deduction in the year of discovery.
If a taxpayer electing safe-harbor treatment later recovers amounts in excess of the amount of qualified investment deducted under the safe harbor, that excess amount is includible in income under the tax benefit rule. Likewise, an additional deduction may be available in a later year provided that the additional deduction has been determined, with reasonable certainty, to be non-recoverable. Unfortunately, as previously mentioned and as discussed further below, the application of the determined with reasonable certaintyâ€ test is fact-intensive and troublesome. Fortunately, under the safe harbor, the taxpayer escapes this troublesome query for much of the theft loss.
A taxpayer qualifying for, and electing, the safe-harbor treatment of Revenue Procedure 2009-20 must complete a statement in the form of the statement attached as Appendix A to the Revenue Procedure. The statement is filed with the taxpayer’s federal income tax return for the discovery year, along with IRS Form 4684 (Casualties and Thefts), which is to be completed in accordance with Section 6.01 of the Revenue Procedure. Lastly, taxpayers who elect not to apply the safe harbor treatment of Revenue Procedure 2009-20 are subject to all of the requirements for establishing a theft loss under existing law.
In summary, investment fraud has dire consequences for those defrauded. It can mean the loss of a lifetime of savings, the burden of unpaid bills, and the prospect of working well beyond an age of physical capability. Whether it occurs through the unauthorized churning of an investor’s account, the presentation of fraudulent financial statements, or the stealing from Peter to pay Paulâ€ found in the classic Ponzi scheme, it is right for the Service to provide investors robbed in this fashion the same relief provided other victims of theft. Unfortunately, many more situations fall outside of the safe harbor of Revenue Procedure 2009-20 than fall within it. It is incumbent upon the taxpayer taking a theft lossâ€ resulting from an investment arrangement, whether within or without the safe harbor, to be sure that the theft lossâ€ deduction is well supported.
The court in Edwards v. Bromberg, 232 F. 2d 107, articulated the most frequently cited definition of theftâ€ for purposes of § 165. The Bromberg court’s broad definition of theft, intended to cover and covering any criminal appropriation of another’s propertyâ€ is still cited. Even the Service continues to cite the broad Bromberg definition of theft.â€ Yet, in application, there are seemingly illogical inconsistencies that suggest a hostility to providing a theft loss deduction to investors who have been victimized by fraud committed by the principals of companies in which they invested, but with whom they did not deal directly.
For example, in DeFusco v. Commissioner, 38 T.C.M. 920 (CCH 1979), the Tax Court held (and the IRS agreed) that the taxpayer suffered a theft loss with respect to stock acquired through an employee stock option plan offered by his employer, Equity Funding, a publicly traded company. Following the bankruptcy of Equity Funding, its officers were criminally charged with filing false statements and securities fraud under federal law for reporting non-existent assets and income. Even though the taxpayer resided in California, and the company officers were criminally charged under federal law and not under the Penal Code of California, the Tax Court found that the facts and circumstances supported theft loss treatment as to the stock acquired through the Equity Funding’s employee stock option plan.
The taxpayer, however, purchased only a small percentage of his Equity Funding stock through the Company’s employee stock option plan. The bulk of his Equity Funding stock was purchased on the open market. As to this stock, the Tax Court upheld the Service’s denial of theft lossâ€ treatment, reasoning that the state’s criminal theft statute required that there be an appropriation by the defrauder of the victim’s property.â€ This misappropriation by the defrauder of the victim’s property could only occur, concluded the Tax Court, if there was privity between the taxpayer and the defrauder as to the stock purchased. Finding no privity between the Equity Funding officers and the taxpayer with respect to the stock the taxpayer purchased on the open market, the Tax Court refused to find a theft,â€ notwithstanding that the taxpayer relied on the same fraudulent representations of the Equity Funding officers with respect to both the stock acquired through the Company’s employee stock option plan and the stock acquired on the open market.
The imposition of a privity requirement originates from the Service’s and the courts’ interpretation of the specific intentâ€ prerequisite for criminal theft, appropriation of another’s property by false pretenses, and other conduct amounting to theft under the law of many states. If there is no privity between the defrauded investor and the defrauder, reason the courts, then the defrauder could not have specifically intended to defraud the investor. This constrained approach is illogical when the investor can show reliance on fraudulent representations and omissions of the issuer of the securities in purchasing the securities, even though the securities are purchased on the open market.
In fact, in some cases, it is clear that the court denied theftâ€ characterization only after analyzing whether the evidences supported the taxpayer’s reliance on the criminal conduct of the defrauders in purchasing the securities. In Paine v. Commissioner, 63 T.C. 736 (1975), the Tax Court denied theft loss treatment for shares in Westec Corp. purchased by the taxpayer on the open market. Subsequent to the taxpayer’s purchase, the principal officers and employees of Westec were indicted for violations of federal securities and mail fraud statutes for falsely representing acquisitions, transactions, and revenue growth with respect to the company. Bankruptcy followed. The taxpayer argued that Westec’s fraud caused him to purchase the Westec stock at artificially-inflated prices, thereby constituting a theft to that extent.
The Paine Court noted the lack of privity between the taxpayer and the Westec officers and employees, as well as the corresponding lack of specific intent on the part of the perpetrators to defraud Mr. Paine in particular. More troubling for the taxpayer, however, was the taxpayer’s inability to present evidence establishing that his Westec purchases were induced by the misrepresentations of the Westec officers, an element of theft by false pretenses under the applicable Texas law. Because the record contained no evidence of when the stock was purchased, it was impossible to determine whether the misrepresentations were made before the taxpayer purchased the stock. The absence of any evidence establishing what portion of the loss was attributable to the fraud also led to the denial of theft loss treatment.
Even if the decline in value were known, it would be impossible on the record of this case to estimate the specific portion of the decline attributable to the illegal activities of the corporate officers . . . as opposed to the decline that might be attributable to business risks.
The foregoing analysis raises the question whether the Tax Court in Paine would have found privity had the taxpayer been able to prove the amount of loss due to the fraud and that he relied upon the fraudulent representations prior to purchasing his Westec stock.
The Tax Court in DeFusco recognized that the taxpayer suffered a financial disaster.â€ The Equity Funding losses nearly wiped out the taxpayer’s entire life savings. The Court was willing to consider disasterâ€ treatment, i.e., treatment as a theft under IRC § 165(c), only for those losses resulting from the stock acquired through the employee stock option program. Yet, the same fraudulent representations were made as to both the stock optionâ€ stock and the open marketâ€ stock. The same losses were incurred for both the stock optionâ€ stock and the open marketâ€ stock. The only difference was in the form taken by the taxpayer’s purchase of the Equity Funding stock.
The result in DeFusco is at odds with the directive found in the Treasury Regulations promulgated under IRC § 165 which provides that [s]ubstance and not mere form shall govern in determining a deductible loss.â€ While a substance over formâ€ doctrine as to the tax treatment of transactions has been used against taxpayers by the Service and recognized by the courts since the Supreme Court’s decision in Gregory v. Helvering, 293 U.S. 465 (1935), taxpayers have not been as fortunate in their attempted use of this doctrine. Instead, taxpayers, once having chosen the form of their transaction, are generally stuck with the tax consequences of the chosen form. Nonetheless, there are instances in which the taxpayer has prevailed by using a substance-over-form argument.
For example, in Estate of Durkin v. Commissioner, 99 T.C. 561, 575 (1992), the Tax Court stated that [r]esort to substance is not a right reserved for the Commissioner’s exclusive benefit, to use or not use â€“ depending on the amount of tax to be realized.â€ Courts have recognized taxpayers’ right to use substance over form in the absence of dishonesty, inconsistency in tax treatment, and unjust enrichment. In the context of theft losses, there is no taxpayer dishonesty, no unjust enrichment (theft losses are not deductible if they are reimbursed through insurance or otherwise), and little opportunity for inconsistent tax treatment. There are only individuals who suffer some calamity as the result of someone else’s criminal conduct.
The Tax Court in Vietzke v. Commissioner, 37 T.C. 504 (1961), looked at the substance of what occurred and found a theftâ€ of monies invested by the taxpayer in a company established by perpetrators of a fraud. The perpetrators, also the principals of the company, proceeded to use the company’s funds for their own personal use. Rejecting the Service’s contention that the theft was actually from the company and not the taxpayer, the Tax Court found as follows:
While the parties disagree as to whether . . . [the company] ever came into existence as a corporate entity, whether it did or not is unimportant in this case. . . Respondent’s regulations under section 165 provide, in part: â€˜Substance and not mere form shall govern in determining a deductible loss.’ Sec. 1.165-1(b), Income Tax Regs. The shell of the corporation cannot cast a shadow so deep that the true purposes of . . . [the perpetrators] are hidden from the light of judicial scrutiny. The corporate entity was the device . . . [the perpetrators] used to route the subscribers’ money into their pockets.
The Service’s position, in Vietzke was, in effect, a privityâ€ argument. The Service argued that the theft did not occur directly from the taxpayer but, instead, through the corporation. The Tax Court rightfully declined to elevate the form of the transactions above what occurred in substance, i.e., the monies invested in the company by the taxpayers were wrongfully used to enrich the principals of the company.
The Tax Court, in Vietzke, recognized that a company can be wrongfully used to enrich its principals and that such use constitutes a theftâ€ from investors. Despite this recognition, neither the Service nor the Tax Court has applied this principle to investments purchased on the open market, even when the companies’ principals or executives have intentionally misrepresented the companies’ financial conditions for the purpose of maintaining an inflated stock value and enriching themselves. The reasoning for precluding a theftâ€ characterization in all cases in which the investor purchases the security on the open market is weak.
For example, the facts in the WorldCom debacle are similar to those in Vietzke, which included the use of a company by the company’s principals to enrich themselves at the cost of the company’s investors. In the case of WorldCom, numerous investigative bodies concluded that WorldCom’s CEO, Bernie Ebbers, its Chief Financial Officer, Scott Sullivan, and certain other of its executives and officers engaged in fraudulent omissions and misrepresentations of the WorldCom’s financial condition in order to enrich themselves by keeping the value of the stock artificially high. The Special Investigative Committee of the Board of Directors of WorldCom, newly appointed following its bankruptcy filing, drew the following conclusions.
From 1999 until 2002, WorldCom suffered one of the largest public company accounting frauds in history. As enormous as the fraud was, it was accomplished in a relatively mundane way; more than $9 billion in false or unsupported accounting entries were made in WorldCom’s financial systems in order to achieve desired reported financial results. . . . Most of WorldCom’s people did not know it was occurring. Rather, the fraud occurred as a result of knowing misconduct directed by a few senior executives . . . , and implemented by personnel in its financial and accounting departments in several locations. The fraud was the consequence of the way WorldCom’s Chief Executive Officer, Bernard J. Ebbers, ran the Company.
. . .
Ebbers presented a substantially false picture to the market, to the Board of Directors, and to most of the Company’s own employees. At the time he was projecting, and then reporting, continued vigorous growth, he was receiving internal information that was increasingly inconsistent with those projections and reports. . . . Ebbers was aware, at a minimum, that WorldCom was meeting revenue expectations through financial gimmickry. Yet, he . . . failed to disclose the existence of these devices or their magnitude.
. . .
The fraud was implemented by and under the direction of WorldCom’s Chief Financial Officer, Scott Sullivan. As business operations fell further and further short of financial targets announced by Ebbers, Sullivan directed the making of accounting entries that had no basis . . . in order to create the false appearance that WorldCom had achieved those targets.
That Committee also found as follows:
[Policy] was disregarded in connection with a transaction in which Ebbers agreed to sell three million shares of WorldCom stock on September 28, 2000. The sale occurred less than 30 days before an earnings announcement, in violation of a policy Ebbers himself had circulated just a few months earlier. Moreover, there is compelling evidence that this sale took place while Ebbers was in possession of significant nonpublic information about a downturn in revenue growth and about proposed actions that could have a negative impact on WorldCom’s stock price.
In sum, the evidence in WorldCom supported findings that Ebbers, Sullivan, and certain other WorldCom officers knowingly, intentionally, and criminally falsely represented WorldCom’s financial condition to keep the value of the stock artificially high, crimes for which the foregoing individuals received prison sentences. They criminally enriched themselves, through use of WorldCom, at the expense of public investors; yet, because these public investors purchased their WorldCom stock on the open market, in the Service’s view, these public investors would not be the victims of a theft entitled to a theft loss deduction under IRC § 165.
The Service’s position on the use of a theftâ€ characterization for open market transactions is unambiguously articulated in IRS Notice 2004-27, 2004-16 IRB (March 25, 2004). The holding of that Notice reads as follows:
IRS won’t allow Code Sec. 165; loss deduction equal to decline in market value of stock that may have been caused by fraudulent accounting practices or misconduct of corp. officers. Only deduction allowed under Code Sec. 165(a); is for completely worthless stock; decline in value of stock isn’t allowable until year in which loss is sustained through sale or exchange of stock. Code Sec. 165(f); states that losses from sales and exchanges of capital assets are capital losses and thus allowed only as permitted in Code Sec. 1211; and Code Sec. 1212.
In short, if a company’s principals or executives, through fraudulent or other wrongful conduct, may have caused a decrease in the value of stock purchased on the open market, the purchaser cannot characterize the decrease in value as a theftâ€ under Section 165.
In support of its position in IRS Notice 2004-27, the Service cited Treasury Regulation 1.165-4(a) which provides, in part, as follows:
No deduction shall be allowed under section 165(a) solely on account of a decline in the value of stock owned by the taxpayer when the decline is due to a fluctuation in the market price of the stock or to other similar cause.
(Emphasis added.) That regulation, however, expressly addresses only those situations where the decline in value is caused by fluctuations in market price. The regulation does not address those situations where the decline in market price is caused by intentional, criminal malfeasance of a company’s principals that would amount to a theft under the law of the applicable jurisdiction.
To get to its seemingly blanket prohibition on theft lossâ€ characterization for investments purchased on the open market, the Service, in Notice 2004-27, simply concludes that the courts have consistently disallowed theft loss deductions relating to a decline in the value of the stock that was attributable to corporate officers misrepresenting the financial condition of the corporation, even when the officers were indicted for securities fraud or other criminal violations.â€ Yet, even the Paine v. Commissioner case cited by the Service in Notice 2004-27, a case that involved criminal misrepresentations of the financial condition of a publicly-traded company by its principals, fails to support the Service’s conclusion.
Initially, the Paine Court pointed to the difficulty the taxpayer had in satisfying the specific intentâ€ requirement of the applicable state law’s concept of theft,â€ requiring that the perpetrator have the specific intent to appropriate the victim’s property. Presumably, if the taxpayer could have proven that the perpetrators’ specifically intended to enrich themselves at the expense of the investors in their publicly-traded company, the taxpayer would have been able to satisfy this element. Thus, it was not the existence of the transaction on the open market, per se, which precluded a theftâ€ characterization, but the inability to prove that the taxpayer was among the perpetrator’s intended victims.
Also troubling to the Paine Court was the taxpayer’s inability to prove that he relied upon the fraudulent misrepresentations when he acquired his stock on the open market and what portion of the decline in value of the stock was due to the fraudulent representations.
[I]t is well settled that when a theft is accomplished through false representations, the false representations must have induced the injured party to part with his property. Petitioner has not only failed to produce evidence that he relied on the misrepresentations, but has also failed to show that his loss was related to those misrepresentations. To establish a causal connection between the fraudulent representations and petitioner’s purchase, the representations must have been made prior to the purchase. Since the record contains no evidence indicating when the stock was purchased, it is impossible to determine whether the representations were made before or after petitioner’s purchase.
Finally, the deduction must also be denied because the petitioner has failed to produce any evidence regarding the amount of the loss. . . Even if the decline in value were known, it would be impossible on the record of this case to estimate the specific portion of the decline attributable to the illegal activities of the corporate officers petitioner describes as â€˜theft,’ as opposed to the decline that might be attributable to business risks, market decline, poor or derelict management . . . .
What is missing from both the holding and the analysis of the Tax Court in Paine is any hint of a per se prohibition on characterizing the loss of money invested by purchasing stock on the open market as a theftâ€ regardless of the circumstances.
Similarly, in MTS International, Inc. v. Commissioner, 169 F. 3d 1018 (6th Cir. 1999), the other significant case cited by the Service as support for its position, there is neither a holding nor an analysis concluding with a per se ban on theftâ€ characterizations for stock purchased on the open market. Instead, as in Paine, the court pointed to the lack of evidence establishing the taxpayer’s reliance on the fraudulent misrepresentations in denying a theftâ€ characterization, stating as follows:
Given . . . [the taxpayer’s] concession that he did not believe that the information received . . . was truthful, it would be illogical to find that . . . [the taxpayer] relied upon that information in making a significant investment.
. . . Such reliance is a necessary element of theft by deception under . . . [the state] law.
The court’s denial of theft loss treatment, then, was not based on the existence of a purchase on the open market; rather, the court’s denial was based on the taxpayer’s inability to satisfy the relianceâ€ element of the law of the jurisdiction’s concept of theft.â€
Lastly, in Jensen v. Commissioner, 66 T.C.M. (CCH) 543, 1993 WL 325102 (1993), the Tax Court articulated what is perhaps the strongest repudiation of a per se privity requirement. In Jensen, the Tax Court rejected the Service’s position that the taxpayers were not entitled to a theft loss deduction for monies invested in a Ponzi scheme through a friend who acted as a broker with respect to the taxpayers and other investors in the scheme, stating as follows:
We find, as a factual matter, that petitioners were investors in . . . [the Ponzi scheme]. There is no requirement that an investor have direct contact with the entity in which he is investing. It is not uncommon for investors to deal only with their brokers and never have direct contact with their investments. In such cases, the brokers act as conduits for the investors’ funds. The record in the case before us indicates that . . . [the broker’s role] in the . . . [Ponzi scheme] was that of a broker; he was clearly acting as a conduit for his clients’ funds. All of the parties involved, including . . . [the perpetrators of the Ponzi scheme], understood that the funds that . . . [the broker] provided to . . . [the Ponzi scheme] were not merely . . . [the broker’s] funds but were also his clients’ funds.
The Service had argued that the taxpayers were not entitled to a theft loss deduction, contending that they only had direct contact with the broker and thus invested with the broker and not the Ponzi scheme. The Tax Court unambiguously rejected a requirement of direct contact.
As the foregoing cases and cited Treasury Regulation illustrate, open market purchases of stock in companies whose principals criminally misrepresent the companies’ financial condition or otherwise criminally use the companies to enrich themselves, create problems of proof with respect to intent, reliance, and causation. They, however, do not logically support a per se ban on theft lossâ€ treatment for investments purchased on the open market based on the lack of privity between the investors and the investment or fraud perpetrators. In the context of open market transactions, issues of intent, reliance, and causation should not bar a theft loss deduction provided the taxpayer has established some causal connection between the securities fraud and the loss in value of his investment. Difficulties in proof surely will exist. These difficulties, however, should not deny the taxpayer the right to a lawful ordinary, theft lossâ€ deduction for a loss caused by the criminal wrongdoing of another.
IRC Section 165(a) articulates the general rule for the timing of a deduction for losses allowable under Section 165, permitting a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise.â€ Under the general rule applicable to all losses deductible under Section 165 (i.e., certain business losses, certain investment losses, and certain casualty and theft losses), a loss is sustainedâ€ when it is evidenced by closed and completed transactions and when it is fixed by identifiable events. For example, the dousing of a fire pretty much fixes the event of a casualty loss resulting from a fire. However, in the case of theft losses resulting, for example, from fraud or embezzlement, often the loss is not discovered until long after the perpetrator has successfully misappropriated the victim’s property.
Because a loss allowable as a deduction under Section 165 is allowable only for the taxable year in which . . . [the loss] is sustained,â€ accurately determining the year in which the loss is sustained is crucial. For this reason, in 1954, Congress enacted IRC § 165(e) to provide that any loss arising from theft shall be treated as sustained during the taxable year in which the taxpayer discovers the loss.â€ Prior to the enactment of IRC Section 165(e), taxpayers were denied theft loss deductions for thefts that were not discovered until years after the actual theft or embezzlement. By then, the running of the statute of limitations for amending the victim’s tax return for the year in which the theft or embezzlement or fraud occurred precluded the taxpayer from ever taking the loss.
Section 165(e), providing that a theft loss is sustained in the year it is discovered, however, does not trump the requirement under Section 165(a), which includes consideration of prospects of recovery.â€ That is, the Service will not allow the deduction of a loss if the taxpayer is pursuing recovery or reimbursement of the loss from other sources. For theft losses, then, a loss is sustained when it is discovered. Even after discovery of the loss, however, it is not sustained if there is a claim for reimbursement as to which there is a reasonable prospect of recovery. If the loss (or a portion of the loss) is subject to a claim with respect to which there is a reasonable prospect of recovery, then the loss (or that portion of the loss) is not sustained until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.â€
The applicable Treasury Regulation provides verbatim as follows:
A loss arising from theft shall be treated under section 165(a) as sustained during the taxable year in which the taxpayer discovers the loss. See Section 165(e). Thus, a theft loss is not deductible under section 165(a) for the taxable year in which the theft actually occurs unless that is also the year in which the taxpayer discovers the loss. However, if in the year of discovery there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, see paragraph (d) of [Treasury Regulation] § 1.165-1.
Treasury Regulation § 1.165-1, in turn, provides in pertinent part as follows:
If . . . there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained . . . until it can be ascertained with reasonable certainty whether or not such reimbursement will be received.
In short, the following two questions must be addressed following discovery of a theft loss: (1) Is there a pending claim with a reasonable prospect of recovery as to some or all of the loss?; and (2) When can it be determined, with reasonable certainty, what the amount, if any, of the reimbursement will be as to some or all of the loss?
If there is no claim with a reasonable prospect of recovery in the year of discovery of the theft loss, then the year of discovery is the year of the deduction. If, however, there is a claim with a reasonable prospect of recovery, then the proper year of deduction is the year in which it can be determined with reasonable certainty that the loss is non-recoverable, a determination which can be made partially in one year and partially in another year if the reasonable certainty testâ€ is not satisfied in one year as to all of the loss. The questions of whether there exists a claim with a reasonable prospect of recoveryâ€ and when a recovery, if any, will be forthcoming as determined with reasonable certaintyâ€ are, unfortunately, highly fact-intensive issues. They are, nonetheless, very important issues to get right.â€
A mistimed loss deduction may become a permanently lost deduction if the proper year of the deduction is an earlier year and the tax return for that earlier year cannot be amended because of the application of the statute of limitations on amending tax returns. The general limitations period for filing an amended return to report an additional deduction and claim a refund of previously paid taxes is the later of three (3) years from the date the return was filed or two (2) years from the date the associated tax was paid. Accordingly, if a taxpayer discovers a theft loss in year 1 for which a taxpayer has filed or intends to file a suit or claim for recovery or reimbursement, the taxpayer will be required to postpone any deduction until the taxpayer has determined, with reasonable certainty, that some or all of the loss subject to the suit or claim is non-recoverable. If the taxpayer determines incorrectly that the loss is non-recoverable in, for example, year 6, when the loss could have been determined, with reasonable certainty, to be non-recoverable in year 2, then the taxpayer will have lost the opportunity to amend the year 2 tax return to claim the loss.
The foregoing result may sound too harsh to occur in actuality, but this was exactly the situation in which the taxpayers in Wisnewski v. United States, 79-2 USTC (CCH) ¶ 9496 (N.D. Tex. 1979) found themselves. There the taxpayers discovered a loss deductible under IRC § 165(a) in 1968, and they filed suit against the alleged perpetrator in that same year. The litigation settled by consent decree in 1972, and the taxpayers claimed their losses, which proved uncollectable, as reasonably ascertainable, in that year, 1972. In the latter part of 1975, the Service examined the taxpayers’ 1972 return and disallowed the loss, contending that the amount of the loss was ascertainable with reasonable certainty in an earlier year, 1971, a year now time-barred by the general three-year statute of limitations for amending tax returns. The court upheld the Service’s position, noting that, by 1971, the alleged perpetrator had disposed of all of his assets that were not exempt from creditors and that the taxpayers had been advised of this fact by their attorney, thereby exemplifying the importance of getting the timingâ€ issue correct.
One option for taxpayers facing uncertainty regarding the proper year of the timing of a deduction because of the pendency of litigation against the perpetrator or the collectability of a claim or judgment is to file a protective refund claim. Protective claims preserve the deduction or position of the taxpayer until the completion of events or contingencies upon which the deduction or position is based. Protective refund claims are creatures of case law and the Service has discretion in deciding how to process protective claims. If treated as such by the Service, protective refund claims have the effect of a continuing claim, thereby preserving the position notwithstanding the running of the statute of limitations on amending returns. Generally, the Service will delay acting on the protective claim, thereby preserving its status as a continuing claim until the pending litigation or other contingency is resolved.
- The Totality of the Facts and Circumstances Govern Reasonable Prospect of Recoveryâ€ and Reasonable Certaintyâ€ Tests.
There is little guidance in the treasury regulations promulgated under IRC § 165 concerning the facts and circumstances relevant to the determination of whether a reasonable prospect of recovery exists and at what point it can be determined, with reasonable certainty, what the amount, if any, of the recovery will be. The guidance in the regulations is as follows:
Whether a reasonable prospect of recovery exists with respect to a claim for reimbursement of a loss is a question of fact to be determined upon an examination of all facts and circumstances. Whether or not such reimbursement will be received may be ascertained with reasonable certainty, for example, by a settlement of the claim, by an adjudication of the claim, or by an abandonment of the claim. When a taxpayer claims that the taxable year in which a loss is sustained is fixed by his abandonment of the claim for reimbursement, he must be able to produce objective evidence of his having abandoned the claim, such as the execution of a release.
At least the foregoing guidance is some guidance, even though the examples of facts giving rise to a determination with reasonable certaintyâ€ of no recovery seem fairly obvious. The settlement or adjudication of a taxpayer’s pending litigation to recover a theft loss from the perpetrator allows for a determination of the amount of the unrecoverable loss with enough certainty to allow for a deduction. A taxpayer’s release or abandonment of a pending claim does likewise.
Less obvious are those situations where a court has appointed a receiver or trustee with respect to the assets of the perpetrator of the fraudulent scheme. A case in point is Kaplan v. United States, 2007 WL 2330841 (M.D. Fla. Aug. 15, 2007), a case in which the taxpayers, a husband and wife, lost millions of dollars in a Ponzi scheme. As previously discussed, for victims of certain Ponzi schemes that elect and qualify for the safe harbor treatment of Revenue Procedure 2009-20, the timing issuesâ€ associated with determining the year in which the losses are deductible are mostly moot. The safe harbor applies fixed percentages of 75% or 95%, depending upon the existence of certain claims for recovery, to the qualifying losses to arrive at the amount deductible in the year of discovery of the loss, as defined in the Revenue Procedure. For cases falling outside the safe harbor, Kaplan illustrates the frustration associated with application of the timing issues.â€
The perpetrator in the Kaplan case ran a Ponzi scheme from 1986 until May of 2001. The taxpayers in Kaplan invested over $5 million with the perpetrator from 1992 through October of 2000. Prior to discovery of the Ponzi scheme, the Kaplans reported on their tax returns millions more in income purportedly earned (but not distributed) on the monies they had invested. Income such as that purportedly earned by the Kaplans on their monies invested is often referred to as phantom incomeâ€ in the context of Ponzi schemes. In 2001, the perpetrator filed for bankruptcy. In 2002, the perpetrator pled guilty to fifteen felony counts and admitted to operating a Ponzi scheme.
Had the safe harbor been available to the. Kaplans, the year of the deductibility of their resulting theft losses would have been 2002, the year in which the perpetrator pled guilty to conduct that would have constituted theft under the law of the state where the conduct occurred. Instead, the taxpayers were left to pick a year for the deduction seemingly reasonable based on all of the facts and circumstances. They settled on their 2001 tax year as the year in which to claim the theft losses.
At first glance, 2001 might appear to be a reasonable year in which to claim the loss, given that the perpetrator filed bankruptcy in 2001. In fact, as to the year 2001, the taxpayers presented the interim report of the bankruptcy trustee estimating that the recovery for creditors would not exceed 21%. The court, however, disagreed with the Kaplans’ choice, concluding that the bankruptcy trustee’s 2001 interim report did not rise to the level of a determination with reasonable certainty, stating as follows:
[T]he trustee stated in the report that the estimated recovery of 20.92% was not his estimate for final recovery, because there were a number of unresolved factors that could either increase or decrease that final estimate. Therefore, at best, the trustee’s report shows that the amount that Plaintiffs would not be able to recover was unknown, and thus, could not be determined with reasonable certainty as of December 31, 2001.
Thus, after years of court and administrative proceedings, the Kaplans learned that their theft lossâ€ deduction was not quite ripe.
The Kaplans’ disappointment was not over. The court also addressed their claim for a theft loss for the income purportedly earned on their investment, i.e., the phantom income.â€ This incomeâ€ was reinvested and thus not distributed to them. They did, however, report the incomeâ€ on their tax returns over the years, and they did pay taxes on the income.â€ The Service argued that there was no â€œincomeâ€ because the investment was a Ponzi scheme and there was thus no income to steal. The court agreed with the Service, notwithstanding that the taxpayers produced an IRS Memorandum addressing this particular Ponzi scheme that concluded that investors who reported income, dubbed â€œphantom income,â€ could take a theft loss for that â€œphantom incomeâ€ under certain circumstances.
The Kaplan case underscores the benefits of the clarity recently received from the Service for victims of certain Ponzi schemes. The safe harbor of Revenue Procedure 2009-20 eliminates the guess work associated with determining when most of the theft loss is deductible. The safe harbor includes â€œphantom incomeâ€ in the calculation of the theft loss. And, even as to those taxpayers who do not elect the safe harbor treatment, the Revenue Procedure recognizes the right of taxpayers to amend prior returns to remove the â€œphantom incomeâ€ and claim refunds of associated tax paid, or, if the prior year is closed by application of the statute of limitations, to include the â€œphantom incomeâ€ in the principal amount of any theft loss allowable in a later year.
Despite the poor result for the taxpayers in Kaplan, the Kaplan case and other cases are replete with language that suggests that the taxpayer need not be an â€œincorrigible optimistâ€ with respect to determining when a loss is really lost.
[H]ence, claims for recovery whose potential for success are remote or nebulous will not demand a postponement of the deduction. The standard is to be applied by foresight . . . [W]e do not look at facts whose existence and production for use in later proceedings was not reasonably foreseeable as of the close of the particular year. Nor does the fact of a future settlement or favorable judicial action on the claim control our determination, if we find that as of the close of the particular year, no reasonable prospect of recovery existed.
Courts also recognize that â€œwhere the financial condition of the person against whom a claim is filed is such that no actual recovery could realistically be expected, the loss deduction need not be postponed.â€
For example, in Jensen v. Commissioner, 66 T.C.M. (CCH) 543 (1993), the Tax Court rejected the Service’s position that the taxpayers were premature in deducting a theft loss resulting from investment in a Ponzi scheme because they had filed a claim in the bankruptcy proceeding of the broker through whom they invested. Neither the broker’s bankruptcy estate, with which the taxpayers filed a claim, nor the bankruptcy estate of the Ponzi scheme perpetrators, with which the taxpayers had not filed a claim, had assets sufficient to pay the millions of dollars owed the many investors. Noting an earlier decision, the Tax Court stated:
Although we held in Huey v. Commissioner, that the filing of a lawsuit creates an inference of a reasonable prospect of recovery, we conclude that petitioners filing of a proof of claim in the bankruptcy case here does not lead to the same inference. Filing the proof of claim in the bankruptcy estate was merely a ministerial act that did not require the same degree of effort as pursuing a lawsuit.
Thus, the court gave little weight to the taxpayers’ claim in the pending bankruptcy.
The Jensen Court did not address the evidence upon which it relied in concluding that the year in which the taxpayers took their theft loss, 1984, was the correct year. The court did note that the bankruptcy estate of the Ponzi scheme perpetrator was converted from a Chapter 11(reorganization) to a Chapter 7 (liquidation) in early 1985 and that the broker’s bankruptcy petition in early 1985 was in Chapter 7 (liquidation). One of the pertinent differences, then, between the result in Kaplan and the result in Jensen appears to be the rapidity with which the available sources of recovery were to be liquidated in bankruptcy.
In circumstances where the perpetrator of the fraud has filed a Chapter 11 bankruptcy petition, a reorganization consistent with ongoing operations, postponement of the theft loss deduction beyond the year of discovery is the more likely rule. In Premji v. Commissioner, 98-1 USTC (CCH) ¶ 50,218 (10th Cir. 1998), the court, in an unpublished opinion, upheld the Tax Court’s denial of theft losses taken in the year 1990. The taxpayers in question invested in a corporation that filed for Chapter 11 bankruptcy in 1990, the year in which they claimed they were entitled to take the associated theft loss. In 1990, however, the corporation’s principal was assuring investors, including the taxpayers, that the corporation would emerge as a viable entity and the bankruptcy schedules reflected that the corporation had assets in excess of liabilities.
In 1991, the court-appointed bankruptcy trustee determined that, in reality, the corporation had been used to perpetrate a Ponzi scheme and that its assets were less than its liabilities. The trustee then filed lawsuits to set aside preferential and fraudulent transfers, recovering, by 1995, over $8 million and expecting, at that time, to recover $14 million more. The court therefore upheld the Tax Court’s conclusion that the taxpayers had a reasonable prospect of recovery in 1990, thereby denying the taxpayers’ deduction for the tax year 1990.
The court did not suggest the year in which the taxpayers might rightfully claim all or some of the loss as without a reasonable prospect or recovery, other than to repeat the often-repeated, sometimes-seemingly-contradictory guidelines articulated by the courts, paraphrased as follows: 
- Bona fide claims for recoupment filed against third parties with a substantial possibility of success constitute a reasonable prospect of recovery, but the taxpayer is not required to be an â€œincorrigible optimist;
- The standard for determining whether a reasonable prospect of recovery is primarily an objective one to be applied at the close of the taxable year in which the deduction is claimed, but the taxpayer’s subjective beliefs at the close of that taxable year are not to be ignored.
Even the â€œsubstantial possibility of successâ€ guideline for recovery by litigation is muddied by language in other decisions noting that â€œ[e]ven a small chance of success might make the pursuit of legal remedies objectively reasonable, especially when the stakes are high.” And, this guidance is counterbalanced by the notion that â€œa theft loss deduction â€˜need not be postponed where the financial condition of the party against whom the claim is filed is such that no recovery could be expected.’â€
- Shifting the Burden of Proof on the Issue of â€œTimingâ€ of the Theft Loss Deduction to the Service Under IRC § 7491.
Unfortunately, outside of the safe harbor of Revenue Procedure 2009-20, there is no bright-line test for determining the correct year for deducting a theft loss, whether associated with a fraudulent investment scheme or other form of theft, larceny, embezzlement, or guile. The burden of proof is, nonetheless, on the taxpayer as to the issue of the â€œtimingâ€ of the deduction, as it is with respect to whether the investment loss qualifies for â€œtheft lossâ€ treatment. If, however, the taxpayer produces credible evidence supporting the â€œtheftâ€ characterization and the year of deduction as the correct year, the burden shifts to the Service to prove otherwise under IRC § 7491.
â€œCredible evidenceâ€ for purposes of IRC § 7491, is evidence of a quality such that, after critical analysis, â€œthe court would find the evidence sufficient upon which to base a decision on the issue if no contrary evidence were submitted (without regard to the judicial presumption of IRS correctness).â€ Application of the foregoing standard does not require the court to accept testimony the court fails to find credible. â€œ[A] tax court â€˜is not compelled to believe evidence which to it seems improbable, or to accept as true uncorroborated evidence of interested witnesses even though uncontradicted.’â€
Under IRC § 7491, taxpayers who can only offer their own testimony regarding their subjective belief that pursuit of litigation against the perpetrator would have been useless will likely fail to shift the burden to the Service on the issue of whether there is a reasonable likelihood of recovery. Subjective belief regarding the fruitlessness of retaining an attorney will also likely fail to sustain the taxpayer’s burden, particularly when the taxpayer files suit after the year in which the deduction is taken. On the other hand, taxpayers who actively monitor the bankruptcy proceedings of the fraud perpetrator, testify as to the bleak prospects for any financial recovery, and offer other corroborating evidence of the unlikelihood of recovery from the bankruptcy estate or otherwise will have a greater chance of shifting the burden of proof to the Service.
- A Portion of a Loss Determined, With Reasonable Certainty, to be Non-Recoverable Is Deductible Notwithstanding the Existence of Pending Claims or Litigation as to the Remaining Loss.
Pursuant to the applicable Treasury Regulations, a taxpayer is not required to wait until final recovery or resolution with respect to a claim or claims before taking a theft loss deduction for that portion of the loss that is unrecoverable.
If in the year of the casualty or other event a portion of the loss is not covered by a claim for reimbursement with respect to which there is a reasonable prospect of recovery, then such portion of the loss is sustained during the taxable year in which the casualty or other event occurs.
The cited regulation then uses, as an example, the total loss of an automobile because of another’s negligence to show how a loss might be trifurcated for purposes of deductibility.
In year 1, the year of the auto accident, a total loss of $5000 occurs, which represents the taxpayer’s adjusted basis or cost in the auto. Because the taxpayer sues the driver who caused the accident, the loss is not deductible in year 1. In year 2, a judgment is received for $4,000; thus, a $1000 deduction is allowed in year 2. In year 3, it becomes reasonably certain that only $3500 can ever be collected on the judgment; thus, an additional $500 is deductible in year 3. 
Notwithstanding the direction provided by the cited regulation, the Service took a contrary position in a relatively recent case, Johnson v. United States, 80 Fed. Cl. 96, 2008-1 U.S.T.C. ¶ 50,142 (Cl. Ct. 2008), contending that the taxpayers in that case were not entitled to a theft loss deduction for any portion of their $78 million loss until all of the many lawsuits filed seeking to recover the loss had been resolved. The court rejected this position, stating as follows:
The government reads the phrase â€œno portion of the lossâ€ to mean that the regulation [Treas. Reg. § 1.165-1(d)(2)] requires that a taxpayer refrain from taking any portion of a theft loss deduction until the taxpayer had determined exactly how much of the entire loss the taxpayer will recover. . . The government’s reading . . . is not supported by the examples contained in Treas. Reg. § 1.165-1(d)(2)(ii). . . . [C]ontrary to the government’s contention, the plaintiffs were not required to wait until the total amount of recovery from every source was established to take a theft loss deduction for a portion of their loss.
Id. at 199-120. Thus, notwithstanding pending lawsuits against a myriad of third parties for recovery of portions of the losses sustained, the taxpayers were permitted to deduct that portion of the loss that was determined, with reasonable certainty, to be nonrecoverable prior to resolution of all of the pending litigation.
- The Defrauded Taxpayer or Theft Victim is Not Required to File Litigation Against the Perpetrator as a Prerequisite to Taking a Theft Loss.
An issue apparently infrequently litigated, but nonetheless pertinent, is whether a theft victim must pursue recovery from the perpetrator or other third parties prior to taking a theft loss. The answer appears to be â€œno.â€ The court in Bromberg, 232 F. 2d 107, pointedly rejected the Service’s contention that the taxpayer, a victim of swindling, could not take a theft loss until he satisfied his burden of showing that he tried, but failed, to recover his losses, stating as follows:
The statute makes no such requirement, and when the nature of the matter dealt with, thieving and thievery, is considered, it seems clear, we think, that only if there were a specific provision imposing this requirement, would a court be authorized to hold that it exists.
The treasury regulations under IRC §165 further support the lack of an obligation on the part of the taxpayer to initiate or file a lawsuit against the perpetrator or third parties for recovery of a theft loss. Treasury Regulation §1.165-1(d)(2)(i) includes in a listing of examples of possible, non-exclusive bases for determining, with reasonable certainty, that there is no reasonable prospect of recovery the release or settlement of a claim and the abandonment of a claim. Presumably, if a claim can be abandoned, a claim for recovery need not be filed. As the court in Kaplan v. U.S. stated:
â€œ[T]he mere existence of a â€˜possible’ claim or pending litigation will not alone warrant postponing loss recognition;â€ instead, â€œthe inquiry should be directed to the probability of recovery as opposed to the mere possibility.â€
Nonetheless, where there is a probability (versus a mere possibility) of some recovery, it would behoove a taxpayer to pursue recovery, given the facts-and-circumstances nature of the tests applied to determining whether there has been a closed and competed transaction for purposes of claiming a theft loss. It should also be noted that for traditional theft cases, not involving investment transactions, there is a clear, statutory requirement to file an insurance claim when the loss is covered by insurance . Under that circumstance, a timely insurance claim must be filed or the deduction of the loss will be denied to the extent covered by insurance.
The excesses of the past few years have seemingly culminated in a wave of fraudulent schemes, from Enron, to WorldCom, to Ponzi schemes and Wall Street firm debacles. Regulators have admitted to less-than-diligent enforcement of laws intended to protect public investors. Little, however, has been done to compensate the investing public who placed their trust, their confidence, and their lifelong earnings in a capital and financial system touted as the soundest in the world. Yet, many of these investors have lost their lifelong earnings to intentional fraud, whether through direct investments with the perpetrators of the fraud or through brokers who recommended the fraudulent investments, or on the open market often in reliance upon fraudulent financial statements and projections.
For these investors, deducting their losses as capital losses from investing in arrangements or companies later found to have committed fraud provides little relief. And, deducting these losses as theft losses resulting from fraud, deceit, or other forms of guile as theft under the applicable local law has been fraught with ambiguity as to the correctness of the position, particularly given the highly fact-intensive nature of the â€œtheftâ€ characterization and the timing of the deduction. Fortunately, for certain victims of Ponzi schemes, the Service has issued Revenue Procedure 2009-20, sanctioning theft loss treatment for qualifying investors in a Ponzi scheme and establishing a â€œbright lineâ€ test for determining when to take most (either 95% or 75%) of the loss as an ordinary, theft loss deduction. At the same time, the Service issued Revenue Ruling 2009-9, putting to rest the question whether theft losses in the context of investment transactions were subject to the limitations on other kinds of casualty losses.
The hope is that Revenue Procedure 2009-20 and Revenue Ruling 2009-9 are evidence of more to come in the way of a recognition by the Service of the theft-like nature of investment fraud and the right of taxpayers to treat the losses as such rather than as capital losses. Less focus on privity and more focus on the role issues of reliance, intent, and causation play in the context of investments purchased on the open market would be welcomed, as would clearer guidance on the facts and circumstances material to determining when a loss can be determined, with reasonable certainty, to be non-recoverable. Until then, outside the safe harbor of Revenue Procedure 2009-20, the characterization of an investment loss as a theft loss and the timing of the deduction of that loss will require an extraordinary degree of care. Prudent attention to supporting the characterization of the investment loss as a theft loss and the timing of the theft loss deduction with credible evidence will place the burden upon the Service to support any disallowance of the deduction under IRC § 7491.
 © Coleman Law Firm, Jeffrey P. Coleman, Esq., 581 South Duncan Ave., Clearwater, FL 33756, www.ColemanLaw.com. A portion of this chapter will be published, in substantially the same form, by The Florida Bar in a forthcoming issue of The Florida Bar Journal.
 Jeffrey P. Coleman is the President and shareholder of Coleman Law Firm, a firm established in 1997. He is also a member of the Public Investors Arbitration Bar Association (PIABA) with years of experience representing defrauded investors in securities-related arbitration or litigation and in advising them on certain tax-related issues. He can be reached at 727-461-7474 or by email at firstname.lastname@example.org. Jennifer R. Newsom is an associate attorney with Coleman Law Firm. She received her law degree, cum laude, from The University of Toledo College of Law and her Masters of Law (LL.M.) in Taxation from The University of Florida.
 Nichols v. Commissioner, 43 T.C. 842, 884-885 (1965)(emphasis added). See also Vincentini v. Commissioner, 96 T.C.M. 400 (CCH), 2008 WL 5137345, at *4 -5(Dec. 8, 2008)(â€œA violation of a Federal criminal statute may also establish that a theft occurred for purposes of section 165.â€)
 Revenue Ruling 71-381, 1971-2 C.B. 126 is obsolete as the result of Rev. Rul. 2009-09 to the extent that it finds theft losses associated with transactions entered into for profit deductible under §165(c)(3) rather than § 165(c)(2).
 Id. The taxpayer in Vincentini, 2008 WL 5137345 lost on the issue of the timing of his â€œtheft lossâ€ deduction. He failed to establish that, in the year that he took his deduction, he was without a reasonable prospect of recovery.
 Rev. Proc. 2009-20, § 4.03. Presumably, investors who invested in Ponzi schemes through flow-through entities would be able to benefit from a pass-through of a theft loss deduction, a topic beyond the scope of this column.
 This â€œdiscovery ruleâ€ puts theft losses on par with casualty losses, as a theft loss from, for example, fraud, might not be discovered until years after the actual wrongdoing. See Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795, 808-812 (March 25, 1974).
 Excluded from the definition of â€œpotential third-party recovery,â€ are actual or potential claims against various sources of recovery, including (i) the investor’s insurance company, (ii) the Securities Investor Protection Corporation (â€œSIPCâ€), (iii) other entities or parties contractually bound to cover the loss, (iv) the perpetrators of the fraud, and (vi) receiverships or similar arrangements established with respect to the perpetrators of the fraud. Id. at § 4.10. Thus it is possible to pursue claims against the foregoing excluded sources and still deduct 95% of the qualified investment, subject to reductions for actual recovery and potential insurance or SIPC recovery.
 See also Revenue Ruling 2009-9 for issues relating to the taxpayer’s basis, the availability of a 3, 4, or 5 year net operating loss carry back for qualifying 2008 theft losses, among other related issues.
 One â€œgiftâ€ from the Service to defrauded investors who either do not elect or qualify for safe harbor treatment is the Service’s newly pronounced position on â€œphantom income.â€ â€œPhantom incomeâ€ is income reported as income by the fraudulent arrangement, but not income in reality because the monies labeled â€œincomeâ€ were derived from other investors and not from a return on the investment. If a defrauded taxpayer included the phantom income in income for purposes of federal taxes, the amount included will increase the taxpayer’s basis in the amount allowable as a theft loss. Id. at §8.02.
 See, e.g., Revenue Ruling 2009-9(â€œFor federal income tax purposes, â€˜theft’ is a word of general and broad connotation, covering any criminal appropriation of another’s property to the use of the taker, including theft by swindling, false pretenses and any other form of guile.â€); Treas. Reg. § 1.165-8(d)(providing that â€œthe term â€˜theft’ shall be deemed to include, but shall not necessarily be limited to, larceny, embezzlement, and robberyâ€).
 DeFusco, 38 T.C.M. 920. The Tax Court, nonetheless, denied the theft loss deduction as to the option stock for the year in which it was claimed based on the possibility of recovery from the claim filed by the taxpayer in Equity Funding’s bankruptcy proceeding and possible legal actions against responsible third parties.
 DeFusco 38 T.C.M. 920. The Tax Court, nonetheless, denied the loss for the year in question because the taxpayer (unlike in this case) had a reasonable prospect of recovery as to his stock. The Tax Court also upheld the IRS’s denial of a theft loss for stock the taxpayer had acquired other than through exercise of his options under his employee stock option plan with his employer, Equity Funding
 See, e.g., Paine v. Commissioner, 63 T.C. 736 (1975)(finding applicable state law to require fraudulent misrepresentations to have been made with specific intent of appropriating taxpayer’s property); Singerman v. Commissioner, T.C. Summ. Op. 2005-4 (Jan. 5, 2005)[decided under IRC § 7463(b) and thus not precedential](finding applicable state law to require intent of defrauder to obtain victim’s property for himself and, thereby, to implicitly require â€œa relationship of privityâ€).
 See Shepherd v. Commissioner, 283 F.3d 1258, 1261 (11th Cir. 2002). The reluctance to allow the use of â€œsubstance over formâ€ by taxpayers in the context of transactions stems from concerns that taxpayers will be unjustly enriched and the Service will be â€œwhipsawed between one party claiming taxation based on the form, and the opposite party claiming taxation based on the substance.â€ Estate of Durkin v. Commissioner, 99 T.C. 561, 575 (1992).
 See Taiyo Hawaii Co., Ltd. v. Commissioner, 108 T.C. 590, 602 (1997)(recognizing availability to taxpayers of substance over form, but rejecting its application to taxpayer seeking to treat debt as equity).
 Report of Investigation by the Special Investigative Committee of the Board of Directors of WorldCom, Inc., dated March 31, 2003 (â€œInvestigative Committee Reportâ€), at 1, 5, & 6 (emphasis added).
 Id. But see Electric Picture Solutions, Inc. v. Commissioner, 96 T.C.M. (CCH) 146, 2008 WL 4132050, at *2 (2008)(noting that generally a taxpayer cannot support a theft under California law for stock purchased on the open market because there is no privity between the perpetrator and the victim)(citing Marr v. Commissioner, T.C. Memo 1995-250, DeFusco v. Commissioner, T.C. Memo 1979-230)(other citations omitted).
 See Rev. Rul. 2009-9 (March 17, 2009)(noting losses from stock purchased on open market are capital losses rather than theft losses â€œbecause the officers or directors did not have the specific intent to deprive the shareholder of money or property).
 See Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795, 808-812 (1974)(finding purpose of §165(e) to neutralize discovery problems associated with theft loss and place on par with other casualty losses).
 See, e.g.,Wisnewski v. U.S., 79-2 U.S.T.C. ¶ 9496 (N.D. Tex. 1979)(finding taxpayers 1968 theft loss was improperly taken in 1972, notwithstanding that earlier year was time-barred);Korn v. Commissioner, 524 F. 2d 888 (9th Cir. 1975)(finding theft loss time-barred because taken years after year in which loss sustained pursuant to Service’s determination).
 Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795, 811 (1974)(citations omitted)(emphasis added); Vincentini v. Commissioner, 96 T.C.M. (CCH) 400, 2008 WL 5137345, at *7 (2008); Kaplan, 2007 WL 2330841, at *6; .
 See Id. (citing Jeppsen v. Commissioner, 128 F. 3d 1410, 1418 (10th Cir. 1997), Ramsay Scarlett & Co., Inc., 61 T.C. at 811, United States v. S.S. White Dental Mfg. Co., 274 U.S. 398, 402-03 (1927)).
 Note that the benefits of IRC § 7491 are available provided that the taxpayer has properly maintained required records, is able to substantiate items of income reported and deductions taken as required by the IRC, and has cooperated with requests by the Service for information.
 See Vincentini, 96 T.C.M. (CCH) 400, 2008 WL 5137345, at *7-8 (finding taxpayer’s testimony that he chose not to hire attorneys because he thought it was a waste of money and lack of testimony regarding his status under a restitution order insufficient support for the year in which the taxpayer chose to deduct his theft loss).
 See Ramsay Scarlett & Co., 61 T.C. at 812-813 (finding taxpayers’ deduction of embezzlement loss in year it was discovered unsupportable in view of taxpayers’ retention of experienced attorney for thorough study of law related to the potential filing of claims against perpetrator and third parties); Jeppsen, 128 F. 3d 1410 (finding taxpayer failed to support year in which theft loss deduction taken, given that taxpayer later retained attorney and pursued claim in securities arbitration against defendants with sufficient assets in relation to amount of claim)
 See Bubb v. United States, 93-2 USTC (CCH) ¶ 50,572, 1993 WL 476193 (W.D. Pa. 1993)(finding taxpayers’ deduction of theft loss from fraudulent investment scheme taken in year of discovery to be correct year, given testimony of taxpayers who actively monitored perpetrator’s bankruptcy proceedings, testimony of chair of creditors’ committee regarding the unlikelihood of recovery beyond a few cents on the dollar, and similar testimony from attorney for the committee of unsecured creditors).
 IRC §165(h)(4)(E).The cited section applies only to casualty losses, including theft losses, falling under IRC §165(c)(3). As previously noted, the Service took the position in Revenue Ruling 2009-9 that losses from investments are losses incurred in connection with transactions entered into for profit, which fall under IRC §165(c)(2) and, as such, they are not subject to the special limitations and rules of §165(h) governing losses falling under IRC §165(c)(3).
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